(Bloomberg) – Renewed worries about the risk of skyrocketing inflation appear to be at the heart of investor concerns about Brazilian assets, which were squashed after President-elect Luiz Inacio Lula da Silva unveiled some of his plans for the ‘economy.
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The so-called break-even rate on two-year inflation-linked notes, a measure of traders’ expectations for the average pace of consumer price increases over that time period, has risen by more than 1.6 percentage points since the start of October at about 6.77%. This is a period that includes the latter stages of the Brazilian presidential election, when it became more apparent that Lula was likely to defeat incumbent Jair Bolsonaro, and the aftermath of the vote.
As a leftist, during the election campaign there was always the expectation that Lula leaned more towards the idea of an increase in social spending than his rival. But since he narrowly defeated Bolsanaro on Oct. 30, Lula’s rhetoric has shifted more openly from fiscal responsibility to more spending, or “social responsibility” in the incoming leader’s words.
For some investors, that suggests echoes of the situation under former president Dilma Rousseff, who took the reins from Lula after her first term in office. She led the volatile 2014-15 period, when inflation soared above 10% and the economy contracted.
Rapid inflation has been a major concern for the country over the past couple of years as well, with runaway price hikes prompting Brazil’s central bank to raise interest rates for much of 2021 and 2022. This has placed it the forefront of global central banks in trying to tackle inflation with tighter monetary policy, and a recent easing of price pressures appears to have given policymakers some respite from having to raise rates further. However, whether this is true in the wake of increased government spending remains to be seen.
Anticipation of higher inflation has caused swap rates and local bond yields to jump on expectations that the central bank will need to keep its key rate high for longer. The short end of the curve, which less than two weeks ago implied that money officials might actually cut rates as early as March, has now erased the possibility of a reduction in borrowing costs next year.
Higher rates have a direct impact on Ibovespa stock multiples, and the benchmark Brazilian stock index is down nearly 8% since the election.
The Brazilian real, meanwhile, is caught in something of a tug of war. While higher rates potentially make it an attractive destination for traders seeking better carry, heightened fiscal concerns and inflationary impacts could dissuade foreign capital from leaving the country. The currency was the second best-performing emerging market peer on Thursday, shedding about 1.3% against the dollar.
Lula’s transition team, in its first act, proposed a tax waiver for the government to spend up to 200 billion reais ($36.5 billion) more over the next few years, regardless of the impact it could have on debt Nation’s Gross Domestic Product Report. Lula said that “the dollar will go up, stocks will go down, so be it.”
Any decline in swap rates “is now on hold for a while,” said Mario Castro, fixed income strategist at BBVA. “The problem here is the signaling the new government is providing to the markets. It’s breaking trust before you start.
–With the assistance of Felipe Saturnino.
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