Brazilian central bank in a tough spot

Summary

We have highlighted our concerns regarding Brazil's fiscal and political situation for some time now. In short, our worries stem from the possibility of President Bolsonaro increasing social spending to rally support ahead of next year's election as well as the possibility of a return to more populist policies after the election. While these concerns started to materialize months ago, they have intensified over the last week, and we now have more conviction in our view that the road ahead for the Brazilian currency will be challenging. In addition, as Brazil's local fiscal and political dynamics deteriorate the burden of economic and currency stability will increasingly fall on the Brazilian Central Bank. To that point, the Brazilian Central Bank (BCB) is set to assess monetary policy this Wednesday, and in our view, the recent bout of currency volatility will force the central bank to lift interest rates more aggressively than its previous forward guidance suggested. However, despite a sharper interest rate hike, we doubt the Brazilian Central Bank will be able to contain politically-driven volatility in the real or stem longer-term currency depreciation and forecast the Brazilian real to hit record lows against the U.S. dollar by mid-2022.

Brazilian central bank preview

The Brazilian real has come under pressure amid President Bolsonaro's push for increased social spending. Bolsonaro's "Auxilio Brasil" proposal is designed to enhance financial support for low-income households to 400 Brazilian reais per month (~US$75) and also extend that support to millions of additional households. Brazil's fiscal balance is already in significant deficit and the sovereign's debt burden is also already unsustainable. Enhancing social support will likely add to the government's fiscal deficit and increase its debt burden, dynamics financial markets have become extremely sensitive to over the years. While Bolsonaro's proposal is still being debated and negotiated, market participants have become overly concerned that new social spending could also breach Brazil's spending cap, a constitutional stipulation limiting annual government spending to the pace of inflation. While a breach of the spending cap is not yet clear, markets have started to bake in the possibility that Brazil'sconstitutional spending limitations could be disregarded.

Politically-driven developments such as this put the Brazilian Central Bank (BCB) in an extremely difficult position. The central bank has little influence over local politics and essentially no influence over fiscal spending decisions. However, when local politics and spending dynamics deteriorate as they currently are, the burden of economic and currency stability usually falls on BCB policymakers. After the recent bout of volatility in the currency, the BCB's burden to stabilize the Brazilian real is quite heavy. In our view, there may not be many policy levers the BCB has at its disposal to stabilize the currency, especially if the constitutional spending cap does indeed get breached and if Brazil turns back to a more populist-style policymaking framework after the 2022 election. The BCB can choose to sell foreign exchange reserves and intervene in currency markets, which is a good option considering the central bank has over $330B worth of FX reserves worth close to 20 months of imports. However, selling FX reserves and BCB intervention eorts have been somewhat unsuccessful in stabilizing the currency over the last 18 months as broader market forces have placed depreciation pressure onBrazil's currency. In addition, the BCB can lift interest rates to make the currency more attractive from a yield perspective. Just this year, the BCB has used a combination of both approaches, utilizing its FXreserve stockpile and intervening in FX markets as well as lifting its Selic rate 425 bps. Despite these efforts, the Brazilian real is still 6.5% weaker against the U.S. dollar year-to-date and has proven to be one of the more volatile currencies in the world.

But, because the BCB is a credible institution, and in our view, committed to stabilizing the currency and placing inflation on a trend back toward its inflation target, we expect the central bank to take aggressive action at its meeting this week. To that point, we expect the central bank to lift its Selicrate 150 bps and take the main policy rate to 7.75% this week. A 150 bps rate hike would be a more aggressive hike than the 100 bps of tightening the BCB signaled in its forward guidance at its meeting in September. In addition, a 150 bps rate hike could provide temporary stability to the currency; however, we believe the Brazilian real will eventually resume its weakening trend and depreciate over the course of our entire forecast horizon. As of now, the USD/BRL exchange rate is hovering around the BRL5.55 level. In our view, we expect the exchange rate will move higher over the coming quarters, and we expect the currency to hit a record low of BRL5.90 by Q2-2022. We also expect the USD/BRL exchange rate to breach BRL6.00 by Q3-2022 and sustain levels above the key BRL6.00level going forward. Looking out past this week, we expect the Brazilian Central Bank to continue tightening monetary policy at its December meeting as well as raise interest rates in 2022. For now, we expect the BCB to lift its Selic rate by another 100 bps at its final meeting in December and for the Selic rate to end this year at 8.75%. As far as risks around our Selic rate forecast, we believe risks are tilted toward a quicker pace of tightening in December. Should the Brazilian real continue to come under pressure and this week's rate hike does little to stem the real's depreciation, the BCB could opt to lift the Selic rate another 150 bps to end the year.

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