Brazil Central Bank Preview

(from me colleagues Dr. Win Thin and Ilan Solot)

The Brazilian central bank (BCB) announces its decision tomorrow after markets close, when markets almost universally expect rates to be increased by 50 bp to 9.00%. We side with consensus on this one.

Last week’s heavy handed FX measures by the BCB should be enough to put to rest any speculation of a hawkish surprise of a 75 bp hike.

First, because the $60 bln intervention plan seems to have improved the situation somewhat: BRL is weaker on the day, but is outperforming most other large EM countries. Second, as we noted, the new actions suggest that the bank is looking to establish some much needed predictability to policymaking.

The big question is how much more tightening is in store? The BCB's official survey shows that economists expect that rates will rise to 9.50%, and stay there for the duration of 2014. Local rates markets are pricing in substantially more hikes, but part of this has more to do with rise in yield due to risk aversion than expectation of tightening.

For our part, we think there is another 75 bp total to go, with risk skewed towards more tightening later on. The difficulty is, of course, is that the bank’s reaction function will be heavily influenced by currency moves. Policymakers are doing their best to dissociate monetary policy with FX policy, but this gets more complicated as inflation pass-through starts to become a reality.

We think that BRL can weaken further from here, but will probably start to outperform many of its peers. We already hit our year-end target for USD/BRL of 2.45. Brazil, along with the currencies most major EM countries are all at the mercy of market sentiment. But at this point, it seems as the recent action have been enough prevent help BRL outperform the currencies of most of the larger EM countries (INR, MXN, TRY, ZAR) – albeit still selling off. If sustained, BRL outperformance within a bearish EM backdrop would be enough to call the $60 bln plan a success.