A Decisive Week for Brazil

 (from my colleague Ilan Solot)

This could be a decisive week for Brazil as the toxic mix of complicated politics, worsening fundamentals and financial market stress comes to the fore.  Today, the congress is supposed to vote on whether to uphold or overturn the decision by President Rousseff to veto a sharp increase in spending.  

If the veto is overturned, it would threaten the government’s already fragile attempt at fiscal consolidation.  At this point it’s unclear whether the government will have enough support to uphold the veto, so it’s possible that they will try to delay the vote.  Still, the uncertainty over this story will be a decisive variable for Brazilian financial markets, which are at growing risk of becoming disorderly.

The Treasury and the central bank are trying to ensure that liquidity remains ample, but it may not be enough, especially the aforementioned veto is overturned.  The Treasury announced a bond buyback yesterday. This is welcome news, at least as a sign that the Treasury is ready to step up alongside the central bank to lean against the moves.  The selloff in the local market debt curve accelerated in September, with yields on swaps maturing in January 2017 rising to 15.61% from around 14.2% at the start of the month.  The growing fiscal concerns have also led to a sharp steepening of the local debt curve (see graph below), worsening sentiment locally and making the government budget funding even more difficult and expensive.

Here is a quick summary of the unfavourable profile and composition of Brazil’s internal federal debt, according to the Treasury’s July report.  Roughly 41% of debt is fixed rate; 33% is indexed to inflation; 21% is floating rate; and 5% is FX-linked.  Financial institutions hold 26% of the internal debt, investment funds hold 20%, non-residents hold 19% (of which 82% of their holdings are in fixed rate securities), and the rest is a mix of government and insurance companies.  In terms of maturity, 23% of the internal debt matures in the next 12 months and the average maturity is 4.5 years.  The average interest rate on government debt over the last 12 months is 15%.

At this point, the central bank is the closest the country has to a macroeconomic anchor, but it is being put to the test.  USD/BRL is nearly at the psychologically important level of 4.0.  The central bank announced a FX credit line auction this week to provide extra liquidity.  This may have helped, but it’s far from a decisive development, just like the decision to increase in FX swap rollover to 100% a few weeks ago.  

Rates continue to rise and are now implying several more hikes to bring rates north of 15%.  Of course, a lot of this is risk premium and a function of the dynamics of local rates.  Indeed, the central bank’s survey suggests rates on hold until the end of the year and even cuts in 2016. Although we don’t discard further rate hikes, the recent moves seem like a clear case of overshoot to us, reflecting how politically-driven stress (or even panic) in local markets can detach assets from fundamentals.  There will be a great opportunity to receive long-end rates in Brazil at some point, but we don’t think its now.

The pressure points for Brazil continue to mount and have been well documented by the media. We highlight two recent developments.  First, the impeachment process is picking up steam and we increase the odds now to 30%. Markets are unclear about whether this is a good or bad development.  We think it is decidedly negative in the short-term as it may lead to social unrest and huge uncertainty.  Moreover, the most likely new president would be the vice president from the PMDB, which doesn’t inspire much confidence. 

Second, news that telecommunications company Oi is seeking advice to improve its debt profile added to the stress on the corporate side.  The company reportedly hired Rothschild for advices amid talk that it was looking to restructure its debt.

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