Brazil rates curves steepen as markets price in dovish central bank, rising fiscal risks

A man passes in front of Brazil's B3 Stock Exchange in Sao Paulo, Brazil

Brazilian interest rate curves steepened on Thursday to the highest in months, as traders priced in official rates being kept lower for longer and as growing uncertainty surrounding the government’s fiscal outlook pushed up longer-term yields.

The shift, which reflects traders demanding higher premiums for lending to the Treasury, came a day after the central bank kept its benchmark Selic rate at a record low 2.00% and doubled down in its pledge not to raise it for a long time.

The difference between near- and longer-term rates rose to the widest since May, when the economy and markets were mired in the worst of the COVID-19 crisis. By many measures, these spreads are now close to breaching even these historic peaks.

“The central bank is not getting the kick out of forward guidance it expected. The problem lies more on the fiscal side than the monetary side,” said Alexandre Schwartsman, former director of international affairs at the central bank.

“People are demanding higher risk premia in order to hold long-term debt instruments. Not because the market does not believe that the central bank will hold rates, but because fiscal risk is on the rise,” Schwartsman said.

The difference between January 2022 DIJF22 and January 2027 DIJF27 interest rate futures contracts rose on Thursday to 425 basis points, the highest since mid-May.

On Aug. 5, the day of the central bank’s last policy meeting when it introduced its ‘forward guidance’ strategy, that spread was 345 basis points.

On a broader measure, the Brazilian yield curve <0#BRBMK:> encompassing yields on three-month bills out to 10-year bonds was higher across all maturities on Thursday than it was the day after August’s policy meeting, especially from three years out.

The Treasury has been reluctant to refinance debt at these higher yields, opting instead to issue more short-term and floating rate ‘LFT’ notes.

This reduces funding costs in the short term because the official interest rates are at a record low. But it exposes the Treasury to any increase in the Selic rate and means it must go back to the market more often to meet long-term financing needs with short-term funding.

Essentially, this is a bet that the central bank will stick to its forward guidance pledge. But the Treasury is finding that investors are increasingly demanding higher compensation for short-term lending too.

The Treasury sold only 90.5 million reais of the 500 million reais of floating rate, three- and six-year ‘LFT’ notes at auction on Thursday, and will go back to the market on Friday.

This is by no means the first failed LFT auction this year. The Treasury’s need for cash prompted the central bank last month to give it 325 billion reais in a special move allowed if there are “severe liquidity restrictions” in funding markets that make it difficult for the Treasury to borrow or pay debt.

Treasury Secretary Bruno Funchal said at the time there had been a “very significant increase” in debt maturing in the next 12 months to 23% of the total, the main red flag of short-term financing risk.

With Brazil’s total debt stock exceeding 4 trillion reais, that would indicate more than 900 billion reais maturing in the next 12 months.

On top of the heavy refinancing load, the Treasury also has to fund a record budget deficit which the government pegs at 866 billion reais this year, and some private sector economists say will end up being closer to 1 trillion reais.

“The lack of response of markets to forward guidance reflects concerns about the fiscal outlook, as a meaningful deterioration could bring a weaker currency, inflationary pressures and the need to hike policy rates sooner than anticipated,” Barclays analysts wrote on Wednesday.

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