Rates 10y Dashboard: Brazil Rates Lag the Currency’s Rally

US yields dropped following Fed Chair Powell’s press conference yesterday as he pushed back against the taper talk and emphasized that the upcoming rise in inflation readings should be transitory. However, the relief did not last long as the US 10y yield rose 3 bp to 1.65% this morning, reaching the highest level in two weeks.

EM 10y rates were also broadly higher as they moved up 2 bp on average. Poland 10y (PLN 10y), Brazil 10y (BRL 10y), and Chile 10y (CLP 10y) were all up around 10 bp each.

In the case of Brazil, rates have underperformed the recent rally in the real (BRL) as the chart below shows. We had written in a note in early March that the risk premia had gone up across the board in Brazil as the currency was moving in sync with rates at the time. Now, however, the correlation between the two has dropped.

The real has rallied for a few reasons:

• The central bank (BCB) started its tightening cycle in March with an aggressive rate hike of 75 bp and indicated that another similar hike was forthcoming at the May 5^th meeting.
• President Bolsonaro reached a budget deal with Congress, breaking the previous impasse, as they agreed to exclude pandemic-related expenditures from the fiscal rules.
• The central bank has continued to actively intervene in the currency market despite the recovery.
• Rising commodity prices are supportive of the current account balance.

At first glance, the above reasons appear to justify the outperformance of the currency against rates since the budget agreement is positive for near-term growth, which is supportive of the currency, and high fiscal deficits should keep long-end rates high. However, this would be true if the currency and long-end rates were at equilibrium levels. Instead, they were at extreme levels with high risk premia priced in both. As such, any reprieve should have supported both in a similar fashion at least in the early leg of the rally.

As such, if the rally in the real is sustained, then long-end rates appear cheap in comparison. However, an outright long position in rates, or even in the currency for that matter, is risky for several reasons:

• Going into the presidential election next year, political noise is likely to rise and volatility across assets is likely to be elevated. Indeed, Brazil’s Senate has launched an inquiry this week into the government’s handling of the pandemic.
• The government has indeed bungled its response to the pandemic, prolonging the pain and keeping economic uncertainty high. Even the vaccination rollout has been a mess with the government cutting by 30% the number of vaccines to be delivered by April.
• With the election in mind, President Bolsonaro is likely to pursue populist policies which with the budget agreement increases the incentive to classify different types of expenditures to be related to the pandemic, thus exacerbating the fiscal crisis.
• While the central bank is due to raise rates at the next meeting, the curve is pricing in over 300 bp of further rate hikes by the end of the year. Inflation expectations for 2021 in BCB’s Focus Survey have now risen above 5%; this is above 4.6% in the same survey at the time of the last BCB meeting, and is considerably above the 3.75% year-end target, though just within the upper end of the target band. Any indication from the central bank that it may underdeliver on the hikes would result in a sell-off across assets, particularly the currency.

Given these risks, a better approach may be to go long rates hedged with the currency. In other words, we expect the relationship between the two assets to reassert to their prior correlation.

Data Source: Refinitiv

Best Longs / Best Shorts

• To our list of underperformers in the attached Rates 10y Dashboard pdf, we added CLP 10y following the sell-off today.
• The list already had Peru 10y (PEN 10y), Poland 10y (PLN 10y), and Mexico 10y (MXN 10y) on it.
• Our list of outperformers is currently empty.

Best Crosses

• Our list of preferred relative-value trades stayed unchanged with Receive PEN 10y vs Pay Indonesia 10y (IDR 10y) or India 10y (INR 10y) or Taiwan 10y (TWD 10y).
• The 3m expected returns for the pairs are in the range of 10-11% (not annualized), assuming mean reversion.