Sovereign Macro- Weekly Latin America Market Outlook

Sovereign Macro- Weekly Latin America Market Outlook

December 13, 2021

Summary: inflationary pressures are broad and persistent in Latin America and the US. Inflation expectations are high and increasing, eliciting strong policy responses everywhere. For next week I have Mexico hiking by at least 25bp (hopefully 50), Chile by 125bp and Colombia by 50bp, this is in addition to Brazil’s 150bp last week. The inflation challenge in the US is significant particularly in goods. Headline goods reached 11.9% and core goods 9.4% and both are higher for instance than in Brazil, Chile or Mexico. Goods inflation is unlikely to recede as long as supply chain bottlenecks persist and there are no signs of progress on that front. In this week’s meeting, the FED will double the pace of tapering to 30bn per month looking to end the process in March and be ready to lift interest rates; the labor market is strong enough to justify rate hikes even early in 2022. We will also see new projections and a DOT plot which should include a minimum of two hikes for 2022 and likely three. Beyond next year, I expect the DOTS to approach a neutral of 2.5% in 2024 up from a median of 1.875%. It makes no sense to keep an accommodative policy for so long when the economy is likely to run above potential and inflation is breathing down your neck. The Fed Funds futures would have to reprice upward beyond 2023. Moreover, the most recent update from the CBO said that once the artificial sunsets are accounted for, the BBB bill would cost 4.9tn USD and add 3tn USD to the deficit over the next decade, much larger than the gimmick-riddled original that yielded a deficit of 231bn. While the inflationary impact of BBB would be much smaller than previous plans because it focuses somewhat more on investment, it will not ameliorate near term pressures. The uncertainty associated with Omicron is dissipating slowly but not fast enough to stop new mobility restrictions mostly in Europe. This will probably make the BOE pause and postpone its hike to February, joining a more cautious Bank of Canada. The meeting of the ECB will be interesting. With inflation surprising to the upside and new Covid related restrictions, the message will be difficult to craft, leave it to Lagarde. Luckily for many in EM, China is pivoting its fiscal and monetary policies to a more stimulative stance as the economy continues to slide and more liquidity is needed to absorb the impact of debt restructurings in the property sector; perhaps going long USDCNY would be a good idea. However, the medium-term growth outlook is not as rosy as the pre-pandemic years and economies in Latin America will have to implement pro-growth structural reforms to compensate weaker foreign tailwinds in a context in which government participation and debt burdens have grown significantly -pandemic or not- and now interest rates are on the rise. The old theme of debt sustainability is back in full force. Unfortunately, the resurgence of leftist and extreme leftist movements and their principles are largely incompatible with the implementation of pro-growth, pro-investment policies and a return to financial responsibility. It is always easier to spend someone else’s money. We already had a taste in Peru’s presidential election. Chile goes to the polls next weekend and the outcome is highly uncertain, but a Boric government could put the country in a dangerous financial path and threaten areas where Chile has been the model of reform, something which we saw already with the pension system saga; institutions, particularly congress, appeared weak. Colombia will be the next country to elect a president with Petro leading the polls by a mile and with a growing chance to win in a single round. Brazil will follow late in 2022 in a highly polarized environment. A “third way candidate” is a hope, but it is possible that Lula makes a comeback. The FED is only one of the many challenges facing the region in the coming year, fasten your seatbelts.

It will be a full and interesting week in Latin America. In Argentina, the program with the IMF will continue to be debated. The post mission communique excluded references to the egregious imbalance in the FX market and how to address it but stuck all the same principles that the IMF has been recommending. CFK gave a speech over the weekend warning Fernandez about yielding to the IMF and its policy recommendations thus slowing the speed of a potential agreement. I would stay away from Argentina bonds waiting for more clarity on the timing of an agreement. Bonds are already at very low levels and could be attractive if an agreement approaches. That said, it is still an open question whether whatever the country agrees to can be successfully implemented.

In Brazil we will have the minutes of the last central bank decision. I believe that the first reaction of the market to the communique was extreme, and I personally didn’t read it as hawkish. The market’s reading of the decision focused excessively on the “substantially restrictive” phrase rather than on the overall message which struck a more confident tone that the end of the tightening was now closer. I would try to take a stab at tactically receiving positions particularly in late 2023 DIs or in Jan 24s. I also like short USDBRL. Brazil will present its latest inflation report forecasts which should reflect those of last week’s decision.

The BCCH will announce its decision to hike rates, in my view by 125bp. We will see the formal projections of inflation the next day along with a new policy corridor that will obviously have to shift up. I would stay put in Chile and adjust positions after we know the result of the election over the weekend. That said, a dovish communique or decision should be met with larger USDCLP positions and steepeners. The curve is flat as a pancake.

Colombia will also announce its policy decision at the end of the week. I am expecting 50 bp, anything less than should be a trigger for steepeners and a long USDCOP position.

Tough decision in Mexico. A 25 bp decision should continue to favor 2s-10s steepeners because there is no way that the board will agree to a 50bp in their next meeting. I also like one-year Breakevens at 3.9%; inflation would be around 4.5% in my latest projections. I will pay a lot of attention to the communique but will have to discount it a bit because it will reflect a lot of ADDL’s thinking and he will not participate in the February meeting. As I said in my preview, a decision to hike 50 bp would hamstring the incoming governor to likely follow through with a faster pace. In such a scenario receiving the 1y1y looks attractive.

Jaime Valdivia

Sovereign Macro

Founder and Chief Economist

jaime.valdivia@sovereignmacro.com