Itaú BBA - The Brazilian curve bear flattens as the 100-bp cut becomes the market baseline

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The Brazilian curve bear flattens as the 100-bp cut becomes the market baseline

March 30, 2017

The Inflation Report signaled a “moderate” increase in the pace of easing, which we take to mean an increase to 100bps from 75bps.

With information available until 6:30pm Brasilia time


  • The Brazilian curve flattened in the session as the Inflation Report signaled a “moderate” increase in the pace of easing, which we take to mean an increase to 100bps from 75bps (see Macro Backdrop). In DI Futures, while the belly widened (Jan-19: +6bps to 9.49%), long yields fell (Jan-25: -2bps to 10.20%). The front end of the curve implies nearly 100bps in cuts for the April meeting and prices another 87bps in rate cuts in May. 
  • In FX, a strong dollar day as US 4Q16 consumption was revised upwardly. In LatAm FX, most currencies under our coverage depreciated. The CLP and the COP were broadly stable at 663.30/USD (+0.01%) and 2,883.78/USD (-0.07%). The MXN marginally weakened to 18.71/USD (-0.04%). The BRL was the regional laggard, depreciating 0.83% to 3.1508/USD.

Macro Backdrop

  • The March edition of the Quarterly Inflation Report reveals inflation forecasts that make room for greater interest rate cuts ahead. In the QIR, the Copom indicated that the ongoing scenario and more widespread disinflation increase the chance of a “moderate” intensification in the pace of monetary easing. Inflation estimates for 2017 are below the target in all four scenarios presented by the Copom. Forecasts for 2018, which are increasingly gaining importance in Copom discussions, are on target or slightly below it in the scenarios that consider market expectations for interest rates (specifically, 9.0% at the end of 2017 and 8.5% at the end of 2018). 
  • In summary, the IR fits the current market pricing, with authorities signaling a "moderate" increase in the pace of easing, which we take to mean an increase to 100bps from 75bps. We thus expect the Copom to cut the Selic by 200bps in April and May, in two equal installments (100bps per month). The main message in this report is conveyed by the 2018 inflation forecast under the “market scenario,” which projects inflation at 4.5% for 2018, the current inflation target – this signals that the easing cycle that drives the interest rate to 9.0% at the end of this year and to 8.5% at the end of 2018 is not inconsistent with reaching the inflation target. For the time being, we stand by our call that the Selic rate will end the year at 8.25%, but the forecasts presented in this report tilt the balance of risks for this call to the upside. Full Report
  • The central government posted a BRL 26.3 billion deficit in February, worse than market estimates (BRL -21.6) and our call (BRL -20.6). Revenues came BRL 3 billion lower while expenditures came BRL 3 billion higher than our forecast. Revenues surprise was due to higher transfers to regional governments while expenditure reflected higher payments with the unemployment insurance and annual bonus, and some payback from the very low discretionary expenditure in January.  The negative surprise doesn’t change the prospects of the central government achieving its target of a BRL 139 billion deficit in 2017. As announced by the government in the past days, extraordinary revenues, the reversion of tax exemptions and discretionary spending cuts will likely help the start of a very gradual positive reversal in fiscal accounts. The consolidated primary result for February (including regional governments and state-owned companies) will come through Friday 9 (March 31). We expect a BRL 25.7 billion deficit with a 1.5 BRL billion surplus in regional governments and a 0.3 BRL billion surplus in state-owned companies. 
  • Core retail sales disappointed, potentially affected by a revision in the methodology. The core segment dropped 0.7% m/m, below our forecast (+0.4%) and the median of market estimates (+0.5%), sustaining the declining trend seen since 1H15. Year-over-year, core sales contracted 7.0%. The revision increased weights of “fuels and lubricants” and “fabric, apparel and footwear”, while reducing weights of “supermarket sales” and “furniture and appliances”, starting in January 2017. The adjustment did not entail relevant impact on the year-over-year change in core retail sales, but may have impacted the seasonally-adjusted monthly result. All in all, even in the absence of a rebound, the quarterly change in the series suggests a smaller decline in core retail sales. 
  • Broad retail sales receded 0.2% in January. Broad retail sales (including vehicles and construction material) topped our estimates, falling 0.2% m/m, compared to our expectation and market consensus (both at -0.9%). Year-over-year, broad sales set back 4.8%. The positive monthly surprise is explained by a 0.3% increase at the margin in “auto & parts”. The methodology revision in broad retail sales increased weights of core retail and construction material in the aggregate series, while reducing the weight of the vehicle component. The impact on the series’ year-over-year evolution was limited, but weight changes probably hurt growth at the margin. Nevertheless, the quarterly change suggests the end of declines in the broad segment, which given its greater correlation with GDP, reinforces the outlook for seasonally-adjusted growth in 1Q17. 
  • In sum, we expect some recovery in retail sales in the coming months, driven by the effect of disinflation on real income and by withdrawals from inactive accounts in the FGTS employment protection fund. In 2H17, gains will depend on the stabilization of the labor market. Full Report
  • Itaú Unibanco monthly GDP (PIBIU) expanded 0.3% m/m in January. At the margin, this was the third consecutive increase in our monthly GDP proxy, but shrank 1.4% y/y. Over 12 months, the change was -4.1%. Five out of ten indexes that form our monthly GDP indicator advanced (50% diffusion). The result was driven by relevant contributions from construction materials (+2%) and agriculture (+1.7%). For February, we expect a slight increase in industrial production, in line with the main coincident indicators already released (auto production, traffic of heavy vehicles on highways, shipments of cardboard paper, among others). Along with agricultural production, these figures will contribute to a gain in PIBIU during the month. Full Report
  • BCB placed the full offering of 10,000 FX swaps. After closing, the central bank announced a partial rollover of FX credit lines on March 31. In its website, BCB stated that there are USD 4.4 billion FX credit lines expiring April 4, while up to USD 2 billion will be offered in the Friday auctions. 
  • Mexico’s Central Bank decided to hike the reference rate by 25-bps, from 6.25% to 6.50%, underscoring its commitment to keep inflation expectations well-anchored and prevent second-round effects from the shocks currently affecting domestic prices. The decision was in line with our call and the majority view, although many analysts were expecting a 50-bp hike. Earlier in March, during the presentation of the inflation report, Governor Carstens mentioned that tightening too aggressively in the short-term could be “inefficient and costly for economic activity”. In the concluding remarks of the statement, the central bank explicitly mentioned the 25-bp rate increase of the Fed as one of the reasons for the decision to hike. Looking ahead, the central bank remains focused on the same factors as before: second-round effects from the shocks affecting domestic prices, the relative monetary policy stance between Mexico and the U.S., and the output gap. Still, the board clearly took some comfort with the behavior of the currency and said that there was no additional deterioration of the balance of risks for inflation. At the same time, board members are a bit more optimistic with the economy as tail risks (U.S. trade policies) are diminishing, arguing that there was some improvement of the balance of risks for activity.
  • We read the statement as consistent with our scenario (only a couple more 25-bp rate hikes, after each move of the Fed). We see the reference rate at 7% by YE17, so Banxico would decouple from the Fed at some point. The better exchange-rate behavior, the already high level of real interest rates (above the central bank’s own estimations of neutral rate in the short to the medium-terms) and the expectation of economic deceleration all play in favor of less aggressive tightening. For 2018, provided that inflation decreases and GDP growth remains sluggish, we believe rate cuts are likely. Full Report
  • The Central Bank of Mexico announced that it will remit a MXN 321.7 billion (1.5% of GDP) dividend to the Treasury in April, which will be crucial to meet the fiscal targets set for 2017. The Central Bank dividend, which is the outcome of exchange rate gains over international reserves, has reached a record-high in 2017, surpassing last year’s MXN 239.1 billion (1.2% of GDP). In our previous Mexico Scenario Review (March), we argued that the Central Bank’s dividend would be around 1.5% of GDP, so the result is consistent with our outlook. We still expect a fiscal deficit of 2.4% of GDP and net public debt of 49.5% of GDP in 2017, respectively (down from 2.6% and 50% in 2016). The Central Bank Dividend not only boosts government revenues, but also is instrumental to lower the debt stock. In fact, the Treasury is legally bound to 70% of the MXN 321.7 billion to amortize the public debt (the remaining amount will be mainly directed to the Budget Revenues Stabilization Fund, the so called FEIP). 
  • In our view, it is likely that the Mexican government will meet its fiscal targets for 2017, potentially preventing a rating downgrade. The government is targeting a primary surplus of 0.4% of GDP, a fiscal deficit of 2.4% of GDP, and public-sector borrowing requirements (broadest measure) of 2.9% of GDP for 2017. In addition to the dividend, we believe that higher oil revenues (in spite of lower oil output) will also support revenues. Lower GDP growth and higher domestic interest rates (implying higher financial expenses), however, would have a negative impact. On the spending side, fiscal consolidation is running its course and the Finance Minister has stated that there is still some flexibility to adjust expenditures, if Mexico faces more challenging conditions to meet the targets.
  • The industrial production index fell 7.6% y/y in February (previous: -1.2%), dragged down by the 16.0% drop in mining production (previous: -2.3%). This is the largest annual mining contraction since the start of the series in 1991. Bearing in mind that the mining labor strike persisted through most of March, the disappointing activity performance will likely extend to the final month of the quarter. Meanwhile, manufacturing production declined 1.0% (January: -1.4%), better than our expectation (-3.3%) and market consensus (-2.8%). The manufacturing of chemical products and beverages (in particular that of wine, due to plant maintenance) had the most detrimental impact on activity in the month (-2.6 p.p.). Once the seasonal and calendar effects are taken into account, industrial production still shrunk 2.3% y/y, deteriorating from the 1.6% drop in January. In the quarter ending in February, industrial production fell 2.4% (4Q16: -2.0%), hampered by the 5.4% drop in mining (4Q16: -3.5%). At the margin, industrial activity improved, in spite of a large mining contraction (-8.4% q/q). Overall, industrial production rose a mild 1.1% (4Q16: -4.8%). 
  • The negative impacts of supply-side shocks, alongside uncertainty in the lead up to the presidential election in November, make a meaningful economic recovery this year unlikely. With partial information (private consumption activity to be released on April 3), we preliminarily expect the GDP proxy to have contracted around 2.0% in February from one year ago. Moreover, we expect activity growth of 1.8% this year, from the 1.6% in 2016, with higher copper prices, low inflation and falling interest rates favoring growth. Full Report

Market Developments 

  • GLOBAL MARKETS: Treasuries widened as the US GDP was revised to the upside. In the third revision, 4Q16 GDP was updated to 2.1% (from: 1.9%) on the back of stronger consumption (to: 3.5%, from: 3.0%). This is likely to boost also 1Q17 GDP tracking. For both the 5-year and 10-year tenors, Treasuries increased 4bps to 1.96% and 2.42%, respectively. Global Markets Tracker
  • CURRENCIES & COMMODITIES: Commodities were mixed as oil prices increase again (WTI: +1.78% to USD 50.39/bbl – above USD 50/bbl for the first time since March 10) and metals posted losses. In FX, a strong dollar day as US 4Q16 GDP was revised to 2.1% from 1.9%. In LatAm FX, most currencies under our coverage depreciated. The CLP and the COP were broadly stable at 663.30/USD (+0.01%) and 2,883.78/USD (-0.07%). The MXN marginally weakened to 18.71/USD (-0.04%). The BRL was the regional laggard, depreciating 0.83% to 3.1508/USD. FX & Commodities Tracker
  • CDS SPREADS & EXTERNAL BONDS: Credit spreads for the 5-year tenor fell all across LatAm. Mexican spreads decreased 2bps to 129bps. Both Colombian and Chilean country risk inched down 1bp, to 133bps and 71bps, respectively. CDS in Brazil fell 2bp to 227bps. External Bonds and CDS Tracker
  • LOCAL RATES – Brazil: The Brazilian curve flattened in the session after market reduced expectations of cuts deeper than 100bps in the coming meetings. The Quarterly Inflation Report signaled a “moderate” increase in the pace of easing, which we take to mean an increase to 100bps from 75bps (see Macro Backdrop). In DI Futures, while the belly widened (Jan-19: +6bps to 9.49%), long yields fell (Jan-25: -2bps to 10.20%). The front end of the curve implies nearly 100bps in cuts for the April meeting and prices another 87bps in rate cuts in May. For the full year, the curve sees 290-332bps in rate cuts, pending on the term premium estimate. Brazil Rates Tracker
  • LOCAL RATES - Mexico: The Mexican curve bull flattened as Banxico decided to hike rates by 25-bp (See Macro Backdrop). In TIIE swaps, the 1-year decreased 5bps to 7.09% and the 10-year fell 14bps to 7.34%. Accordingly, breakevens tightened (5-year: -4bps to 3.69%). Mexico Rates Tracker
  • LOCAL RATES – Chile and Colombia: In Chile, rates traded lower as industrial production fell in February. In Camara swaps, the 1-year inched down 1bp to 2.82% and the 10-year fell 4bps to 4.13%. Chile Rates Tracker In Colombia, rates increased in the session. In IBR swaps, the 1-year went up 2bps to 5.82% and the 10-year increased 5bps to 6.13%. Colombia Rates Tracker

Friday Events

  • In Brazil, the nationwide unemployment rate will hit the wires. We expect the unemployment rate to reach 13.1% in the quarter ended in February. Then, the BCB is releasing its monthly activity index (IBC-Br) for January. We expect a 0.1% m/m decline. Moreover, the consolidated primary budget balance for February will come through. We expect a BRL 25.7 billion deficit. Finally, the National Monetary Council will release the TJLP long term interest rate. We expect no change to the TJLP in the near future, currently at 7.5%. 
  • In Chile, the central bank will publish the minutes from the March monetary policy meeting. In the meeting, the board of the central bank cut the policy rate by 25-bp to 3.25%, in line with expectations. Also, INE will publish the national unemployment rate for the quarter ending in February. We expect to see some further evidence of labor market loosening with an increase in the unemployment rate to 6.3% from 5.9% in the equivalent period last year. 

Latam Macro Calendar

For details, refer to our Monthly Strategy Report.

Today's editors: Eduardo Marza, Pedro Correa

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