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How much can market long-term real rates decline in Brazil? - Fixed Income Strategy

January 21, 2019

The real rate of Brazil’s long-term bonds can decline to 4.0% (or below) if the pension reform is approved.

We believe the real rate of Brazil’s long-term bonds (NTN-Bs 2045/2050) can decline to 4.0% (or below) if the pension reform is approved. The rate is now at around 4.6%, down from 6.0% in mid-2018.
 

The target at 4.0% is based on our view that Brazil’s neutral interest rate now stands in between 2.5% and 3.0% (see full report) and that the premium from the neutral to the long-end rate will likely remain below 1.0%. The first chart below compares the rate of the NTN-B 2045 to a proxy of the market’s view of Brazil’s neutral interest rate, extracted from the BCB weekly Focus survey. We built this series using the median SELIC rate expectation 5 years ahead and the median inflation expectation 5 years ahead in every point of time in the Focus survey.

This Focus survey neutral rate has a tight correlation with the market long-term rate, and the long-term rate is always running higher than the neutral rate, in line with expectations. The difference between the two rates (premium) has a historical average of 1.5% but now stands at around 0.5%. The correlation between the two rates is strong, in our view, because the Focus survey neutral rate contains substantial information. Market participants built their interest rate forecasts with inputs such as the current monetary policy rate, fiscal policy expectations, and their views on global interest rates.

The market’s view of the neutral interest rate - now at 4.1% in real terms - seems too high. The second chart below indicates that the relationship between rates and GDP growth has shifted since 2012. It suggests that a real rate near 2.5/3.0% is now consistent with GDP growth at 2.0%, close to potential. Real rates at 4.0% would be consistent with below-potential growth of 1.0%.

Pension reform approval is probably required for the market’s view of neutral rate to shift lower. The likely reason for the market to still expect higher rates over the long-term is the unsustainable public debt dynamics. Pension reform approval would ease fiscal concerns, triggering the market to lower long-term interest rate forecasts.

Going forward, if the market’s view of the neutral rate declines to 3.0% and the premium from the neutral to the long-end rate remains below 1.0%, the real rate of the NTN-B 2045 may fall below 4.0%. The third chart shows that the premium usually falls when market rates are falling and increases when market rates are increasing. If the pension reform is approved, it seems likely that the premium will remain below 1.0%.

In the table, we simulated different scenarios for the market’s view of the neutral rate, and the premium, and what these scenarios imply for the long-term real rate. We only built scenarios in which the market’s view of neutral interest rate declines. The only scenario in which the long-term rate ends up higher than the current rate (scenario 7) is if the premium increases back to its historical average and the market’s view of neutral rate declines only to 3.5%.

We continue to receive the NTN-B 2050 rate with a 21bps gain so far. The main risk to the trade is if the pension reform is not approved or gets delayed.



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