Brazil’s Bleeding Real Needs Big Rate Hike, Not Just a Band-Aid

The central bank’s aggressive intervention last week saved Brazil’s real from its lowest point in almost a year. But for the currency to have any chance of avoiding a fresh drop to a record low, policy makers may need to go big and bold at their interest-rate decision this week.

Central bankers are staring down a weakening currency that’s fueling faster inflation, but also mindful that being too aggressive with their first interest-rate hike in six years could curb desperately needed economic growth. Last week, they pumped the equivalent of $3.2 billion into the market and, to traders’ surprise, did so when the currency was already gaining on the day. That’s a change of tack for policy makers who historically only step in to curb outsized losses in a bid to avoid inflation.

The strategy worked, helping the real break a four-week losing streak, while also fueling a debate on whether the interventions were aimed at easing pressure for a more aggressive cycle of rate hikes.

While most analysts predict a 50 basis point hike in the benchmark interest rate to 2.5% on Wednesday, currency traders say it would take a full percentage point to really bolster the real, already among the worst performers in emerging markets this year. The decision is one of the biggest tests thus far for central bank President Roberto Campos Neto, who took over in 2019.

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“The best course of action would be to start with an aggressive 100 basis point hike,” said Alvaro Vivanco, a strategist at NatWest Markets. But “these interventions increase the chance of only 50 basis points.”

Brazil is poised to become the first major central bank in the world to raise rates in the pandemic era, a sharp contrast to developed markets where policy makers are busy reassuring investors that borrowing costs will stay suppressed for the foreseeable future. But economists say Brazil’s unique situation means the central bank has little choice at this point.

Brazil’s Bleeding Real Needs Big Rate Hike, Not Just a Band-Aid

The real has been hit from all sides this year -- battered by the government’s spending frenzy, fears of a comeback for a former president who has turned decidedly more left wing, and a Covid toll that’s one of the worst in the world.

But investors’ desire for a rate hike isn’t only motivated by the real’s slump. If anything, its underperformance is just a glimmer of the slew of bad news that could justify higher borrowing costs.

Brazil’s inflation surged to a four-year high of 5.2% last month and bond-market forecasts for price increases are nearing the upper-bound of the central bank’s target range. The government is set to boost consumption through another round of cash handouts of as much as 44 billion reais ($7.9 billion), after doling out $57 billion last year, threatening more price pressure. This has led economists to bet on a weaker currency, faster inflation and higher interest rates, according to a central bank survey published on Monday.

Politics aren’t helping. President Jair Bolsonaro scared off investors after replacing the chief executive officer of state-oil giant Petroleo Brasileiro SA following a spat on fuel prices, raising fears of interventionism. A few weeks later, a Supreme Court judge annulled criminal convictions against former President Luiz Inacio Lula da Silva, opening room for him to run for office next year.

The Lula episode sent the real to the weakest level in 10 months before the rout eased as U.S. Treasury yields came of their highs. The central bank took advantage of investors’ increased appetite for risk assets and sold dollars even as the real was already gaining, fueling a 4.8% two-day rally in the currency. It ended the week slightly stronger at 5.56 per dollar.

Brazil’s Bleeding Real Needs Big Rate Hike, Not Just a Band-Aid

The interventions provided temporary relief, but traders say they need meaningfully higher rates to really buttress the real. NatWest’s Vivanco estimates a half-point increase will lead the real to weaken 1.2%, while a 75 basis point move would trigger a small gain of 0.3% and a full percentage point hike would boost the currency by 2.9%.

“If the central bank hadn’t intervened and then delivered just 50 basis points, the real would easily reach 6 per dollar,” said Italo Abucater, the Sao Paulo-based head of foreign-exchange trading at Tullett Prebon Brasil. “Ideally, we should end the year with interest rates around 6%, but honestly I don’t believe this will happen.”

Abucater, who also says only a hike to 3% this week would boost the real, expects the central bank to increase rates to 4.5% or 5% by the end of the year. This will likely “frustrate the market” and send the real to 6.3 or even 6.5 per dollar, he predicts. Economists surveyed by Bloomberg forecast the currency at 5.14 per dollar by the end of the year.

The real is down 7.9% this year against the dollar, the most among 31 major currencies tracked by Bloomberg. Both local and foreign investors have been increasing their short positions since the start of the year, according to local exchange B3 data. Swap rates imply a 64 basis point hike this week, up from a prediction of 32 basis points a month ago and 4 basis points at the end of last year.

The central bank “is likely to find it difficult to meet the wide-ranging rate hike expectations without jeopardizing the economic recovery,” said Melanie Fischinger, a currency analyst at Commerzbank AG in Frankfurt. “So in the near term, the big bailout for the Brazilian real is unlikely to materialize.”

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