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Elections loom over financial markets and economy
The Central Bank’s inability to place a R$ 2 billion bond issue prompted a
large scale sell-off in fixed income markets on 11 June, as investors
became increasingly unwilling to hold debt that matures after the 6
October nationwide elections. Mounting concerns about the possible victory
in presidential elections of the left-wing Labour Party presidential
candidate, Luiz Inácio da Silva (‘Lula’), could threaten economic policy
continuity and government’s willingness to continue servicing increasingly
high debt payments, have significantly increased risk perceptions.
Investors remain concerned that a Lula administration, rather than moving
to the political centre, would reverse economic reforms of the past eight
years by introducing protectionism and even reversing privatizations. The
benchmark Brazilian sovereign debt J.P. Morgan EMBI+ spread rose from 976
basis points to comparable US Treasury (UST) securities at the end of May
to 1,527 at the end of June. The spread widened further in the first week
of June to 1,715 basis points to the UST – the highest level since the
1999 currency devaluation and even above the spreads of country’s in
default. According to the most recent opinion polls, Lula continues to
enjoy a comfortable lead over the government’s candidate José Serra, who
with 20.5% of the vote remains well behind the 38.0% endorsement that Lula
currently enjoys.
Currency under pressure as political risk looms heavy
The desire of investors to rid themselves of Brazilian risk was reflected
in a marked deterioration of the currency, which weakened from 2.52 reais
to the US$ at the end of May to 2.84 on 28 June – an 11.3% drop in value.
The June depreciation in the currency was the strongest decline in value
observed since the devaluation in January 1999. The currency stabilised
somewhat in the first week of July to close just 0.1% weaker than at the
end of January. The Central Bank’s announcement that it intends to sell
US$ 1.5 billion in reserves to stem the deterioration throughout July,
served to bolster the real. Starting 8 July, monetary authorities plan to
intervene in exchange rate markets by selling US$ 50 million daily. This
month’s Consensus sees the real recovering lost ground throughout the year.
Currency weakening looms over inflationary expectations
The mid-June consumer price index (IBGE-IPCA 15), which covers monthly
price increases up to the 15th of every month, increased 0.3% over May,
down from the 0.4% increase in the preceding month. The June figure
lowered the annual inflation rate from 7.7% in May to 7.6% in June. The
recent deterioration in the exchange rate has raised concerns since
further weakening could pass through to domestic prices and curtail
monetary authorities’ ability to bring down interest rates to bolster
growth. With this objective in mind, the Central Bank has also decided to
raise the inflation target for next year to 4.0% from 3.25% established
earlier and to widen the +/-2% margin to +/- 2.5%. According to Consensus
data, inflation this year will continue to drop.
Persistence of market pressure could forestall further monetary easing
In its 19 June meeting, the Central Bank decided to leave the benchmark
SELIC rate unchanged at 18.5% for the third consecutive month. Monetary
officials stated that the solid economic fundamentals and favourable
inflation prospects would enable easing in the coming months but that the
short-term volatility in financial markets and the exchange rate warranted
a more cautious policy stance. Participants have not adjusted their
interest rate forecasts this month, expecting the Central Bank to lower
rates once the current volatility has subsided and bringing down the
benchmark interest rate to 17.0% by the end of the year.
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