Fraga-Like Rates Reversal Anticipated to Avoid 2008 Redux: Brazil Credit

Traders are betting the Brazilian central bank will lower borrowing costs as soon as October in the fastest reversal of monetary policy in 10 years to protect Latin America’s biggest economy from the global slowdown.

The yield on interest-rate futures contracts due in October fell six basis points in the past month to 12.37 percent, suggesting investors expect policy makers to cut the benchmark rate a quarter-percentage point from 12.5 percent by the meeting that month after raising it in August.

Central bankers in Turkey and Serbia have lowered borrowing costs this month as concern mounts that the European and U.S. debt crises are driving the global economy into recession. Brazilian traders expect central bank President Alexandre Tombini will respond faster than his predecessor, Henrique Meirelles, did during the global financial crisis. Meirelles raised the Selic five days before Lehman Brothers Holdings Inc. collapsed in September 2008 and waited four months to cut it.

“We see signs that the reaction this time will be different than in 2008,” Marcelo Salomon, chief economist for Brazil at Barclays Plc, said in a telephone interview in New York. “The tool that is going to be used to prevent a bigger slowdown will be interest rates.”

The last time Brazil changed course faster was 2001, when policy makers led by bank President Arminio Fraga raised the overnight rate in March after cutting it in January. In 1999, Fraga, a former hedge fund manager for billionaire George Soros, reversed direction even quicker, cutting the rate to 42 percent on March 24 after boosting it three weeks earlier to stem the real’s devaluation.
Commodities Slump

The deepening global slump is driving down commodities and curbing inflation expectations in Brazil, prompting traders to abandon calls for more rate increases.

As recently as July 15, futures showed the central bank would raise borrowing costs for the sixth time this year on Aug. 31 to bring annual inflation down from a six-year high. Tombini, who served as a director on the bank’s board for five years before taking the top spot in January, has raised the Selic 175 basis points in 2011.

The yield on the Brazilian government’s benchmark bonds due in 2021 fell 40 basis points in the past month to 12.15 percent at 8.52 a.m. New York time, according to data compiled by Bloomberg.

The Federal Reserve pledged last week to keep the benchmark U.S. interest rate near zero until at least mid-2013 because growth in the world’s biggest economy is “considerably slower” than anticipated.
‘Big Wave’

Hypermarcas SA (HYPE3), a consumer products company, expects a “big wave” of deceleration in the Brazilian economy in the second half, which will hit other industries as a “tsunami,” Chief Executive Officer Claudio Bergamo said on a conference call with analysts yesterday. The economy will grow 3.9 percent this year, according to the median forecast in an Aug. 12 central bank survey of about 100 economists, down from 7.5 percent last year, the fastest pace in more than two decades.

“If we continue on this trajectory of falling world growth, we could have a rate cut this year,” Carlos Kawall, chief economist at Banco J. Safra SA, said in a telephone interview from Sao Paulo. “The chances of a cut are rising.”

Brazil’s gross domestic product shrank 4.2 percent in the fourth quarter of 2008 in the wake of the collapse of Lehman Brothers, its deepest contraction on record. The economy contracted 1.9 percent in the first quarter of 2009.
Yield Spread

Brazil is likely to rely on lowering interest rates to stimulate growth rather than boosting government spending, which would drive up debt levels, Barclays’s Salomon said. President Dilma Rousseff told her top allies in Congress last week that she will oppose any measures to increase expenditures this year because it would send the wrong signal to investors, said a government official who declined to be identified because the talks were private.

The central bank’s press office declined to comment in response to an e-mailed question.

The extra yield investors demand to own Brazilian dollar bonds instead of U.S. Treasuries fell 2 basis points to 198, according to JPMorgan Chase & Co.

The cost of protecting Brazilian bonds against default for five years fell 10 basis points yesterday to 140, according to data provider CMA, which is owned by CME Group Inc. and compiles prices quoted by dealers in the privately negotiated market. Credit-default swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent if a government or company fails to adhere to its debt agreements.
‘High Level’

Inflation remains too high to give the central bank room to cut interest rates this year, said Maristella Ansanelli, chief economist at Sao Paulo-based Banco Fibra SA. Consumer prices rose 6.9 percent in the 12 months through July, the fastest pace since 2005. Tombini last week repeated a pledge to bring inflation down to the mid-point of the government’s 4.5 percent target range by next year, a goal Ansanelli says he’s unlikely to meet.

“Domestic demand is sustaining services inflation at a very high level,” Ansanelli said in a telephone interview. The drop in “commodities might help, but it’s not enough,” she said.

Commodity prices tumbled 4.8 percent this month, according to the Standard & Poor’s GSCI Index.

Brazil’s biggest exports are iron ore, crude, soy, sugar and coffee, according to trade ministry figures. Food prices have a 23 percent weighting on the benchmark inflation index, while transport costs, which include fuel, have a 19 percent weighting.
‘Deflationary Forces’

Economists covering the Brazilian economy cut their 2011 and 2012 inflation forecasts for a second straight week in the most recent central bank survey. Brazilian consumer prices will rise 5.23 percent next year, according to the median forecast in the survey. The estimate is down from 5.27 percent on Aug. 5 and 5.3 percent on July 29.

“There are significant deflationary forces at play that suggest emerging-market central banks are now on hold, and could cut rates if necessary,” HSBC Holdings Plc. analysts, including New York-based head of emerging-market research Pablo Goldberg, said in a report yesterday. “Economic activity is decelerating in most places.”