(Bloomberg) — First, there was a currency collapse. Now, other Brazilian financial markets are also in the crosshairs as investors lose confidence in the government’s ability to contain the deepening fiscal crisis.
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The selloff that has brought the real to record lows has engulfed everything from stocks to local-currency bonds to dollar bonds, with traders even rushing to hedge against sovereign default. Market watchers say the extraordinary measures announced by the central bank on Tuesday to halt the currency’s slide are only temporary measures, and moves by lawmakers to water down high-profile austerity measures are adding to the chaos. It warns that it is likely to only increase further.
The widening rout shows how skeptical investors are that President Luiz Inacio Lula da Silva is serious about reining in the soaring budget deficit. Brazil’s annual budget gap is 10%, much larger than it was under the leftist president’s first administration. His recent emergency brain surgery couldn’t have come at a worse time, making efforts to shore up his public account even more difficult.
“Brazil is in a ‘sell first, ask later’ situation in the current market,” said Sergey Goncharov, a money manager at Fontbel Asset Management. “Central bank reactions to fiscal concerns and currency fluctuations led to panic selling.”
The real has been the world’s worst-performing currency over the past four sessions, having fallen 21% against the dollar this year. The benchmark Ibo Vespa stock index, Latin America’s largest, fell 3.8%. Swap rates skyrocketed. Dollar bonds were the biggest decliners in emerging markets after Lebanon defaulted and five-year credit default swaps widened to their highest level in more than a year.
“From a fixed income perspective, we’ve reached a crisis stage,” said Jack McIntyre, portfolio manager at Brandywine Global Investment Management. “Lula has to say something constructive.”
Brazil’s lower house of parliament late Tuesday changed Lula’s spending proposal in a way that could further spook investors. Lawmakers approved the plan, pending a vote in the Senate, which would allow the government to limit companies’ access to tax credits in the event of financial distress. Controversial plans to change the military pension system have also been postponed until 2025.
The currency fell as much as 2.3% on Wednesday, underperforming all emerging markets, with losses widening as Federal Reserve officials reduced the number of interest rate cuts they expect in 2025. Earlier, Finance Minister Fernando Addad said Brazil “may be in a speculative situation.” “This is an attack,” he said, adding that he expected the currency to eventually calm down.
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Swap rates rose to a new session high after reversing an earlier decline caused by a government bond auction that buys and sells notes and bonds over the next three sessions with the aim of reducing volatility.
abandoned bet
This week, strategists rushed to abandon their bullish bets on the country’s assets as the currency’s decline widened. JPMorgan Chase strategists have shed their positive view on Brazilian dollar debt over the past two days, while Credit Agricole has eliminated its tactical overweight position on the real in the first two weeks of trading.
“Investors have clearly thrown in the towel,” said Olga Yangor, head of emerging markets research and strategy at Credit Agricole. Although there are encouraging signs in economic growth and central bank actions, “there is a sense that as long as the current president is in power, he seems to be completely immune to market fluctuations.”
Last month, Prime Minister Lula announced plans to cut annual spending by 70 billion reais ($11.5 billion), but it was accompanied by new income tax cuts, much to the dismay of traders. On Tuesday, the lawmaker in charge of planning the spending cuts said Congress is considering further watering down the proposal, citing the potential impact on social programs.
With the government reluctant to stick with interest rate cuts, much of the heavy lifting has been left to the central bank, which last week vowed to raise the benchmark interest rate entirely to combat inflation, raising it to 14.25% by March. did.
Despite tight credit conditions, Brazil’s economy, Latin America’s largest, continues to grow, with unemployment near record lows and wages rising. Additionally, it has foreign exchange reserves of approximately $360 billion. Lula has shown that he is delivering on his promise to use economic growth to improve the living standards of the poor.
However, there are growing concerns that the economy is overheating, with inflation expectations deteriorating significantly. Traders now expect interest rates to peak at around 16.25%, which would increase the government’s interest costs and further widen the budget deficit.
In addition to the rate decision, the bank has undertaken its largest direct intervention since the early days of the pandemic, injecting $5.8 billion into the market through spot bidding since Friday. Each time, the movement gave a momentary jolt to the real thing, but it quickly dissipated.
Investors said the risk of fiscal domination, where monetary policy becomes ineffective, is starting to creep in.
“Central banks are playing a supporting role,” said Marcos de Marchi, chief economist at Oriz Partners. “The star of this movie is fiscal policy.”
For now, few investors are willing to bet on when the rout will end unless the government changes course.
“Momentum is driving everything Brazil-related,” said Gregory Hajan, global macro strategist at Loomis Sayles in Boston. “Finance is 100% the main issue. And substantive fiscal action is the real catalyst for turning things around.”
–With assistance from Maria Elena Vizcaino, Zijia Song, Leda Alvim, and Philip Sanders.
(Updates prices in 8th paragraph.)
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