Morning Note /

Latam Daily: Latam central banks still have room to hike rates further

  • Talking Points: Regional rates still below neutral rate projections for most Latam economies

  • Forex: BRL rally may persist as currency remains undervalued

  • Fixed Income: Brazil auction in focus, pressure on CLP swap spreads eases

Lloyd Miller
Lloyd Miller

Head of Developed Markets and Latin America Research

Danny Greeff
Daron Hendricks
Kieran Siney
ETM Analytics
24 March 2022
Published by

Talking Points: Regional rates still below neutral rate projections for most Latam economies

Brazil: The release of the report will be followed by a press conference with BCB President Campos Neto, and Director Guardado at 11 am local time. The Q1 inflation report will provide updated forecasts for several variables, including inflation and growth. Notwithstanding the better than expected Q4 GDP print, expectations are that the central bank will confirm the output gap remains significant. Moreover, the quarterly report will also provide an update on financial conditions in Brazil. High-frequency money supply and credit growth data shows that financial conditions have tightened significantly in recent months.

On the news front, Brazil has temporarily lifted its 18% tariff on all US ethanol as of Wednesday, running through to the end of the year to decrease inflationary pressures. The ethanol industry leaders said they would continue to pursue a long-term, open, and mutually beneficial ethanol trading relationship with Brazil as they work to make this temporary reduction permanent

Mexico: It is a busy day ahead for the domestic market from an economic standpoint, with bi-weekly CPI and retail sales data scheduled, which are likely to be overshadowed by the monetary policy decision later on (see the interest rate outlook below for further details about the release). Mexico’s retail activity is expected to have improved at the start of the year due to improving demand off a low base. Should consensus expectations for a figure of 6.1% y/y be realised, it would end eight consecutive months of steady declines. Looking ahead, retail growth is likely to pick up this year, aided by fewer constraints on economic activity and improving employment prospects. However, the pace of growth will be challenged by high inflation, especially food and fuel, rising interest rates and low wage growth

Mexico’s central bank is expected to deliver its third straight 50bps increase to tame inflation, which is also its seventh consecutive adjustment during the normalisation cycle that began in June 2021. Mexico's low growth and high inflation scenario continue as the Russia-Ukraine war threatens to bring a fresh round of price pressures. Core inflation picked up considerably more than expected in the first half of February, climbing to levels not seen in over 20 years. In order to tackle inflation, Banxico may need to frontload its interest rate hikes. A 50bps rate hike would be enough to increase the real interest rate and more than offset higher US interest rates while keeping room for further changes and limiting headwinds on activity. Furthermore, we foresee the central bank raising its inflation forecasts.

In other news, Banxico has brought forward two key monetary policy meetings this week as they clashed with the country’s annual banking conference, altering the setting of interest rates. While the changes will not affect the rate announcement scheduled today, nor the length of the meetings scheduled this year, they amount to an administrative complication at a time when Banxico is under pressure with inflation running at more than double its target.

Colombia: Two of the presidential election candidates, leftist Gustavo Petro and centrist Sergio Fajardo, announced their running mates yesterday, with both opting for environmentalists who represent Colombia's poorest regions. Progressive Francia Marquez is running alongside Gustavo Petro, the favourite in polls, while Luis Gilberto Murillo would become vice president if third-placed centrist Sergio Fajardo wins. With these VP picks, both candidates are aiming to shore up minority and left-wing support, contrasting the more usual tactic of trying to reach out to centrist voters. It will thus be interesting to see who second-placed conservative candidate Federico Gutierrez announces as his running mate in the days ahead, and whether he can steal votes from the centre with his pick.

Chile: The investment community will continue to digest news flow surrounding the pension fund industry. There have been rumblings over another withdrawal from AFPs which many believe will be the final straw for the industry which has been hollowed out from the previous withdrawals, we don’t believe that this will be passed by the current administration. The disruption to the financial markets coupled with the drain on the longer term finances of the country have been well documented, as has the impact of the wall of cash hitting the economy causing a ramp up in consumer spending and causing the economy to run red hot.

One thing is certain is that the current administration will need to keep to their word about overhauling the system, which was one of the biggest demands of the 2019 protests. Finance Minister Mario Marcel stated earlier in the week that the bill to reform the pension system will be in congress next year, this is something that the government cannot stall on.

The Senate yesterday approved a bill which increases the funding available for the Fuel Price Stabilisation Mechanism from $750m to $1.5bn and it now becomes law. The move was necessary to underpin economic stability and smooth out the fuel price increases given the higher energy prices. Many countries around the world are grappling with social pressures as the cost of energy has risen exponentially over the past year, exacerbated by the Russian-Ukrainian conflict

Peru: Southern Copper has said that there has been some progress in talks with communities to end the protests that have halted operations at the miner's Cuajone mine. Even with progress, it is too early to say that the issue has been resolved, according to Southern Copper. Meanwhile, communities have once again blocked the road to MMG's Las Bambas copper mine, just days after the previous blockade was lifted. This has prompted the mining ministry to request that these communities continue with a dialogue on 30 March. The reintroduction of blockades is a worry that what progress has been made is not enough and that mining operations in Peru will continue to see sporadic disruptions in the weeks ahead.

On the interest rates front, currently most Latam countries have enough room to keep raising rates without restricting economic activity. Peru, Chile, Colombia, and Mexico all currently have rates well below their theoretical neutral rates, with only Brazil hiking aggressively enough in recent months to take rates above neutral. Peru's neutral rate is currently estimated at around 5%, suggesting that there is room for at least four more 25bp rate hikes, or two 50bp hikes, before economic activity starts to become negatively impacted. The bank has previously said that rate hikes will end when neutral rates are reached (see below), but given the current macroeconomic backdrop, we could see the BCRP's hand forced into hiking into restrictive territory in order to ease inflationary pressures.

Forex: BRL rally may persist as currency remains undervalued

Brazil: Tailwinds for the BRL remained robust on Wednesday as international commodity prices rose on the back of ongoing concerns over the supply disruptions caused by the war in Ukraine. The rally in commodity prices comes on the back of improved fundamentals, with factors including Brazil’s positive real interest rates and improved fiscal outlook providing support for the BRL. The BRL was once again amongst the top-performing emerging market currencies on the day, with the local unit gaining an impressive 1.73% against the USD to end the session at a fresh year-to-date low of 4.8267, according to Bloomberg data.

Yesterday’s appreciation in the BRL means that the local currency has strengthened by 15.52% since the start of the year, making it the best performing emerging market currency in 2022. The next best performing emerging market currency is the South African Rand which has gained 7.86% since the start of the year. While local traders have scaled up their BRL hedges amid fears that the rally in the BRL may be overdone, given that the BRL is still significantly undervalued, we see room for the BRL to appreciate further, especially as foreign investors continue to pile into domestic assets.

Mexico: The MXN’s bullish bias remained entrenched yesterday, extending its winning streak to eight consecutive sessions against the USD. The local currency closed at 20.2803/USD and is on course to revisit its 2022 high of 20.1577/USD. However, the greenback recovered some lost ground from yesterday’s session to cap the MXN’s gains. This week's main catalyst for the MXN will be the central bank rate decision. However, when looking at how the USD-MXN stochastics crossed over in oversold territory and are bottoming out, the bearish bias may well dissipate. Investors, therefore, should be on the lookout for a buy signal in the coming sessions.

Colombia: After Tuesday's strong advance, the COP retreated yesterday with the market booking profits after an unsuccessful break of the currency's year-to-date high around 3730.00/$. Specifically, the COP depreciated 0.60% on Wednesday, paring much of the previous day's gains in the process. The currency will likely continue trading at the mercy of broader USD and oil-market moves in the near term, while local political developments are expected to increasingly come into play as the May elections draw nearer.

Chile: The trading session yesterday was almost a mirror of Tuesday, any spikes to the topside were quickly pared and we closed at 793.05, versus 792.85 on Tuesday. First major support comes in at 782.75 which is the 50% retracement line, while resistance can be found around 797.87 which corresponds with the 200DMA.

Peru: The PEN firmed for a second straight session yesterday, tracking the positive sentiment seen in the Latam FX space. The PEN closed at 3.7669 to the USD, with 3.8000 still acting as support while the main resistance level to watch for the local unit is the 3.7500 mark for now. Technical still suggest that there may be some room for some downside for the local unit, but the momentum is slowly shifting towards the bulls for now.

Fixed Income: Brazil auction in focus, pressure on CLP swap spreads eases

Brazil: Movements in the local bond market were relatively subdued on Wednesday, with the shorter-dated 2yr yield edging 5bps higher, while the longer-dated 10yr yield closed the session relatively unchanged. While bond movements were modest yesterday, it is worth noting that Brazil’s 5yr credit default swap continued to edge higher, climbing 3bps to 222bps, reflecting increased fiscal concerns. Although the risk of Brazil slipping into a position of fiscal distress is relatively low, it is worth noting that Brazil has the fourth highest CDS out of the 21 emerging market countries tracked by Bloomberg.

While Brazil’s CDS is trading well above some of its similar rate emerging market peers such as SA, reflecting higher fiscal risk, it is must be noted that higher bond yields compensate investors. For context, Brazil’s 10yr bond yield is currently trading more than 200bps higher than the comparable South African bond yield. This, together with the BRL's higher carry score in ETM’s Carry Attractiveness model, suggests that Brazilian bonds are a more attractive trade for international investors than many of its peers.

As always, the results of the weekly vanilla auction could result in some fresh impetus for the secondary market. National Treasury plans to sell fixed-rate LTN local currency bonds maturing in 2022, 2024 and 2025 and fixed-rate NTN-F local currency bonds maturing in 2029 and 2033 at today’s auction.

Mexico: Mexico’s breakeven rates have continued to rise, now trading at levels last seen during the third quarter of last year. The focus for Mexican policymakers this week will be centred on inflation expectations. The market is pricing in a significant amount of inflation risk over the next two years. For context, Mexico’s 2yr breakeven rate, which we use as a proxy for market inflation expectations, has risen by more than 122bps since the invasion of Ukraine to sit at 5.32%. Moreover, the 2yr breakeven rate sits well above the 5yr and 10yr breakeven rates at 4.86% and 4.64%, respectively. The 2yr breakeven rate is expected to rise in the coming weeks as the commodity shock works its way into the global economy. Further monetary policy normalisation by Banxico will help roll back some of the inflation risk currently being priced in.

Colombia: Colombian bond yields continued to rise on Wednesday, adding to a broader move seen this week (and month) as investors braced for an accelerated tightening of global financing conditions. Similarly, this positioning has also driven credit default swaps and interest rate swaps higher, with the market pricing-in rising concerns that global monetary tightening will add to Colombia's fiscal deterioration, and also BanRep rate-hike risk. Global developments will likely continue to drive Colombian fixed-income markets in the near term, with the balance of risks still tilted to the topside for bond yields, CDS rates, and IRS rates, for now.

Chile: Pressure on the 2v10 swap spread has dissipated somewhat with the spread now coming in at -193.50 bpts versus the lows all time lows of -204.50 bpts seen earlier in March. There are two major factors we are unpacking at present, there is a tug of war amongst the analytical community as to whether or not this level of curve inversion points to strong recessionary pressures building or whether or not it’s an anomaly due to the massive stimulus provided and the hangover the economy is currently going through.

Secondly, we are in for higher rates which will underpin the front end of the curve for now, the question however remains whether or not too much has been priced in and whether or not after this massive inflation spike, we head into deflation causing the front end to collapse.

Peru: Local bonds continued to weaken yesterday, although we saw a reversal of Tuesday's move on the 2023 tenor, according to Bloomberg data. Looking at the global markets, we see that core yields are rising once again with the benchmark 10yr UST yield looking to head back towards its recent highs. This coupled with rising liquidity concerns globally, will pressure Peru's bonds, with a flattening of the curve still expected to persist through the coming weeks. Peru's CDS spreads, meanwhile, are rising with the 5yr benchmark back at around 84.2bp. This is still someway off its recent peaks, however, with investors not expecting anything really in the way of a credit event in the country.