Brazil: Credit Risk or Not? Buy bonds.

Below is a chart of:
1/ Brazil CPI Headline + CPI Services
3/ Unemployment Rate (%)

And then there is chart of:
1/ CPI Headline + longer-dated swap rates
2/ Longer-dated swap rates x spot rate (steepness)
3/ Longer-dated swap rates x realized inflation (real carry on a long-dated receiver position)

So the slope of the curve implies either or both:
a/ Inflation will come back in the future and what the BCB is doing now (cutting rates to all time lows… 3Q2020 point to spot below 2.5% CDI) is wrong
b/ Credit Risk is increasing in Brazil and we won’t be able to pay our bills.

Now some thoughts:

From the first chart one can see that, disconsidering some major micro-stuff that Dilma screwed up with in 2012-2014* both brazilian headline inflation and services inflation (less volatile, stickier) moved way higher, above BCB’s inflation target band. But what also happened during that time was a pretty steep drop in unemployment. Towards the end of Dilma/PT years Brazil was seeing full employment, thus private sector wage pressures together with public governments on federal, state and municipal levels also hiking wages. That is indeed the formula for higher inflation and, towards the end of Dilma’s stay, a steep currency devaluation.

After Dilma and our wonderful politicians screwed us up and crashed the economy the ensuing largest-recession-to-date killed inflation through skyrocketing unemployment and massive economy-wide deleveraging. And adding to that, starting with Temer and through Bolsonaro+Guedes’ government the country still experiences huge slack and a healing private sector that does not have Government support at all – at least until recently.

So back to market pricing of long-end rates, a lot of people are freaking out stating that Brazilian inflation will come back. They point their fingers at:
1/ Ongoing currency devaluation -> end 2018 to dec2019 -> USDBRL +22%. 1Q20 another +29%.
2/ Insolvency: rising credit risk

BUT the facts:
// Brazil owns more foreign currency than it owes money to foreigners. So basically balance sheet improves as BRL devalues.
// Private sector has reduced its foreign currency liabilities because BRL yields have dropped dramatically and local capital markets were able to absorb lots of credit issuance, thus FX risk inside private sector is also much lower
// the country can print its own – devalued, yes – currency to fund its growth if the country’s external accounts are doing minimally well -> which should considering the level of currency devaluation seen. Similar happened in 2012-2015.. USDBRL 2.50 -> 4.0 and C/A deficit from 4.5% to flattish.
// Where will price pressures come from if before COVID unemployment was still running near all-time highs and now we’ll see it even higher, with ample slack in manufacturing and services?
// What is this inflation that will show up in Brazil due to currency pass-through that didn’t yet appear when BRL devalued by 30% in 18 months till end of 1Q20?
// Year-end 2020 CPI is projected to be below 1%. 2022 Breakevens below 2.3%
// Kinda interesting that entire planet is exploding with fiscal deficits and weighted-average global bond yields are at all time lows.

So to the last chart… so much of the bad stuff is priced in already – namely our politics which suck.

Despite Brazil being a shitty country as a whole in many ways compared to dollar-block (US, CAD, AUD, NZD) or other DM I don’t think our institutions or our people are like Argentina’s or Venezuela’s which already have a dollarized economy. Brazil is a relatively closed economy.

Yes, the country lacks an educated people to add more value in manufacturing, software and to elect the right politicians, but exporting commodities can still be done to help plug deficit in domestic savings and our entrepreneurs have survived all the last 10 years and I strongly believe they’ll survive the next 10 as it’s a relatively oligopolistic business environment.

So in practical terms… those long-end yields look pretty juicy despite a multitude of silly politicians and the king-of-mockery, our beloved Bolsonaro.

I mean, 550bp in nominal curve steepness, 700bp in real carry.. Size accordingly, play the ranges and keep rolling those long-dated swap receivers.

* Dilma suppressed electricity prices and intervened into Petrobras fuel pricing policy that nearly bankrupted the company.


Feel free to get in touch. I will surely answer you when I find some time. A brief introduction would be welcomed.