BRL Yields and anchoring bias

In the past year a lot of people said “yields are too low” in Brazil, including seasoned traders. Almost all retail investors and wealthy entrepreneurs I know thought they were “too low” a year ago, 200-300bp ago.

It all can change back rather quickly, for sure, but it proves how pervasive anchoring bias is! Especially from those used to “1%+/month” for 2-3 decades!

Too low relative to what? Here’s BRL yields and USD yields.
– Top panel = nominal.
– Bottom panel = real.

Do I believe front-end BRL yields have much more to go? No. Curve is pricing in 5.5% for next 6-9 months already.
Do I believe brazilian realized inflation will move higher in the next 2 years? No.
Do I believe longer-term break-evens will move significantly higher? No. Flat to lower from here, but not by much for now. Lots of slack in economy.

Basically we’re starting to price in:
1/ Lower inflation volatility
2/ BCB’s 2021 inflation target of 3.75% (from old 4.5% tgt) = hawkish stance without having to hike = better for long-end, flatteners.
3/ IP’s low capacity, lots of overhand in Real Estate, 12% unemployment, near 20y highs = lots of slack.
4/ A radical shift in government, from PT’s left to a new Center-Right/Rightist team at the helm, focused on productivity, meritocracy, private investments.
5/ A seemingly more hawkish BCB, which understands that another 50bp here or there won’t make growth change much from here and that, from here, we need micro/macro reforms in credit, etcto work its magic (but it’s happening!).

Do I like the front-end of the curve? I got out of 50% of my positions days ago. I think when the BCB restarts the cutting cycle you get out of everything with a duration under 1y and trade-around as risk-reward has deteriorated significantly with the last leg down in yields. Market is pricing in 95bp in cuts until January 2020 and a slow start to a hiking cycle which I don’t think will materialize to any large degree.

My view is that we’ll be somewhere between 5%-5.5% until Dec2020, so playing the front-end is inferior to other bets in Brazil (it had been inferior before already).

The long-end offers decent carry and should remain anchored for longer, but should be traded around too. Add to receivers on spikes, don’t chase lower.

Risk parity has worked very well, will likely still work for longer, but the risk-reward has shifted strongly towards equities for the next few years.

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