Last week, the Central Bank of Brazil kicked off a rate-tightening cycle following a sharp rise in inflation in recent months, making it the second major emerging market (EM) to raise interest rates since the start of the COVID-19 pandemic. What happened - and is it sign of things to come across EMs?
Turkey was the first major EM to raise rates, in September 2020. The move - the first of its kind since 2018 - occurred after a series of other measures fell short of stabilizing the lira. It not only surprised economists; it was also dramatic, increasing the country's benchmark one-week repo rate from 8.25% to 10.25%.
The Central Bank of Brazil is likely to adopt a much more gradual approach to tightening than Turkey did. We expect the benchmark Selic policy rate (the central bank's overnight rate) to trail Brazil's consumer price index (CPI) for much of this year and keep real interest rates in negative territory until next year.
Policymakers in Brazil face a difficult situation in the short term. A weak Brazilian real (BRL), combined with higher global commodity prices, has pushed the tradable segment of CPI into the double digits and dragged the full CPI above the Central Bank of Brazil's target band (1.75% to 4.75%). With the economy still struggling with the effects of the pandemic, higher nominal rates are needed to support the currency rather than slow demand - hence the need for a cautious approach.
For local investors, the bond market has already reacted strongly to these trends, and we believe it has overpriced policy tightening over the next 12 to 18 months. Brazil stands out among its peer group in this regard and offers attractive yield premium in the belly of the curve.
The Central Bank of Brazil hiked 75
