Brazil
The Monetary Policy Debate
June 09, 2009

By Marcelo Carvalho | Sao Paulo

The central bank is widely expected to cut rates to single-digits at the monetary policy committee (COPOM) meeting on June 10. As rates fall to unprecedented lows for Brazil's own historical standards, and the easing cycle moves closer to its end, two themes seem to emerge. The first theme is a debate about appropriate inflation targets, as the national monetary council meets on June 25 in order to announce for the first time a target center and a tolerance band for 2011. The second theme is whether real interest rates can be sustained at permanently lower levels going forward. Our view: First, there is room for lower inflation targets and a narrower inflation tolerance band in coming years, as Brazil gradually converges towards international standards. Second, real interest rates in Brazil should trend lower over time, under the right conditions - but we suspect that policy interest rates may still have to go up at some point next year.

Nominal Rates: Get Ready for Single-Digits

Nominal rates are falling to unprecedented lows. There is little doubt that Brazil's monetary policy committee will cut the policy interest rate at its meeting on June 10. Remarkably, a rate cut now can bring the nominal policy rate to single-digits for the first time in recent history. The COPOM cut the policy rate by 100bp in the latest meeting, in April. That was a slower pace of easing after March's 150bp cut, and brought the policy rate to a record-low level of 10.25%.

The notion of a currently wide output gap seems crucial in the central bank's recent thinking. The latest COPOM minutes highlight that the growth downturn has opened up important slack in the economy, which will not be eliminated quickly in an environment of gradual recovery. The market consensus has priced in a 75bp cut, but we suspect that the release of a weak 1Q09 real GDP growth reading on June 9 could tip the balance in favor of a 100bp move at the policy meeting the next day.

As monetary easing gets closer to its end, two themes are likely to gain ground in the monetary policy debate going forward. The first theme is the choice of an appropriate inflation target center and tolerance range for the coming years. The second is whether Brazil can take advantage of global and local conditions to lock in permanently lower real interest rates for the coming years.

Theme #1: Inflation Targets - Ripe for More Ambition

The authorities will soon decide on inflation targets. On June 25, the national monetary council is scheduled to ratify the current inflation target center and tolerance band for 2009 and 2010.  It should also announce for the first time a target center and tolerance band for 2011. We think that the current target and band are very unlikely to be changed for 2009 and 2010, but the 2011 set-up remains open to debate. In our view, there is room for gradual convergence in Brazil's inflation targets towards international standards, over time.

Brazil's inflation target is high by international standards. Brazil's current 4.5% target is at the high end of the spectrum among inflation-targeting economies. A central target in the 2.0-4.0% range seems much more common in the international experience. Likewise, Brazil's two-percentage- point tolerance band (either way) is wide by international standards. Most other central banks pursue a one-percentage-point tolerance band. Put together, Brazil's 4.5% target plus an upside tolerance band of two percentage points leaves Brazil with a 6.5% tolerance ceiling, which is at the high end in our sample.

Inflation expectations are falling below the target center. Encouragingly, the market consensus view for 2009 and 2010 has already dropped below the 4.5% target center, although perhaps not as low or as fast as the central bank might wish. The central bank's own forecast also sees inflation falling below the 4.5% target center through the forecast horizon, judging by the latest quarterly inflation report, as of March.

The inflation target plays an important role as an anchor for market expectations. Here, the 2007 experience is telling. In June 2007, the national monetary council frustrated market hopes for a lower inflation target. It maintained the inflation target for 2009 unchanged at the 4.5% mark, as well as the tolerance band at two percentage points either way. The decision disappointed hopes for a lower target (say, 4.0%) or at least a narrower tolerance band (say, 1.5 percentage points). Interestingly, back then, market inflation expectations for 2009 and 2010 had been steady at 4.0%, but then eventually started to climb after the 4.5% target center was extended for 2009. In other words, the notion that a higher inflation target could open more room for monetary easing fails when market expectations are endogenously influenced by the policy target itself. (Or as the economics jargon would put it - the idea of playing along the Phillips Curve is vulnerable to the Lucas critique, as forward-looking economic agents adjust their expectations to policy announcements.)

Theme #2: Lower Real Rates - Here to Stay?

Along with nominal rates, real rates have fallen to unprecedented lows. After years of double-digit readings, real rates in Brazil have now fallen toward mid-single-digit terrain - and not because a sudden jump in inflation is eroding rates - but instead because nominal rates are falling while inflation is under control.

Real rates are coming down. How long can they stay there? The debate here seems to boil down to structural versus cyclical considerations, with two main camps. In what we might call the ‘multiple-equilibrium' camp, analysts would argue that, once real rates fall, they may well stay there sustainably. According to this view, one reason why rates historically have been so high in Brazil is simply habit - or ‘hysteresis', to use the academic jargon. Once rates are down, it is easier to keep them there. Observers in this camp would point to the previous experiences in Chile and Mexico (from the late 1990s to the current decade) to illustrate how real interest rates can fall to a structurally lower range once the right conditions are in place. 

By contrast, observers in the ‘emergency cuts' camp would argue that ongoing rate cuts, in part, are an emergency response to fight the cyclical growth downturn. According to this view, structurally lower real interest rates would likely require structural reforms. Who is right? We do not know, but suspect both camps have good arguments. In our view, with the right conditions in place, real rates in Brazil should trend lower over time - but probably not in a straight line. Once global conditions normalize after the currently massive global monetary policy stimulus, we suspect that policy rates in Brazil might have to go up at some point next year, although perhaps not as early as markets currently expect. That is, the local yield curve seems too steep right now, as it already prices in rate hikes in Brazil by early next year. By contrast, our forecast assumes monetary tightening in Brazil only in late 2010 - unless global and domestic conditions force a hike earlier next year.

Bottom Line

The central bank is set to cut rates to unprecedented single-digits on June 10. As the easing cycle moves closer to its end, two themes emerge: inflation targets, and sustainability of lower real rates. Our view: First, there is room for lower inflation targets in coming years, as Brazil converges to international standards. Second, under the right conditions, real interest rates should trend lower over time, but policy rates may have to go up at some point next year.

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United States
Review and Preview
June 09, 2009

By Ted Wieseman | New York

Supply pressures ahead of another very heavy upcoming week of coupon issuance, a renewed and intensified plunge in the mortgage market that sent MBS yields blowing well through the prior peaks hit during the initial mortgage market breakdown on May 27, key economic data that the market took as much better than expected even though underlying details in the employment report in particular weren't nearly as good (to the extent that ‘good' can be used to describe a 345,000 drop in employment) as the headline result, and rallying equity and credit markets combined to clobber the Treasury market over the past week, the market's worst week so far in the now 11-week reversal from the recent lows yields hit in March after the FOMC announced its stepped-up buying programs.  Although the front end wasn't the worst-performing part of the curve for the week - the belly of the curve was, as it was crushed by the worsening MBS market collapse and resulting heavy duration-related paying and selling pressures that also sharply blew out swap spreads on top of the huge rise in Treasury yields - probably the most notable aspect of the latest sell-off was that the front end was unable to sustain its prior stability and joined the rest of the curve in moving to new high yields for the year as the futures market moved towards pricing in near-term Fed rate hikes, with fed funds futures now pricing a high likelihood of a hike to 0.50% by the November FOMC meeting. We think we're a long way from that point still.  The recent run of data make clear that the economy is no longer collapsing, but it still appears to be contracting at a substantial rate as of mid-year, a shift consistent with the headline payroll and ISM survey results released for May that were still quite weak in absolute terms but not nearly as bad as seen during the depths of the post-Lehman global economic contraction. Also, based on the early indications from chain store and motor vehicle sales released in the past week, the renewed downside in consumer spending that began in March after a brief bounce early in the year has extended into May, though, in line with moderating weakness in other key indicators, certainly not at the near-record rate seen in 2H08. Moreover, the recent surge in mortgage rates - with 30-year rates likely to be moving to around 5.75% in short order in line with the rout in the MBS market, after having held at record lows near 4.75% for two months through late May - creates substantial renewed downside risks to what had been emerging signs of stabilization in the housing market. 

As we move towards the upcoming FOMC meeting, the Fed will need to decide to what extent the severe back-up in interest rates, with the major spillover more recently into mortgage rates, reflects improving economic fundamentals or rising inflation expectations and how much it reflects the balance sheet-constrained financial system's inability to deal smoothly with the overwhelming amounts of Treasury supply in generally alternating weeks and more recently the self-reinforcing negative momentum that the sell-off in mortgages is adding to this supply-driven weakness. To the extent that the back-up in yields reflects a supply-driven shock, which Fed Chairman Bernanke made clear in testimony Wednesday, he believes has been probably the main driver (though economic news and the spiraling impact of worsening mortgage market conditions caused by the post-employment report sell-off were clearly the most immediate drivers of Friday's sell-off), it would represent a shock to an economy whose forward-looking prospects the Fed is still only cautiously optimistic about and could bring a more aggressive attempt by the Fed to offset supply through stepped up Treasury purchases. Certainly, the causes and consequences of the enormous recent back-up in yields and the Fed's likely response should be the primary topic of discussion at the FOMC meeting later in the month. 

For the week, benchmark Treasury coupon yields surged 32-51bp, with the 5-year and 7-year being hit hardest, thanks to the severe mortgage market dislocations, but the front end also coming under major pressure after having traded in a narrow range since late January, as a 19bp collapse in the November fed funds contract to 0.485% on Friday had the market predicting a near certainty of a Fed rate hike by the early November FOMC meeting. The 2-year yield rose 39bp to 1.31%, 3-year 45bp to 1.86%, 5-year 51bp to 2.85%, 7-year 49bp to 3.55%, 10-year 38bp to 3.85% and 30-year 32bp to 4.65%. Friday's post-employment report plunge was front end-led and pulled 2s-10s and 2s-30s back a decent amount from all-time highs hit at Thursday's close. With such a huge sell-off in nominals and added support from a further rise in commodity prices, TIPS naturally outperformed, though still suffered substantial losses in absolute terms (except at the very short end, where TIPS moves are basically a simple oil proxy trade). The 5-year TIPS yield rose 19bp to 1.12%, 10-year 23bp to 1.85% - leaving the benchmark 10-year inflation breakeven right at 2% - and 20-year 21bp to 2.45%.

As severe as this Treasury market sell-off was, the more notable story in the interest rate space on the week was the even more severe knock-on impact this had on the MBS market and the effect this then had on swap spreads, which in turn further fueled the broader pressure across rates markets as MBS investors moved to adjust to the major extension in the durations of their portfolios (for those unfamiliar with this aspect of the mortgage market, mortgage-backed securities have negative convexity, meaning that their duration increases when rates rise, the opposite of Treasuries, since prepayments slow as fewer people can refinance the underlying mortgages, so for an investor holding a portfolio of mortgages and having a duration target for their portfolio, a sharp back-up in MBS yields requires moves to bring duration back down in some way through paying fixed in swaps, selling Treasuries, or something along those lines, potentially adding to the selling pressure in the interest rate markets that caused the initial duration-adjustment needs in the first place). Current coupon MBS yields initially surged to their post-November high of 4.67% on May 27 after having been close to 4% for a couple of months, but improved partially back down to 4.31% at the end of the prior week. Major renewed downside was seen again through most of the latest week, however, and by Friday's close, yields were at new highs closing in quickly on 5% (note, though, that while this was a big negative economic shock, MBS performance was at least much better on a Libor OAS basis, since interest rate volatility continued moving much higher through the week). 30-year consumer mortgage rates had held steady close to record lows of 4.75% during the prior period of MBS stability, but now will likely quickly head towards 5.75%. A 100bp rise in mortgage rates, in addition to ending what had been a decent (if somewhat disappointing relative to initial expectations) refinancing wave and presenting a threat to the recent stabilization in home sales, is the equivalent from an affordability perspective of about a 12% rise in home prices, so all else being equal, this recent mortgage market correction could lead to an additional downward move in home prices of around this magnitude on top of what had previously been seen as needed to restore balance to the housing market. 3-month Libor moved to another series of new record lows through most of the week, fixing Friday just off the all-time low at 0.63%. But mortgage-driven paying far offset whatever positive impact this improvement might have had on swap spreads, which blew out for a second straight week. The benchmark 10-year spread rose another 19bp in the latest week and 24bp the past two to 38bp, a high for the year after hitting a record low of just 8bp as recently as May 19. With 10-year Treasury yields up 61bp since May 19, this means that 10-year swap rates have now surged about 90bp over this short time period.

Upside in risk markets was only a mild background negative to Treasuries compared to the more intense pressures coming from supply, mortgage dislocations and upside in the data, but the ability of equity and credit market to post good gains in the face of such turmoil in interest rate markets was either impressive or perverse, depending on one's view of the underlying situation. Equity gains were comparatively restrained, with the S&P 500 gaining 2.2%.  There was at least the start of a potentially notable shift away from financials being the leading sector in the upside, with the BKX banks stock index falling slightly on the week, and towards more cyclical areas driving the upside. Investment grade credit performance was much better than equities, with the IG CDX index trading another 18bp tighter at 121bp late Friday, its best level in about a year.  High yield performance was also strong, though somewhat more in line with the comparatively restrained equity performance than the stronger surge in IG, with the HY CDX index 58bp tighter at 972bp through Thursday's close and then rallying another point Friday. The leveraged loan LCDX index also had another robust week, tightening 121bp through midday Friday to 915bp. Adjusted for the roll into the current series LCDX index that began trading in mid-April, the LCDX spread has now been more than cut in half so far in 2Q. Against these strong gains, the commercial mortgage CMBX market was again a stark negative outlier, substantially extending the downside since S&P warned of major looming downgrades a couple weeks ago that threatened to short-circuit the legacy CMBS TALF plan. The AAA CMBX index fell nearly two-and-a-half points on the week to 69.69, a low since April 23 and down from the recent peak of 81.29 reached May 20 after the Fed announced the expansion of TALF to include AAA rated legacy CMBS. Lower-rated indices have been trading much more technically recently, but major additional downside in the latest week has now largely reversed what had been an enormous short squeeze-driven rally in mid-May. The subprime ABX market saw some downside in the latest week, but has been much more stable recently than CMBX.  Still, this has meant that what had been a steady rally off the early April lows into mid-May has now, at best, clearly stalled out. 

Economic data the past week continued a consistent recent story - the economy is still in bad shape as we approach mid-year, but the rate of contraction has downshifted to a more typical recession from the near-record collapse in 4Q08 and 1Q09. Key early May data were somewhat mixed relative to expectations but broadly in line with this trend. Payrolls fell a lot but a lot less than expected, though other key underlying details of the employment report were much weaker. The two ISM surveys both showed further improvement from the extraordinarily depressed levels seen late last year, though they both remained at low levels consistent with widespread economic weakness, and key underlying details were mixed in the two surveys, with the manufacturing results a lot more robust than non-manufacturing. And while early indications for May retail sales were mixed - motor vehicle sales posted a decent rebound after falling to a level just above the low since 1981 hit in April, but chain store sales results were quite weak - overall, they suggested that the renewed downside seen in consumer spending starting in March has continued. Data directly bearing on GDP growth pointed to a somewhat smaller decline, and we boosted our 2Q forecast to -2.0% from -2.7% after what at this point looks likely to be a minor downward revision to 1Q to -5.8% from -5.7%.

Although market focus was largely on the headline payroll print, the May employment report taken as a whole was mixed at best. Non-farm payrolls fell 345,000, the smallest decline since September. There were less severe job losses in a number of industries, with manufacturing (-156,000) the notable exception, but much smaller declines in business services (-51,000 after drops averaging 136,000 over the prior six months) and construction (-59,000 after drops averaging 113,000 over the prior six months) and a swing to slight growth in leisure (+3,000) after a run of sizable declines. Aside from the smaller payroll drop, other key details of the report were very weak. The unemployment rate surged another half-point to 9.4% and is rapidly closing in on the post-war high of 10.8% hit in 1982. The average workweek fell to a record low of 33.1 hours, causing total hours worked to plummet 0.7%. Manufacturing hours were particularly weak, falling 2.1%, pointing to a bad industrial production report. Average hourly earnings rose only 0.1% for a second straight month, causing aggregate weekly payrolls, a gauge of total wage income, to plunge 0.6%, pointing to a weak personal income report. 

Both ISM surveys showed further improvement in May, though both remained at levels well below the 50 boom/bust line, but underlying details were more mixed, with the manufacturing results actually looking a bit better even with a lower composite gauge.  The composite manufacturing ISM index rose to 42.8 in May from 40.1 in April, still a depressed level but well up from the low of 32.9 hit in December. Some key underlying details were more positive. In particular, the orders index rose 4 points to 51.1, moving above the 50-breakeven level for the first time since late 2007. The production index (46.0 versus 40.4) also showed a good improvement, but employment (34.3 versus 34.4) remained severely depressed. By sector, five industries reported growth in May, led by plastics and machinery, up from only one in April and none in March and February. Meanwhile, the composite non-manufacturing ISM index rose only marginally in May to 44.0 from 43.7. And underlying details were quite a bit weaker than the small uptick in the headline index. The business activity (42.4 versus 45.2) and orders (44.4 versus 47.0) gauges both fell, and employment (39.0 versus 37.0) only rose slightly to a still very weak level. A surge in the less important supplier deliveries index (50.0 versus 45.5) instead drove the upside in the composite index. By sector, six industries reported growth in May and 11 contraction, a weaker showing than in April, when seven industries were growing. 

Early signs for May retail sales were mixed but negative overall. After having fallen back to a 9.3 million unit annual rate in April, just barely above the low since 1982 of 9.1 million hit in February, motor vehicle sales rebounded to a 9.9 million unit annual rate in May, the best reading of the year, though certainly still terrible in any absolute sense. While this will provide support to overall retail sales, weak chain store reports pointed to notably weaker results for ex auto sales. Wal-Mart, by far the biggest retailer, stopped reporting monthly sales results as of this month, so certainly the information content of the chain store reports has been significantly reduced. But the overall decline in comps in May was the worst, excluding Wal-Mart, in quite a while (we haven't computed aggregate ex-Wal-Mart numbers any worse in the seven years we've been tracking these numbers) and a good bit worse than consensus expectations. So, the weakness seen in non-auto retail sales that resumed in March after a bounce in January and February, following possibly the worst holiday shopping season ever, looks to have extended into May.

April data bearing directly on 2Q growth forecasts came in better than expected, and led us to boost our 2Q GDP forecast to -2.0% from -2.7%. In particular, within the construction spending report, non-residential spending posted a second straight, very surprising surge, with construction of factories inexplicably now up 71% over the past year even as capacity utilization rates continue sinking to new record lows. As hard to believe as these results are, they unavoidably point to much better results for business investment in structures (though we strongly suspect that this upside will eventually be revised away when the Census Bureau incorporates more complete data in next year's annual revisions) in 2Q than we had previously expected. We boosted our forecast for structures investment all the way to +5% from -10% and overall business investment to -15% from -17%. The personal income report also showed a smaller drop in real consumption in April (-0.1%) than we expected that was only partly offset by a slight downward revision to March (-0.3% versus -0.2%) that pointed to about a 1% decline in 2Q real PCE, a bit less of a decline than we previously anticipated. 

Supply will be the main focus in the Treasury market in the coming week, with a US$35 billion 3-year auction Tuesday, US$19 billion reopening of the 10-year Wednesday and US$11 billion reopening of the 30-year Thursday for another US$65 billion total in gross coupon issuance, less than the US$101 billion in 2s, 5s and 7s issued a couple weeks ago but with a longer duration mix. Otherwise, the calendar is quiet. The most notable economic release will be retail sales on Thursday. The Fed will release the Beige Book prepared for the upcoming FOMC meeting on Wednesday. Otherwise, the Fed calendar is pretty quiet aside from regular buying - Treasuries Monday and Wednesday, agencies most likely Friday and MBS daily. Although it is outside of typical monetary policy focus, a speech by new Fed Governor Tarullo on Monday on financial regulation could be noteworthy, since his background will likely make him a leading voice at the Fed on these issues as discussions proceed about how to reshape the post-crisis financial regulatory framework. The other most notable data releases due out are international trade and the Treasury budget Wednesday and retail sales Thursday.

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