Analysis: Brazil bond investors expect inflation to stay high

No matter how tough Brazil's central bank talks about inflation, bond investors are not buying it.

Inflation in Brazil has exceeded the mid-point of the bank's target for the past two years, and investors worry that prices could become a long-term problem unless policymakers act soon. Traders see inflation averaging 5.77 percent between now and 2018, according to the so-called breakeven rate that measures the gap between yields for fixed-rate and inflation-linked debt.

"Markets want to show economic authorities that there is an inflationary problem out there that needs to be sorted out now," Vitor Pericles de Carvalho, a fixed-income trader with Ativa Corretora in S��o Paulo, said.

A higher breakeven rate causes investors to demand a premium for holding debt that protects them against future inflation rather than other types of debt such as bonds with a fixed-rate coupon. Other countries in the region that have kept a firmer grip on prices, such as Chile and Colombia, have seen their breakeven rates narrow recently.

Growing liquidity in the inflation-linked bond market has made breakeven rates a "powerful thermometer" of policymakers' commitment to fight inflation, Carvalho said.

In Brazil, the central bank cut its benchmark Selic interest rate to a record-low 7.25 percent last year despite the heavy price pressure. That decision may have helped support an economy that grew just 0.9 percent in 2012, but it diminished the monetary authority's credibility among investors.

Some investors believe that President Dilma Rousseff has herself pressured the bank to keep rates low -- an allegation government officials strongly deny. Brazil's central bank does not enjoy formal independence, but has in recent years enjoyed the autonomy to make rate decisions.

The bank has an inflation target of 4.5 percent, plus or minus 2 percentage points. Inflation was 6.31 percent in the 12 months through March 1.

The bank's willingness to bring inflation to the mid-point of the range "seems low," said Drausio Giacomelli, a strategist with Deutsche Bank Securities. His team says the central bank may in fact be privately aiming for inflation of around 5.5 percent -- what they call the "perceived true" target.


Brazil's breakeven rate between now and 2018 actually narrowed sharply from 5.9 percent in December to 5.48 percent in mid-February, when central bank officials began indicating the Selic could rise in the months ahead.

Indeed, markets expect the Selic will rise to 8.25 percent by the end of this year, according to a recent poll of economists conducted by the central bank.

But the breakeven rate widened again after more recent statements by policymakers that they remain cautious about the timing of a possible rate hike. Officials reiterated their next decision will mostly hinge on the outcome of economic data.

The declining trend in breakeven rate reversed as the bank "showed itself reluctant to raise rates preemptively," said Luciano Rostagno, a strategist with Banco WestLB do Brasil.

The current deterioration in price gauges could be the biggest threat to price stability since 2002, when a steep currency tumble and political uncertainty drove annual inflation to 12.5 percent.

Consumer price increases have been widespread: three in four goods and services measured by national statistics agency IBGE have presented price gains on a monthly basis - the highest so-called diffusion rate in nearly a decade.

That helps explain why market forecasts have underestimated inflation every month since July, said Rodrigo Melo, chief economist at asset management firm Mau�� Sekular, in S��o Paulo.

The three most-watched core inflation gauges have also stayed above the 4.5 percent target mid-point since late 2009. The recent rate-easing cycle, which began in August 2011, helped boost average core inflation levels to around 6 percent, above those of prior cycles.

Core inflation is widely used by economists to understand underlying price trends; it excludes the most volatile prices such as food and energy from the basket used to calculate inflation.

At the same time, the gap has widened dramatically between prices set by the government, such as utility rates, bus fares and fuel prices, and so-called free prices -- like those for foodstuffs and apparel.

Rousseff's strategy to curb inflation by slashing government-set prices has helped slow inflation in that category below an annual 2 percent. In contrast, free prices have jumped nearly 8 percent -- near the highest pace in a decade.


In other words, years of easy credit, rampant government spending and robust job creation boosted demand for goods faster than supply could keep up. The bond market is basically predicting that high inflation will persist for years - which is why breakevens have ranged between 5.5 percent and 6 percent over the past few months.

Part of the central bank's delay in implementing higher rates is because the Rousseff administration resorted to tax cuts to bring down prices for staples. But economists agree that such relief will be short-lived unless the growing gap between supply and demand is narrowed through interest rate increases.

"Brazil stands out as the country where the implicit target has trended up -- thus threatening the anchoring of inflation expectations," Deutsche Bank's Giacomelli noted.

Ativa's Carvalho expect breakeven rates could spike to around 6 percent if the central bank delays in raising interest rates to a level that helps anchor inflationary expectations.

Deutsche Bank is recommending investors take "strategic" positions in long-term inflation breakevens via inflation-linked bonds due in 2018 and 2024.

(Editing by Brian Winter and Leslie Adler)