Inflation forces policy makers to make tradeoffs; markets are punishing a lack of policy credibility with sharp increases in risk premia in rates.
Our central case is that we are in an inflationary environment, and inflationary environments are more volatile in aggregate.
This viewpoint continues to play out, especially in interest rate markets, where the market continues to increase risk premium in the front end of curves. In the US June 23 Eurodollar contract increased by 13bps in yield and Mexican 2y yields rose by 27bps following higher than expected inflation reading. Inflation proxies rose, 5y US inflation swaps reached the highest level since 2008, and US equities rallied, led by strength in financials.
It was also an important week in data. On the positive side, flash October PMI services data beat expectations in the US, UK, and France, driven by a fading Delta effect on services activity. However, manufacturing, and industrial production data showed that supply chain issues are getting worse. EU manufacturing PMI fell to the lowest level since July 2020; in the US September Industrial production fell by 1.3% and flash PMI revealed that supplier delivery times made another record. The bottom line is that supply side inflationary pressures are not showing signs of easing yet.
Overall, the view that the inflation pressures in the global economy were transitory has resulted in central banks being behind the curve. The distribution of risks for inflation and the policy pathway is now skewed higher. Furthermore, rising inflation narrows the options for central banks, as seen in Russia last week where the central bank increased rates by 75bps while Moscow re-enters lockdown.
Indeed, it is not just monetary policy makers who face difficult trade-offs in a rising inflation environment. Inflation is now a major political and fiscal issue.
In response to rising inflation and falling popularity, President Bolsonaro decided to change the spending cap rules to accommodate ~BRL40bn/$7.25bn in transfer payments. This decision resulted in front end Brazilian interest rates rising by 150bps last week. Substantively, the additional spending will have limited impact on fiscal sustainability but breaching the spending cap displays that fiscal prudence is now secondary to political expediency.
This puts all the pressure on the central bank to anchor policy credibility. They will now likely raise rates even more sharply than before, further tightening financial conditions, and with it, making the political prospects of President Bolsonaro even dimmer. The only potential silver lining to the scenario is that it raises the possibility of a centrist candidate gaining ground, but the likelihood of a centrist winning the election is low at this point, given the polarized voting blocs in Brazil and Lula’s strong support base. Lula may moderate in response to this threat, but his spending priorities are less likely to change.
The one positive that Brazil has is a solid institutional foundation with a credible central bank. In contrast, Turkey is far beyond that point. Like President Bolsonaro, President Erdogan popularity has fallen, and his political future is uncertain. Unlike his Brazilian counterpart, he has control of the central bank which, to foster growth, breaking with policy orthodoxy once again, cut rates by 200bps last week despite inflation remaining well above target. This was followed by the expulsion of 10 ambassadors, including from the U.S., France, and Germany following a statement from the ambassadors calling for the urgent release of activist Osman Kavala. This rise in geopolitical risk comes a time when energy costs have risen, and global liquidity conditions are tightening. The prospects for the Turkish Lira are bleak.
The events of the week support our thesis that we remain in a murky market environment where inflation risk premium will remain high to reflect the risk of policy errors and continued oscillation between perceived stagflation and reflationary regimes. We are paid US inflation swaps, front end US and Polish rates, and have exposure to energy equities and energy exporting frontier currencies with sufficient real rate buffers. However, the volatility of this environment also creates dislocations and opportunities. While the outlook in Brazil is not positive, the market has priced a significant amount of risk premium in Brazilian assets. Brazil is not Turkey, the strength of institutions does constrain President Bolsonaro, and given this, we see opportunities to fade some of the more extreme moves in Brazilian equities, in particular in the financial sector.