Central Bank of Brazil unlikely to hike rates as aggressively as forecast next year

Brazil might already be in distress due to fiscal dominance, while the inflation targeting framework of the Central Bank of Brazil might not be functioning. Fiscal considerations are mainly driving inflation expectations. Meanwhile, monetary policy's efficiency to curb inflation and anchor expectations are likely to have been restricted.

"With Brazil facing its worst recession since 1930, we think the BCB is unlikely to hike rates as aggressively as the +170bp that is current priced in over the next year. We recommend receiving real rates in Brazil (long NTNB 19) or, alternatively, receiving July-16 DI", says Barclays.

In the last few months, the country's fiscal, economic and political outlooks have considerably declined. In order to steady debt dynamics in the short and medium term, the country requires a much tighter fiscal stance. But, the advancements in structural reforms and fiscal measures have been hindered by the political crisis. Market participants are questioning how the country can solve its fiscal problems and return to stable economic growth and sustainable debt without a political solution in sight.

There are increased worries regarding the Central Bank of Brazil's capability to stand by its inflation target due to the uncertain fiscal situation. Inflation breakevens and expectations have floated away from the central bank's target rate, while the nation is facing a deep recession.

The BCB, under normal scenario can raise real interest rates to re-anchor inflation expectations and control inflation. But, if markets see an actual risk from debt monetization, fiscal considerations will mainly drive inflation expectations. The fiscal accounts can get worse with higher real interest rates and push long-dated inflation breakevens to new highs.

"The BCB will likely deliver symbolic hikes at best, as monetary tightening has not only become less effective but also may aggravate the negative dynamics of fiscal dominance on growth and even inflation itself", says Barclays.