UNITED STATES
Risk appetite in the US remains high, above the 1STD measure of the past 10yrs. This despite recent volatility in equity markets and signs that the Fed will move rates higher—in our view, well beyond what the market currently expects. The main event this week is the release on Wednesday of the minutes of the Jan/31 FOMC meeting. The committee left the funds rate target unchanged but added the word “further” to describe expected rate increases. The minutes should add some description. While it is too soon for the FOMC to characterize the economy in over-heating territory, this assessment must have crossed the minds of committee members and Fed staff. The post-meeting statement upgraded its descriptions of economic activity, noting “solid” gains in employment, consumption, and investment. Changes to the assessment of inflation data were more hawkish, and the CPI data last week confirmed this assessment. Meanwhile, it is now apparent that fiscal policy is even more expansionary than earlier forecasted. Whereas, in the past, as the economy strengthened, and the debt burden increased, Congress responded by raising taxes and cutting spending, this time around, the opposite occurred. Most forecasts now see the deficit rising above 5.5% of GDP and the unemployment rate soon reaching levels 1pp below its sustainable level. The implication is that monetary policy should shift into contractionary territory.
Market forecasts of interest rates rose. The market-implied longer-run neutral rate appears to have risen to roughly 3-3.25%, no longer below the Fed’s estimate. Market-implied terminal rate expectations for this cycle appear closer to 2.75-3%. The FOMC is likely to take rates higher, higher even than its estimate of the neutral. The market seems to confuse the neutral rate as the limit rate for the Fed. Obviously, this is not the case. If the FOMC wants to brake the economy, it must increase rates beyond the neutral. The issue is what rate we are talking about, the short-run Fed funds rate, which the Fed controls, or the longer run 10yr yield on the Treasury bond, which it does not. Arguably, from its impact on expected activity, it is the latter that matters. So, the question is also what happens to the inclination of the yield curve. Since the market seems to be more conservative than the FOMC, betting on lower future rates than the committee’s own forecasts, likely, the yield curve will be rather flattish. This argues for an even more aggressive FOMC—fighting to convince the market that it wants the economy to slow down.
- Wednesday, February 21: Minutes from the January 30- 31 FOMC meeting. As discussed above, the market will focus on the meaning of the added word “further” in last week’s Statement, used then to describe expected rate increases. See above.
BRAZIL
For the first time since the end of the military dictatorship in the 1980s, the federal government intervened in a state government, this time, taking over the security functions in the state of Rio de Janeiro. It was only a matter of time before the acute financial crisis in the state produced an exceptional circumstance. And it is not a surprise that it happened in the security-and-police function. Crime in the state is rampant, with parts of its territory taken over by gangs that commandeer all public functions, including territorial security. The city of Rio de Janeiro is one of the most violent in the country, if not the most violent; and Brazil is now a more violent country—in number of homicides per 1000 inhabitants—than Mexico or Colombia. Part of the problem is drug-related, Brazil again in the unenviable position of retaining the second largest consumer market for cocaine in the world, after the US. As the commander-in-chief of the armed forces said, it is not clear that, in the long-run, the army will do better in producing lasting security. The armed-forces would rather not get involved. But this was a strategic decision by President Temer, in part, grasping for some way to remain active and relevant in what is, in effect, his lame-duck period, after the April conventions and the start of the campaign for the October elections.
Meanwhile, in the short-term, the economy is doing well and improving. Growth in 2017 likely exceed 1.1% as foretold by the Central Bank’s indicator released on Feb/19. Growth in 2018 could reach 3%, at least by the Ministry of Finance’s (MoF) accounting. And they have a point. In part, the last recession was due to forced deleveraging by firms and households, after a credit boom fueled largely by public banks starting in 2009 and lasting through 2014. At its height, households used more than 40% of their disposable income for debt service (ex-mortgages). Presently, this figure is down to 21%, with lower interest rates on the remaining and re-accumulating debt. The change could yield an increase in income available for consumption equivalent to 2pp of GDP, or more. And consumption is what drives this economy, still operating under enormous political uncertainties that discourage investment in fixed capital. Uncertainty is large but short-term confidence is improving. The cyclical rebound has legs. And, within the elite, there still is the expectation that the political center will get its act together; field a single coalition candidate; and win the Presidency for 2019-2022. In that regard, Temer’s strategy of reasserting his political position, and influence over his succession, helps.
After Carnival, this week already brought the new data on the Central Bank’s activity indicator reported above, and better than expected Federal fiscal revenue for Jan/18.
- Friday, February 23:: FGV Business Confidence Manufacturing (Feb preview) and Consumer Confidence (Feb). Sustaining short-run confidence is key for the ongoing recovery and we believe it is on hand.
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CPI inflation – IPCA-15 (Feb). (Consensus: 0.4%mom). Inflation at the start of the year is lower than forecasted, leading forecasters submitting estimates to the Central Bank’s Focus Survey to revise down their latest numbers for yearend 2018 inflation to 3.8%. This mid-month reading should confirm the trend.
IMPORTANT NOTICES:
This report is a general discussion of certain economic and geopolitical trends and forecasts. It does not constitute investment advice of any kind or constitute a recommendation to buy or sell any security or other financial instrument. Investors may not rely upon any of the conclusions or other statements contained herein.
Certain of the factual information contained herein was obtained from third party sources which the author considers reliable, but the accuracy of such information cannot be guaranteed.
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