Brazil's Policy Blunders Open Opportunities

Wednesday, 26 Jun 2013 07:37 AM

By Ashish Advani

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Before I get to the main subject of the day, I wanted to show you the policy blunders of the Federal Reserve here at home.

I mentioned a couple of weeks ago that the Federal Reserve chairman is making a huge mistake announcing the possibility of tapering bond buying. He seems to be reading economic data that no one else sees. Now we are seeing various Fed heads starting to flip flop and exhibit public opposition to the chairman. I sense the panic in the markets will be short-lived and by end of summer, when the economy stops appearing rosy, quantitative easing will be back and we will all go back to mind-numbing stock buying.

Today, I want to talk to you about the blunders of another central bank. I have been very critical of the antics of the central bank in Brazil, which lost its independence when it bowed down to the political will and did nothing as the real was artificially weakened. Starting in 2011, when the new president took control, they imposed taxes on currency inflows and basically made it very hard to invest in Brazil.

I, along with many other writers, cautioned against such moves and was wary of run-away inflation if the policies continued. Of course, they did not listen, and when I visited Brazil back in April, I was shocked to see how inflation had eaten away at the core of businesses.

As a result of the terrible policies of the government, gross domestic product (GDP) growth has been significantly below standards for the past three years now. GDP was 0.9 percent in 2012 and is expected to be about 2.5 percent this year. As inflation has taken a deep-seated hold of the economy, we see wage inflation of about 8 percent and non-exportable inflation even higher, at around 9.8 percent. This is causing major policy upheavals right at the time when the world markets do not trust the government's policies.

With sub-par growth and total loss of credibility, the Brazilian government is out of options. They have tried to woo back the investors. With the Soccer World Cup in 2014 and then the summer Olympics in 2016, they desperately need capital. Remember, capital flows where it is treated well. After the shabby treatment in 2011, most investors are reluctant to go back in.

Desperation growing, the central bank finally awoke from its slumber back in April. Yet, instead of treading boldly, it was meek in its approach. Brazil's Central Bank Monetary Policy Committee raised rates a mere 0.25 percent in April and are gradually growing bolder with a 0.5 percent increase in the Copom rates in May.

The interest rates are forecasting about 4 percent increases by end of 2014. While political and economic challenges will tend to make the central bank undershoot the market expectations, inflation has now settled into core expectations and will require firm handling.

However, this interesting fork in the economic path of Brazil brings us some investing opportunities. Given that the interest rates are expected to rise in Brazil, it is assumed that bond prices will move lower. Remember that bond prices and yields are negatively correlated.

It may be time to short the Brazilian bonds. While any investment strategy is risky, this one is particularly risky as the carry cost for this trade can be high.

There is money to be made here, but only for the investor with a steel-lined stomach.

Back home, one must learn lessons from the blunders in Brazil and ensure that central bank policies are well-founded in facts and not what appeases the masses, markets or politicians.

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