Commerzbank FX analyst Michael Pfister examines why higher Brazilian interest rate expectations tend to weaken the Brazilian Real (BRL) rather than support it. Using correlation, regression and mediator analysis, he finds that fiscal dominance and widening CDS spreads drive BRL depreciation when the expected rate differential versus the US increases, and he maintains a forecast for higher USD/BRL levels.

Fiscal dominance undermines Brazilian Real

"Rising expectations of key interest rate hikes should in theory cause a currency to appreciate. In Brazil, however, the opposite is true. A one-percentage-point increase in expectations causes the Brazilian real to depreciate by more than one percent."

"Rising expectations regarding the interest rate differential between Brazil and the US were associated with higher USD/BRL levels over the last couple of years. Expectations of a higher Brazilian carry have thus even weakened the real."

"Regressing the performance of a BRL index against changes in Brazilian key interest rate expectations yields a strong result: if expectations of the key interest rate two years from now rise by one percentage point in a single week, the BRL depreciates by roughly 1.5 percent. One might suspect that this is due to the time period chosen or a lack of control variables."

"This unusual relationship is likely to be explained by Brazil’s fiscal policy. A simple test shows that an increase in interest rate expectations by one percentage point causes CDS spreads to rise by 10.1 basis points."

"In short, rising interest rate expectations are a warning sign for the Brazilian real, rather than an indication to buy. If the Brazilian president's ambitious spending plans lead to higher fiscal risks, the real is likely to come under further pressure. We are thus maintaining our forecast of higher USD/BRL levels."

(This article was created with the help of an Artificial Intelligence tool and reviewed by an editor.)