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Bond Market Bets on Higher Inflation After Lula: Brazil Credit

Concern is growing that President Luiz Inacio Lula da Silva’s successor will fail to keep consumer prices in check, trading in Brazil’s bond market shows.

Investor expectations for inflation, implied by the difference between the government’s two-year inflation-linked bonds and fixed-rate notes, rose to 648 basis points, or 6.48 percentage points this week, the highest since December 2008, from 541 basis points on June 28. The gap, known as the breakeven rate, compares with 388 basis points in Mexico, Latin America’s second-biggest economy after Brazil.

While countries from the U.S. to Japan are considering measures to fend off deflation as the global economy slows, investors are betting the inflation rate in Brazil will hold above the government’s 4.5 percent target unless policy makers curb spending or raise interest rates. Dilma Rousseff, who is leading in polls ahead of the Oct. 31 election runoff, called reducing spending a “crime” in an August television interview.

“The market doesn’t have a very strong belief that the next government will act on the fiscal side to contain public spending,” said Marcelo Schmitt, a fixed-income portfolio manager at SulAmerica Investimentos in Sao Paulo, who bought inflation-linked bonds three months ago. “The market is expecting more inflationary pressure lasting for longer periods, extending throughout 2011.”

Yields on Brazil’s 6 percent notes due in August 2012 that offer protection against inflation fell 41 basis points this month to 5.52 percent, according to data compiled by Bloomberg. Yields on the 10 percent fixed-rate notes due in January 2013 declined 4 basis points to 11.97 percent.

Unemployment, Wages

Economists forecast growth of 7.55 percent this year, the most in over two decades, according to a central bank survey of about 100 financial institutions released this week. The jobless rate fell to a record low in September and average inflation-adjusted wages rose 6.2 percent over the past 12 months to 1,499 reais ($881), the statistics agency said last week.

Annual inflation will quicken to 5.3 percent by December from 5 percent in mid-October and 4.3 percent at the end of 2009, according to the central bank’s survey of economists. The median forecast a week earlier was 5.2 percent.

Policy makers, led by central bank President Henrique Meirelles, held the benchmark overnight rate at 10.75 percent for a second straight meeting on Oct. 20 after raising it 200 basis points earlier in the year. The bank said in minutes released yesterday from the meeting that its “prevailing understanding” is that inflation will converge toward the 4.5 percent target. That forecast “hinges on the fiscal and credit trajectories with which the monetary policy committee works,” policy makers said.

Rising Spending

Investors are becoming concerned that policy makers aren’t doing enough, said Nick Chamie, the global head of emerging markets at RBC Capital Markets in Toronto.

“By most accounts it seems as if the central bank should be tightening the policy and they’re not and that’s most people’s concern, that Meirelles is eager not to upset his new bosses,” Chamie said in a telephone interview. “We’re starting to see a rise in inflation premium locally.”

The central bank declined to comment yesterday in an e-mailed statement.

Lula’s government boosted spending 18.2 percent in July from a year earlier, helping push the budget deficit to the equivalent of 3.4 percent of gross domestic product from 1.3 percent in October 2008.

Rousseff, Lula’s former cabinet chief and energy minister, tripled her lead over opposition rival Jose Serra four days ahead of the runoff vote, a Sensus poll showed.

Widening Lead

Support for Rousseff rose to 51.9 percent from 46.8 percent in the previous Sensus poll taken Oct. 18-19. Support for Serra, a 68-year-old former Sao Paulo governor, declined to 36.7 percent from 41.8 percent, according to the poll of 2,000 people nationwide. The survey has a margin of error of 2.2 percentage points.

In the first-round vote on Oct. 3, Rousseff took 47 percent of the vote while Serra won 33 percent.

Rousseff, 62, said on Oct. 21 that the economy can expand 7.5 percent a year while keeping inflation under control. Speaking to reporters in the coastal city of Porto Alegre, Rousseff said the country was “technically” at full-employment and that inflation has to be kept “strictly under control.”

Rousseff’s campaign staff didn’t reply to questions sent by e-mail.

‘Inflation Credibility’

The increase in inflation expectations will probably halt as the new administration takes over next year, said Guillermo Osses, who helps oversee $50 billion in emerging-market assets at Pacific Investment Management Co. in Newport Beach, California.

“In the longer run, it will depend on the policy mix adopted by the new economic team and new central bank authorities,” Osses said. “But we think they do understand the benefit that inflation credibility has for the economy and for their own political future.”

Inflation has slowed from a high of 17 percent in Lula’s first year in office in 2003, helping the economy maintain an average annual growth rate of 3.4 percent and lift 21 million people out of poverty, according to the Rio de Janeiro-based Getulio Vargas Foundation.

Yields on interest-rate futures due in January 2012 fell three basis points to 11.33 percent, signaling traders expect the central bank will raise the benchmark rate to about 12.25 percent by then, according to data compiled by Bloomberg.

Real’s Rally

The extra yield investors demand to hold Brazilian dollar bonds instead of U.S. Treasuries rose one basis point to 173, according to JPMorgan Chase & Co.

The cost of protecting Brazilian debt against non-payment for five years with credit-default swaps fell one basis point to 99, according to data compiled by CMA DataVision. Credit-default swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent should a government or company fail to adhere to its debt agreements.

The real gained 0.2 percent to 1.7013 versus the dollar by 10:22 a.m. in New York.

Record-low interest rates in the U.S., Japan and Europe are fueling demand for Brazilian fixed-income assets, helping push the real to 1.6442 per dollar on Oct. 14, the strongest level since September 2008. The Finance Ministry tripled a tax on foreigners’ purchases of fixed-income assets this month to 6 percent to curb the currency rally and shore up exports.

Money Supply

The central bank bought $4.2 billion in the first half of October after tripling purchases to $10.8 billion in September to weaken the real, according to data on the bank’s website.

Those purchases are injecting reais into the economy, adding to inflation even as the central bank seeks to drain the cash back out, RBC’s Chamie said. Annual money supply growth, as measured by the M1 monetary aggregate, quickened to 19.8 percent in August from 12 percent at the end of last year, according to data compiled by Banco Central do Brasil.

The “central bank has been intervening very hard and sterilization efforts aren’t very helpful,” Chamie said. “It generates money supply growth and as a result that’s going to add to inflation concerns.”

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