South America’s Worst Bonds Set for Reprieve on Rate-Cut Outlook

  • Citigroup overweight on Chile’s local bonds given rate outlook
  • Brown Brothers Harriman forecasting interest-rate cuts

South America’s worst-performing government bonds are poised for a turnaround.

That’s according to Brown Brothers Harriman and Citigroup Inc., which contend that Chile’s local-currency securities are appealing because of the potential for interest-rate cuts within the next year. Analysts who forecast higher borrowing costs have reversed course as inflation slows toward the central bank’s target and economic growth falls short of estimates.

The peso-denominated bonds, the highest-rated government debt in Latin America, are drawing investors’ attention after lagging behind those from Brazil this year. Citigroup has gone overweight on the notes, while Brown Brothers Harriman expects the gains to materialize in the next three to six months.

“With inflation likely to continue falling and the central bank’s next likely move to be a cut, we think Chilean bonds will start outperforming,” according to a Brown Brothers Harriman report on Aug. 5.

While all 19 economists in a Bloomberg survey predict Chile’s central bank will keep rates at 3.5 percent Thursday, derivatives traders see the possibility of a cut. Two-year interest-rate swaps fell to a 12-month low this month, after peaking in January.

The Imacec index, a proxy for Chile’s economic growth, increased 0.8 percent in June, trailing the median forecast for a 1 percent increase, according to the central bank. Annual inflation slowed to 4 percent in July, within the target of 2 percent to 4 percent.

The local-currency bonds have returned 6.1 percent in 2016, compared with 28 percent for Brazil and 18 percent for Peru. It’s the least among local-currency government bonds in Latin America, except for Mexico.

In the minutes of its July 14 meeting, one member of the central bank board of governors raised the possibility that rate cuts may now be more appropriate than increases.

Even if Chile doesn’t lower rates, international investors fleeing negative yields in Europe and Japan will drive demand for its bonds, according to Pablo Diez, the head of international markets at Santiago-based brokerage Tanner Corredores de Bolsa SA.

In June, Citigroup increased exposure to Chilean bonds in its emerging markets portfolio to overweight. This week it added longer dated bonds. “With the central bank inching closer and closer to removing the hawkish bias we think the next move may well be a cut,” strategists led by Dirk Willer wrote in a note to clients on Wednesday.

Morgan Stanley recommends buying one-year interest rate swaps with a target price of 3.25 percent, down from the current 3.45 percent.

“Inflation is falling back to target, the economy is still very sluggish and copper prices are likely to fall again," Thin said in an interview.

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