Opinion – Solange Srour: Why did the market accept the Transition PEC?

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Based on the behavior of financial asset prices so far, we can say that the Transition PEC scared economists more than investors.

Even though the future interest curve removed the Selic’s downward pricing in 2023 and the Brazilian stock exchange suffered during a time of recovery abroad, the movements were moderate given the country’s increased risk of insolvency. More surprisingly, the real has hardly moved since the election results, even with the approval of the State-owned Law.

A very different reaction occurred in the second half of 2021, when the PEC of Precatories was approved, opening up space on the ceiling for the creation of the Brazil Aid. At the time, the dollar went from around R$5 to almost R$5.70. Why now, faced with a “gap” of almost 2% of GDP —which will put our debt on an explosive trajectory and leave the country without a fiscal framework—, are we not witnessing a more emphatic response from financial assets?

The explanation does not lie in the tranquility of investors with the direction of fiscal policy, but in the perspective that global inflation has already reached its peak and the main central banks —the Fed, in particular, which has already tightened considerably— will respond, sometime next year, to the risk of recession with falling interest rates. Since the elections, the real has depreciated by close to 3%, while the currencies of emerging countries have appreciated, on average, around 7% against the dollar.

Moments in which the improvement in global risk prevents the worsening of domestic risk from manifesting itself immediately are not rare. The question that arises is: is this movement of greater appetite for global risk sustainable?

In fact, US inflation is showing signs of slowing down, allowing the Fed to reduce the pace of interest rate hikes this week, after having implemented the fastest tightening of monetary policy since the 1980s. However, Jerome Powell made it clear that it’s too early to call it quits, and he signaled that interest rates will remain high long enough to bring core inflation, which is currently at 6%, to a level close to 2%.

Despite this communication, the markets remain buoyant with the first signs of inflationary relief. The American interest rate curve prices cuts in the second half of next year, in a cycle of more than two percentage points scheduled to end in mid-2025 – the biggest cycle of monetary policy easing since 1989.

Animation can be premature. The current environment is still one of high inflation, and an exaggerated easing of financial conditions is something to be avoided.

The main reason is the heated job market in the US, implying a slower and more moderate fall in inflation than in the pre-pandemic decades. In addition, while the ongoing downturn in the housing sector is likely to drag GDP growth downwards, a financial crisis of widespread defaults is unlikely to affect the financial sector as it has in the past.

Furthermore, families are much less indebted and still have high savings to sustain consumption. Companies are also proving relatively immune to higher interest rates because the debt issuance boom of 2020 and 2021 has suppressed their need to refinance this year and next. One potential reason the Fed will need to keep rates higher for longer is simply that there is more excess liquidity to drain now than at any time in the past.

With its credibility shaken and no confidence in its ability to forecast inflation, the Fed appears to want to see inflation move closer to its 2% targets before signaling rate cuts and actually implementing them. Most likely, that means waiting until 2024.

The tightening already carried out by the Fed managed to “burst” some bubbles, such as cryptocurrencies. However, that is not its objective, but rather to bring US inflation close to 2% —a prospect that could push risk appetite to an even low level in 2023.

In view of all this, it does not seem safe to say that the market “accepted” the PEC, but rather that the new government is having some time to show fiscal responsibility after the proposed overflow. If this is used for the reversal of structural reforms and complete destruction of the existing framework, sooner or later, the adjustment bill will arrive.

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