Understand why the interest rate curve signals a risk of recession in Brazil in 2022

For the first time since the 2014-2016 recession, Brazil is seeing a movement in the interest rate market that, in other countries, is seen as a sign that anticipates a period of economic contraction.

This is called the inversion of the interest curve, that moment when a short-term investment, of two years, for example, has a higher return than a longer-term investment. By financial logic, the long term should offer a return above the short term, and not the other way around.

Data from the US central bank—more specifically from the Federal Reserve in New York—show that since the late 1960s, the reversal of the yield curve has preceded all US recessions.

In Brazil, there is no historical data that allows making such a comparison, but a work by economists Gilberto Borça Jr., Gabriel Galípolo and Igor Rocha shows that the same movement occurred, for the last time, in the years of 2015 and 2016 and is repeating now.

For them, this increases the chances that the country will face a new recession, or a period of almost zero growth, in 2022. It also creates a scenario that reinforces the attractiveness of investments in short-term fixed income, to the detriment of higher risk assets and the financing of productive activity.

Negatively sloping interest curves show the expectation of a very strong increase in the cost of money in the short term. This postpones investment and consumption, weakens the economy and may even cause a contraction in activity, leading the BC (Central Bank) to subsequently reduce rates to revive demand.

Considering the NTN-F (treasury paper pre-fixed with semiannual interest), for example, the annual rates were at 4.25% for 2023 and 6.83% for 2031 in January of this year. They reached 9.18% and 11.10%, respectively, at the beginning of October, while the BC maintained a pace of one percentage point increase in the basic rate.

When discussions about breaking the spending ceiling gained traction at the end of last month, and the BC accelerated the pace of monetary tightening, the shorter rate jumped to 12.16%. The longest had a milder rise, to 11.63%.

The move coincided with the revision of growth projections for 2022 made by several institutions, some already talking about a contraction in activity.

The work of the three economists shows that the same movement occurred with the interest curve on bonds linked to inflation, again, returning to the scenario of 2015 and 2016.

“Moments of very strong and rapid monetary tightening, like now, are characterized by an inversion of the interest rate curve”, says Gilberto Borça Jr., Master’s in Economics from UFRJ (Federal University of Rio de Janeiro). “The central bank raising interest rates more quickly caused the curve to reverse.”

According to him, a turn of the curve to its positive slope may occur if the monetary authority manages to bring inflation, currently above 10%, closer to the target — the limit for 2022 is 5%. Or, in the worst case, if the market adjusts long-term interest rates upwards, if there is a perception that Brazil will live with higher rates for a longer period of time.

He lists a number of other signs that support expectations that there is a risk of recession in 2022, such as a worsening external scenario for emerging economies, a still weak labor market and a general worsening of financial conditions.

Borça Jr. explains that one of the main activities of the financial system is to raise funds in the short term at a lower cost in order to lend money over longer terms, earning with the difference. If the curve is inverted, according to him, the bank cannot transform this short-term cost into a profitable long-term asset.

Economist Gabriel Galípolo, co-author of the study, says that the same is true for anyone investing in an enterprise with a long-term return, which needs to be postponed until the cost of funding is compatible with the rate of return.

“The interest he will pay to get the loan is higher than the remuneration of a concession project. So you postpone investments. It’s like a guy who keeps the money in savings and has debt on the overdraft.”

Galípolo claims that the last two inversions of the curve reflect moments of insecurity in relation to the current economic situation and that the next few years will be particularly restrictive from the point of view of liquidity and credit.

“When this higher premium is proportional along the entire curve, that is, when the entire curve shifts, it’s bad. When there is this dysfunctionality, giving a higher premium for a more immediate period in fixed income, you reduce even more investments in the stock market, in the real estate market and makes it more expensive to start any type of venture.”

In a report released this week, Camilla Dolle, from XP’s fixed income area, says that Brazil is experiencing a time when fiscal lack of control leads the Central Bank to raise the Selic rate well above the so-called “neutral interest” to control expectations of inflation. But the market does not believe in permanent fiscal loss, since, in this case, longer bonds should have this risk premium, and the curve should maintain an ascending shape.

The current curve signals the expectation that the base rate will rise from the current 7.75% per annum to 13.5% in 2022 and fall to 12% in 2023, where it would remain for a long time. But the monetary relief may be greater than market-priced, she said.

On the other hand, the market may start pricing this risk of permanent fiscal loss at some point, considering next year’s presidential election.

“Should that happen, the scenario could get worse for longer interest rates,” says Dolle.