Major regional central banks begin an easing cycle

Major regional central banks begin an easing cycle

A monetary easing cycle is now under way in the region, with several major countries cutting rates in recent weeks, including Chile (in June), Brazil (July), Mexico (August) and Peru (also August). In addition, several smaller countries, such as Paraguay, Costa Rica and Jamaica, have cut rates this year too.

Monetary easing comes amid weak inflationary pressures (excluding the likes of Argentina and Venezuela, where inflation is out of control) and weak GDP growth. The easing cycle embarked on by the US Federal Reserve (Fed, the US central bank) also gives the region's central banks some leeway to act without narrowing the interest-rate differential with the US and risking capital outflows; we expect the Fed to undertake two more 25-basis-point cuts—one in December and another in March 2020.

Looking ahead, we expect additional cuts in Brazil, Mexico and Chile (and a cut in Colombia), but there is less room for monetary easing in Peru, given that interest rates are already low.

Against this backdrop, Latin American sovereign and corporate bond issuance will be driven by search for yield as investors seek to reallocate some of their assets. On the pull side, the region's issuers will be fairly conservative, given that the outlook for the regional (and global) economy is tepid, curbing the demand for investment.

Monetary policies in Latin American countries with inflation-targeting regimes have diverged in recent years, partly reflecting idiosyncratic inflation trends and different business cycles. However, one commonality has been the correlation with the Fed's policy cycle. In 2016 many countries in the region pursued a tightening bias as the Fed began to normalise policy from near-zero interest rates following the global financial crisis. This was to pre-empt capital outflows and currency weakness from causing inflation overshooting. In 2017 international investors became more relaxed about Fed normalisation, taking pressure off the region: some countries eased policy amid benign inflation dynamics and then maintained a status quo in 2018. Mexico was an outlier as its central bank (Banco de México—Banxico) continued tightening in order to bolster confidence amid bilateral US trade tensions and a transition to a less market-friendly and untested, leftist government under Andrés Manuel López Obrador after the July 2018 election.

Easy goes

 In the context of a global economic slowdown amid the US-China trade war, the start of interest-rate cuts by the Fed in July marks the beginning of another phase in global and regional monetary policies, with an easing bias in 2019-20 and normalisation mostly starting in 2021 (including in Latin America). Few countries in the region have room to lift disappointing economic growth rates (both Brazil and Mexico flirted with recession in firsthalf 2019) via fiscal stimulus, owing to high public debt burdens. With inflation muted in most of the region's big economies, this means that another monetary policy easing cycle will be the main tool to stimulate demand, but it will be a rather weak one. This is partly because of starting-points: interest rates are already in stimulative territory and room for cutting is more modest than in the previous easing cycle. An additional factor is that global and local demand is set to remain weak, curbing credit demand.

In Latin America, Chile was the first to act. In what was seen as a pre-emptive cut (coming before the Fed's 25-basis-point cut on July 31st), its central bank (Banco Central de Chile) cut the policy rate by 50 basis points to 2.5% on June 7th. We expect more cuts (of 25-50 basis points), probably in 2020 or perhaps earlier if the Chilean economy fails to pick up moderately as we forecast. Peru's central bank (Banco Central de Reserva del Perú) cut its policy rate by 25 basis points to 2.5% in August, despite heightened political uncertainty, which otherwise might have prompted greater caution. Further monetary easing is unlikely, as the rate is already at its lowest level since August 2010. Colombia's central bank (Banco de la República) has kept its policy interest rate unchanged at 4.25% since its last 25-basispoint rate cut, in April 2018. Nevertheless, we expect it to undertake one rate cut by the end of 2019 to support economic growth.

Brazil and Mexico have the most room for rate cuts. On July 31st Brazil's central bank (Banco Central do Brasil) cut the Selic policy rate by 50 basis points to 6%, an all-time low. Our outlook for Brazil's easing cycle is becoming more bullish, with another 100 basis points in cuts going into 2020, where it will remain stable until rate normalisation in 2021-22. We consider that Brazil's real neutral policy rate (3%) is now about 1-2 percentage points higher than in the other inflation-targeting countries. But Brazil's real neutral rate is now lower than the 5% rate in the past, owing to expected approval of pension reforms to stabilise the public debt/GDP ratio, and other measures to reduce distortions in the financial system. In Mexico, Banxico reduced its policy rate by 25 basis points to 8% on August 15th, following the Fed's rate cut two weeks earlier, thus maintaining the same spread with the US federal funds rate, a key consideration in light of concerns over peso appreciation if the rate differential were to widen. Banxico is likely to follow in the Fed's footsteps this year, before cutting more deeply in 2020 in order to get closer to the neutral rate. We expect another 25-basis-point cut in the fourth quarter and a further four cuts in 2020, bringing the end2020 rate to 6.75%.

Argentina is a case apart (with hyperinflationary Venezuela in another category altogether). The Macri government abandoned a normal inflation-targeting framework in 2018 (which it adopted after taking office in 2015 as part of efforts to normalise the economy) and, following a currency crisis, turned to an emergency IMF US$57bn programme and adopted monetary targets to try to tame runaway inflation. Following the shock primary election result, which makes policy discontinuity more probable, policymakers jacked up interest rates, which are likely to remain high for the time being.

Fed cuts boost bond activity

 Although regional interest-rate cuts should help to support demand for some emergingmarket (EM) assets as they boost growth at the margin, the outlook for potentially growthenhancing capital inflows through international bonds will be driven mostly by Fed easing, as this increases the attractiveness of Latin America's higher-yielding securities. That said, darkening clouds over the global economy will pour some cold water on this and bouts of market volatility could generate sporadic restrictions. But we expect that most Latin American countries will be able to raise sufficient external financing to honour international debt obligations and fund some investments over the medium term. A return to the boom of 2012-14 (during the twilight of the commodity boom years) is unlikely, meaning that the boost to growth will be limited.

The value of LAC (Latin America and Caribbean) bond transactions fell by 17% in the first half of the year, owing largely to a drought at the outset of 2019. Traditionally, EM international bond activity spikes in January, although that did not happen this year because of heightened uncertainty over the Fed's policies. As the Fed subsequently pivoted from a tightening to an easing bias, risk appetite for EM assets improved. LAC international bond deal volumes soared by 48% in April-June year on year and by 41% quarter on quarter.

This trend has continued into the third quarter, with bond deals amounting to US$17.7bn in the period from July 1st to August 12th, more than three times than the total of US$4.7bn registered in the whole of the third quarter of 2018, boosted by the expectation (which proved correct) that the Fed would lower its policy rate at its July 31st meeting.

Contagion from Argentina will be limited

 Demand for LAC bonds was exuberant in the days that preceded and followed the Fed's end-July interest rate cut, but investors took fright over the shock result of the presidential primary election in Argentina on August 11th. Before the poll, investors had already been fretting over the risks of a potential return to power of a figure who would make for policy discontinuity, namely Alberto Fernández, who is running on a ticket with Cristina Fernández de Kirchner (who managed the economy poorly during 2007-15). Even so, Argentinian firms were able to return to the international bond market in July, having been absent since the second quarter of 2018. Such was the case for below-investment grade corporates YPF Energia, Pampa Energia and Telecom Argentina, which sold long-term bonds for US$400m, US$300m and US$400m, respectively in July. In retrospect, these forays appear well-timed, given the spike in the country risk premium since the primaries. Barring an unexpected defeat for Mr Fernández at the October national elections, the sudden stop in access to capital for Argentinian borrowers will persist for some time, but we do not expect that this will translate into a sell-off of LAC assets across the board, as investors have for some time learned to differentiate between countries across the region.

Nevertheless, the Argentinian crisis is likely to usher in greater scrutiny of the region, particularly the countries with more complex fiscal scenarios—such as Brazil, Mexico and Colombia, just to name the larger economies in this category. Reflecting these relative concerns, five-year sovereign credit default swaps (CDS, an insurance against default and measure of the country risk premium) have increased for Colombia more than for the other two countries in August, as it has become evident that the government does not enjoy sufficient political support to push through much-needed structural fiscal reforms. Concerns over Mexico increased following the resignation in early July of the finance minister, Carlos Urzúa, and negative news about the financial health of Pemex, the state-owned oil company. In Brazil, investors are still awaiting final approval of pension reform (the Senate is expected to approve it by October), following relatively swift passage through the lower house, which approved a robust version of the bill in early August. This increased scrutiny is likely to temper the upside to regional bond issuance from the renewed easing of global liquidity.

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