After the Carnival: Going with the local view on Brazil

In Brazil, markets open for their first full day of trading after Carnival. Based on Wednesday's markets with limited hours, the outlook is good. The Bovespa rose over 1.1% on low volume, and USD/BRL closed down to 2.940, compared to Friday's intraday high over 3.00.

The markets have now had a handful of days to digest the corruption charges against a former Lula government official and to consider the implications. Since the weekend, there has been no new information released that is damaging to Lula or his government. There have been some allegations about the Workers' Party fundraising in the past, and that may warrant some investigating on a broad level when the Senate returns on March 2. But we do not think that would hurt the government directly. Furthermore, as a result of Lula meeting with his core team of advisers in recent days, the government seems to be more co-ordinated in responding to any allegations.

The unanswered questions before Carnival remain unanswered now - was Waldimiro Diniz (the government official fired because he was on videotape illegally fundraising when he worked for the state of Rio de Janeiro) also involved in corrupt activities while in the Lula government or only before that? Did his boss in the government, Lula's powerful chief of staff Jose Dirceau, know about Diniz's actions or was at least negligent of oversight?

Barring new concrete charges, we think that the scandal will fade without too much difficulty for the government. We also sense a different view between locals and foreigners. The locals we speak to definitely see a calmer domestic environment in the past few days. On the other hand, the foreigners are taking a more cautious approach regarding those developments and are less willing to use current levels as good entry points to Brazilian assets. Our view is to be with the locals here, and as such as looking for good entry points to buy, particularly to see USD/BRL in the NDFs as the yield is high and the USD flows into Brazil will remain strong.

What would be helpful to the government is something else for the market and the press to focus on. That may come this morning with the release of the minutes from last week's central bank meeting. The central bank held rates steady last week at 16.5% for the second straight month, and gave an unusually terse statement after the decision, so the market is hungry for information about what is behind the decision.

The key question as far as rates go is - is the recent pickup in inflation due to seasonal factors or something else?
The central bank expressed its concern that seasonal inflation pressures could become permanent after its January meeting, and so the meeting notes this morning may be important hints whether or not those concerns are easing. On the data front, we may get some answers to that question with the release of the broad IGP-M price index for February - market is looking for 0.70% from 0.88% in January - and the CPI for the Sao Paulo area for the four weeks to February 21.

So far, the market view on interest rates is not changed, with the most recent central bank survey showing the overnight rate ending 2004 at 13.75%, meaning cuts of 275bps from the current overnight rate. However, the volatility in the market last week over the corruption allegations and political concerns left interest rate futures projecting very little in cuts this year. In our view, as the market digests the political noise and sees that there is limited follow through, the FRAs will return to pricing in an end-year Selic rate in the neighbourhood of 14.0%.