(Bloomberg) -- First it was a collapse in the currency. Now the rest of Brazil’s financial markets are in the cross-hairs as investors lose faith in the government’s ability to contain a deepening fiscal crisis.
The selloff that sent the real plunging to a record low is engulfing everything from stocks to local-currency debt to dollar bonds, with traders even piling into hedges against a sovereign default. Market watchers say extraordinary measures on Tuesday by the central bank to stem the currency’s slide are little more than a temporary fix, and warn that lawmakers’ moves to water down a high-profile austerity package are likely to only add to the turmoil.
The widening rout shows how investors are increasingly skeptical that President Luiz Inacio Lula da Silva is serious about reining in a soaring fiscal deficit. Brazil is running an annual budget gap of 10% — far wider than the ones seen during the leftist president’s first administration. His recent emergency brain surgery came at the worst possible time, further complicating efforts to shore up public accounts.
“Brazil has become ‘sell first, ask later’ in the current market,” said Sergey Goncharov, a money manager at Vontobel Asset Management. “The fiscal concerns coupled with the central bank’s reaction to the FX move triggered some panic selling.”
The real has been the worst-performing currency in the world over the past four sessions, adding to a 21% drop this year against the greenback. The benchmark Ibovespa stock index — Latin America’s largest — has fallen 3.8%. Swap rates jumped. Dollar bonds tumbled the most in emerging markets after defaulted Lebanon and five-year credit default swaps widened to their highest level in more than a year.
“It’s reached a crisis stage from a bond standpoint,” said Jack McIntyre, a portfolio manager at Brandywine Global Investment Management. “Lula’s got to say something constructive.”
Brazil’s lower house altered Lula’s spending proposal late Tuesday in ways that may further unnerve investors. While they approved the plan, which awaits a vote in the Senate, lawmakers struck a proposal that would have let the government restrict the use of tax credits by companies if finances worsen. A controversial plan to change the military pension system was also punted until 2025.
As the currency selloff spread this week, strategists rushed to abandon bullish bets on the country’s assets. Over the past two days, JPMorgan Chase & Co. strategists ditched their positive view on Brazil’s dollar debt, while Credit Agricole SA exited its tactical overweight position on the real two weeks after entering the trade.
“Investors clearly have thrown in the towel,” said Olga Yangol, head of emerging-markets research and strategy at Credit Agricole. Despite positive signs on growth and actions from the central bank, “the perception is that as long as the current president is in charge, he seems to be quite impervious to market gyrations.”
Last month Lula unveiled a plan to cut 70 billion reais ($11.5 billion) in annual spending, but it was accompanied by new income tax breaks, disappointing traders. On Tuesday, a lawmaker in charge of the spending cut plan said congress was considering watering down the proposal even further due to its potential impact on social programs.
The government’s reluctance to follow through with cuts has left most of the heavy lifting to the central bank, which last week lifted benchmark interest rates by a full percentage point and vowed to bring the rate to 14.25% by March as they combat inflation.
Despite the tight credit conditions, Brazil’s economy — the largest in Latin America — has continued to grow, with unemployment near record lows and wages gaining. What’s more, it has about $360 billion in international reserves. Lula has capitalized on the economic growth to show he’s delivering on his promises to improve living standards for the poor.
But it has also stoked concerns that the economy may be overheating, with inflation expectations having deteriorated significantly. Traders now expect rates to peak near 16.25%, which would increase the government’s interest cost burden and widen the deficit even more.
In addition to its rate decision, the bank has carried out its biggest direct interventions since the early days of the pandemic, pumping $5.8 billion into the market through spot auctions since Friday. Each time, the moves gave the real a temporary jolt that quickly faded.
Investors said the risk of fiscal dominance, whereby monetary policy becomes ineffective, is starting to creep in.
“The central bank is a supporting actor,” said Marcos de Marchi, chief economist at Oriz Partners. “The main actor in this movie is fiscal policy.”
For now, few investors are willing to wager when the rout will end, unless the government changes tack.
“Momentum is driving everything Brazil-related,” said Gregory Hadjian, a global macro strategist at Loomis Sayles in Boston. “Fiscal is 100% the main problem. And a material response on fiscal is the real catalyst to turn things around.”
--With assistance from Maria Elena Vizcaino, Zijia Song and Leda Alvim.
(Updates with lawmakers’ moves in seventh paragraph)
