Traders Cherry-Pick Latin America Bets on Split Rate Paths

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(Bloomberg) -- Money managers are pitting Latin American assets against each other, hunting for winners as the region’s largest economies take opposite paths in the wake of the Federal Reserve’s first interest-rate cut in four years.

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Mexico’s central bank is expected to follow suit and lower borrowing costs Thursday, and there are growing calls for a deeper cut in Colombia, which decides on rates this month, amid subsiding inflation. Brazilian policymakers, meanwhile, kicked off a hiking cycle with a quarter-percentage point increase, and signaled there’s more to come as inflation expectations deteriorate.

The rate differential, investors say, will likely shore up the Brazilian real while its peers face pressure from imminent rate cuts. The real is trading near the strongest in a year against Mexico’s peso, rebounding from a 20-year low, and banks including BNP Paribas and Morgan Stanley are touting bullish positions in the Brazilian currency against the Colombian peso.

“People got used to synchronized monetary policy over the past four years — but it wasn’t that way before the pandemic,” said Jose Oswaldo Monforte, a portfolio manager at hedge fund Vinland Capital in Sao Paulo. “Relative-value bets in rates and currencies make a lot of sense in Latin America.”

Monforte’s Vinland, whose flagship fund has returned more than 54% after fees over the past five years, outperforming a basket of peers, is betting the real will fare better than the Mexican peso. Vinland, one of Brazil’s hedge funds expanding their reach to Mexico, is also betting borrowing costs there will fall more than what’s currently expected by traders.

These relative-value trades are becoming popular as geopolitical concerns and wavering growth cloud the global outlook and the path of the US dollar. Currencies from Mexico, Brazil and Colombia have weakened more than 7% each versus the greenback this year, among the worst in the world, as uncertainty over local politics and government spending plagues the region, making outright bullish bets risky. The real lagged emerging-market peers on Monday on concerns over the fiscal outlook, following three-consecutive weeks of gains.

One way around that is to bet on monetary-policy divergence as countries that slashed rates to record lows in tandem during the pandemic have begun to split.

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Inflation picked up faster in Brazil, pushing it to be one of the first to hike and also to cut among major central banks. Now, traders are pilling onto payers, positions that profit from higher interest-rate futures, as they anticipate further tightening after last week’s hike. They’re also touting the battered real, which should become more appealing to carry traders as rates climb.

“The outlook between the real and the peso has started to diverge,” said Billy Lang, a portfolio manager at Neuberger Berman. “As Brazil’s central bank initiates a rate-hike cycle, we anticipate BRL to receive support.”

The Brazil call is far from a consensus, and particularly disdained among locals. Investment firms such as Verde Asset Management are sticking to wagers on a weaker currency, betting the sour mood fueled by the government’s spending habits will offset any benefit from the widening rate gap with the US. Swap-rate contracts maturing in January 2029 were up about 9 basis points on Monday, extending last week’s advance.

In the rest of the region, money managers are taking positions that benefit from lower rates, like longer maturity bonds, as policymakers from Mexico City to Bogota take cues from the Fed.

“In Latin America, I am more comfortable with duration and rates stories,” said Valentina Chen, co-head of emerging markets at investment firm Mackay Shields in London. “While I would be more inclined to go long Brazil’s real, I would prefer funding it through Colombia’s peso instead of Mexico’s peso” as the latter could be sensitive to a sharp, short-term rally due to technical factors, she added.

Traders are pricing in more than one percentage point of monetary easing in Chile, Colombia and Mexico over the next six months, swap markets data shows. For Brazil, money managers are expecting more than 1.5 percentage points in hikes in that period.

Mexico’s central bank is expected to cut borrowing costs by 25 basis points to 10.5% on Thursday. It could add further pressure on the peso, which has been rattled by the ruling party’s congressional majority that allows for constitutional changes — including a massive overhaul of the judicial system — and upcoming US elections. Hedge funds are the most bearish on the currency in about 17 months.

“Mexico is tricky,” said Sophia Drossos, an economist and strategist at Point72 Asset Management, who favors the real. “Much of its position depends on attracting foreign investment — and some of these strategic decisions to invest in Mexico may be affected by the political developments like the weakening of the judiciary.”

Meanwhile in Colombia, lawmakers are tangled up in budget discussions for next year, which investors are following to gauge inflation expectations and policymakers’ reaction. The government has been pushing for lower rates — the finance minister, who’s a voting member of the board, has called for a 75 basis-point reduction at this month’s meeting.

“It’s a challenging set up,” Grant Webster, co-head of emerging-market sovereign debt and currencies at Ninety One, said of Latin America. “Currencies are very vulnerable to shifts in sentiments, and they’re also very differentiated from each other.”

What to Watch

In Brazil, monetary policy will remain in focus with the release of minutes of the central bank’s Sept. 18 meeting and its quarterly inflation report

The Fed’s outsize rate cut and dovish forward guidance point to Mexico’s central bank reducing rates to 10.5%, with more cuts to come

Sri Lanka’s central bank is likely to keep rates on hold, though more easing may be ahead; the country held presidential elections on Saturday

People’s Bank of China is expected to hold its one-year medium-term facility rate steady at 2.3% in September

--With assistance from Tugce Ozsoy.

(Updates with real move in sixth paragraph and swaps markets moves on 10th and 13th paragraphs.)

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