What is the Best Fiscal Risk Premium Measure: Exchange Rate, Stock Market Index or Yield Curve?

BRAZIL ECONOMICS - Report 30 Jan 2023 by Affonso Pastore, Cristina Pinotti, Paula Magalhães and Diego Brandao

The absence of a fiscal framework results in a risk premium that is manifested in the prices of assets, such as the exchange rate, stock prices and the position and slope of the yield curve. Although in evaluating the reactions to the information related to fiscal policy, we look at these three price parameters, we give greater weight to the shifts and changes in slope of the yield curve.

First, when rolling over the debt that matures every quarter, the Treasury will have to pay an interest rate that rises with the upward shift of the yield curve, increasing the average interest rate paid on the debt and thus increasing the distance between r and g, worsening the debt dynamics. Second, although the exchange rate and stock prices are sensitive to domestic factors, they are more strongly affected by external impulses.

The exchange rate is significantly affected by the variations of the dollar, represented by the DXY, and stock prices, measured by the IBOVESPA, which react significantly to variations of the S&P500 and the exchange rate measured in R$/US$. It is important to demonstrate the properties of these prices empirically to avoid misguided interpretations. For example, after the timid fiscal package proposed for 2023 (insufficient to eliminate the primary deficit) and the absence of a new fiscal framework, the IBOVESPA increased substantially, last week hovering between 112.000 and 114.000 points, and the Real appreciated, fluctuating around R$5.10/US$ last week.

The improved international scenario explains a good part of this movement of the IBOVESPA: China reopened its economy, favoring the prices of metal commodities; recent data indicate that Europe will likely avoid a recession this year (which only a few months ago was assumed to be certain); and rising optimism regarding the evolution of the interest rate in the United States has caused the dollar to weaken (decrease of the DXY). With regard to the Real, we show that the great majority of other currencies are appreciating accompanying the weakening of the dollar, but this effect on the Real is being minimized due to the fiscal risk premium. We close this Report by analyzing the recent behavior of the yield curve.

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