Brazilian fixed-rate bonds are beating inflation-linked debt for a fourth straight month, the longest streak since 2005, after central bankers confirmed investor expectations that consumer price increases are slowing. Invest in Brazil Government Bonds. Request more information here.

Fixed-rate bonds gained 1.2 percent this month, compared with a 0.9 percent return for notes linked to the IPCA index, according to data compiled by Rio de Janeiro-based National Association of Financial Market Institutions.

The benchmark securities are heading for their biggest advance since May 2009 as consumer prices drop and growth slows after expanding at the fastest pace in 15 years in the first quarter. Central bank President Henrique Meirelles raised the overnight lending rate 50 basis points on July 21, surprising 48 of 51 analysts in a Bloomberg survey who forecast an increase of 75 basis points, or 0.75 percentage point.

“The market is reacting to a more dovish central bank at this stage,” said Luiz Fernando Figueiredo, a former Brazilian central bank director who oversees 1 billion reais ($569 million) at Sao Paulo-based hedge fund Maua Investimentos Ltda. “We’ve seen some signs of deceleration in activity and more benign inflation numbers.”

Yields on Brazil’s 10 percent bonds due in January 2012 fell 53 basis points in the past three months, the biggest drop since March 2009, to 11.63 percent. The yield on the country’s 6 percent inflation-linked bonds maturing in August 2012 fell 36 basis points to a three-month low of 6.16 percent.

Deflation Reading

The gap between the two securities, which reflects investors’ expectations of the average inflation rate, narrowed 17 basis points during the same period to 547. The so-called breakeven rate dropped from an 18-month high of 580 on May 4.

Investor demand for inflation protection is waning after consumer prices fell 0.09 percent in the month through mid-July, the first deflation reading since 2006, and retail sales climbed 10.2 percent in May, less than analysts forecast.

Meirelles, 64, and his colleagues voted in a unanimous decision to lift the benchmark rate to 10.75 percent from 10.25 percent on July 21, saying in a statement that inflationary risks have eased because of “the recent evolution of domestic and external factors.”

U.S. Federal Reserve Chairman Ben S. Bernanke told lawmakers on July 21 that the outlook for the world’s largest economy “remains unusually uncertain.” European countries are implementing austerity measures to reduce budget deficits, sparking concern their economic recoveries will falter.

‘Soft Patch’

“Meirelles is concerned about the U.S. and European economies, and he found a soft patch in the Brazilian economy,” said Guilherme Figueiredo, who oversees $1.3 billion as director at M. Safra & Co. in Sao Paulo. The outperformance of the fixed- rate bonds shows “the market is more comfortable with inflation,” he said.

The yield on the interbank rate futures contract due in January tumbled nine basis points to 10.88 percent yesterday, a level that indicates traders expect the central bank to raise its benchmark target another 25 basis point by year-end. The yield has slumped 40 basis points in the past month, the biggest drop since March 2009.

Bonds tied to inflation may start to outperform as a decline in the unemployment rate and an increase in wages fuel consumer price increases, according to Maua’s Figueiredo.

Unemployment fell to 7 percent in June from 7.5 percent in May, the national statistics office said yesterday in Rio de Janeiro. Annual inflation, while falling to 4.7 percent through mid-July from 5.1 percent in June, remains above the central bank’s target of 4.5 percent.

‘Under Control’

“We are still seeing a tight labor market,” said Marcelo Saddi Castro, who oversees 18 billion reais as chief investment officer at SulAmerica Investimentos in Sao Paulo. “Inflation is still a concern, and activity is in a good shape. The yield curve will have to move higher.”

The extra yield investors demand to own Brazilian dollar- bonds instead of U.S. Treasuries narrowed eight basis points to 218, according to JPMorgan Chase & Co. indexes. The yield gap has fallen from a nine-month high of 251 on June 8.

The cost of protecting Brazilian bonds against default for five years fell three basis points yesterday to a two-month low of 120, according to CMA DataVision prices. Credit-default swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent should a government or company fail to adhere to its debt agreements.

The real rose 1.3 percent to 1.7581 per dollar.

Brazil’s fixed-rate bonds returned 2.3 percent in the second quarter, following a 3.2 percent gain in the first three months of this year. Inflation-linked notes with a maturity less than five years gained 1.9 percent and 3.9 percent, respectively.

Budget Minister Paulo Bernardo told reporters in Brasilia yesterday that there is “no need” for the central bank to raise rates again this year.

“Inflation is back under control,” he said.

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