Not even an interest rate hike would save the worst emerging currency

It is possible that the monetary policy makers of Chile announce the biggest hike to the interest rate key in two decades, however, even that is unlikely to prop up the burdened weight.

The currency has fallen more than 11% in the second half of the year, the worst performance among the 24 emerging market pairs that Bloomberg tracks. The peso plunged 2.6% last week alone, its biggest drop in two months.

The drop came despite the central bank raising rates 75 basis points to 1.5% on August 31 as policy makers prepare to announce more decisive measures again tomorrow. Many analysts expect a 1 percentage point increase, which would be the largest increase since a 300 basis point increase announced in August 2001. The bank has few options. Consumer prices rose 1.2% in September from the previous month, the fastest pace in more than 10 years.

Six out of 12 analysts surveyed by Bloomberg estimate an increase of 1 percentage point, while five expect a rise of 75 basis points. Felipe Hernández, of Bloomberg Economics, predicts an increase of 150 basis points amid “broad and strong” pressure on prices.

Judging from its September results, even a 1 percentage point hike is likely not going to do much to reverse the peso slump. While the currency advanced 2% in the week ending Sept. 3 after the surprising 75 basis point rate hike, it wiped out all of those gains the following week. The Chamber of Chile swaps curve now discounts a rate hike of 137 basis points for Wednesday.

The peso is being affected by the increasingly controversial Chilean politics ahead of the presidential elections on November 20. Peso-denominated bonds have plunged more than 30% this year in dollar terms, lagging behind all pairs of developing countries, according to Bloomberg indexes.

The November elections could consolidate a shift to the left, as the main conservative candidate has steadily lost support in the polls to a rival on the right, while the favorite on the left remains firm. At the same time, a new constituent convention is beginning to rewrite the Constitution, as lawmakers debate a fourth round of early pension withdrawals.

Citigroup recently added a 0.5% underweight to the peso in its portfolio of emerging markets bonds, citing the pension bill as a risk factor among other concerns.

The impact of the withdrawal proposals “is already being seen in the exchange rate,” New York-based JPMorgan economist Diego W Pereira wrote in a report to clients on Friday. A weaker currency, coupled with rising energy prices, will result in a higher pass-through to the CPI, generating “an additional source of upward inflationary pressures.” That negative feedback loop could only be broken when the central bank makes hikes “more aggressively than it is discounted,” according to Pereira.

The peso is now trading at its weakest level since May 2020 and is less than 3% from the key support level of 850, reached on April 28 of last year. Going beyond that level could open the way for further falls to the all-time low of 879, recorded in the early days of the pandemic.

The central bank will announce two consecutive rate hikes of 100 basis points in October and December if no new pension withdrawals are authorized, Creditcorp wrote in a report on Friday. If the withdrawals are approved, the policy rate will need to rise another percentage point by year-end to reach neutral, according to analysts Samuel Carrasco and Daniel Velandia.