FX Dashboard: Chilean Central Bank is Set to Deliver Another Hawkish Surprise

Banco Central de Chile’s (BCCh) upcoming monetary policy meeting on October 13 will be closely watched. At the last meeting on August 31, BCCh delivered a hawkish surprise by raising the policy rate by 75 bp versus market expectations of 50 bp. This time around the median expectation on Bloomberg has already jumped to a 100 bp hike.

We expect the BCCh to increase the pace of tightening even further, possibly raising the policy rate by 150 bp or higher, for a few reasons:

• High inflation and inflation expectations: Inflation prints continue to surprise on the upside in Chile. Headline CPI for September came in at 5.3% YoY, higher than the August CPI of 4.8% and outside the target band of 3% +/- 1%. More worrisome for BCCh is that long-term inflation expectations have deteriorated:
  • BCCh’s monthly survey shows that year-end inflation expectations in September rose to 5.1% from 4.2% the previous month. Inflation expectations for 12 months forward also experienced a jump to 4.3% from 3.5% a month ago. More concerningly, 2y inflation expectations rose to 3.2% after being anchored at BCCh’s target of 3% since 2011.
  • Inflation breakevens have also been rising steadily. As the first chart below shows, the 5y inflation breakeven, which has historically hovered around 3%, has reached levels not seen since 2012. Indeed, the entire breakeven inflation curve going out to 20 years is now above the inflation target of 3% as the second chart below shows.

Data Source: Refinitiv

• Strong growth: The expansionary fiscal and monetary policy stance along with the rally in copper prices have led to a sharp recovery from the pandemic-driven recession, with the economy showing signs of overheating:
  • GDP growth forecasts continue to be revised up for 2021, with Bloomberg consensus forecast now at 10.3%. BCCh’s forecast is even higher at 10.5-11.5% in the latest Monetary Policy Report.
  • If the fourth pension withdrawal – which the Senate is due to vote on this month – is approved, then it would add further fiscal stimulus to the economy.
• Currency weakness: Despite the strong recovery and expectations of further monetary tightening, the Chilean peso (CLP) has underperformed the rest of EM over the past few months (see the first chart below).
  • The currency has been weighed down by political uncertainty due to the upcoming presidential election next month and the new constitution being written by the Constitutional Assembly. Based on the latest polls, the extreme right-wing candidate, José Antonio Kast, has overtaken the more market-friendly center-right candidate, Sebastián Sichel, to take second place behind the left-wing candidate, Gabriel Boric. Given the high rejection rate for Kast, the market is concerned about Boric winning in the run-off election. In any case, neither Kast nor Boric is preferred by the market who would rather see Sichel or the centrist Yasna Provoste get elected.
  • The currency depreciation presents passthrough risk, adding to worsening inflation expectations. Moreover, if the currency depreciation continues at the same pace, then it may present financial stability risk as well. This leaves BCCh with two possible options:
    • Raise rates aggressively to anchor inflation expectations and the currency: We expect the central bank to take this approach and are therefore looking for a rate hike of 150 bp or higher. Indeed, if the central bank delivers only 100 bp, in line with market expectations, then in our view the currency would sell off further following the announcement.
    • Announce a currency intervention program: In November 2019, BCCh announced a USD 20 bn program after the currency had depreciated by 14% in a few weeks following deadly riots. This time around, the currency has weakened by 14% since July with 8% of the depreciation over the last month alone (see the second chart below). Our expectation is that the central bank is likely evaluating a program similar to 2019.
  • Finally, in terms of strategy, we have been constructive on the Chilean peso based on our view that the risks are overpriced. Although we expected volatility to increase going into the election, the pace of CLP’s depreciation has been faster than we anticipated. We have been stopped out of one of the trade recommendations (Long CLP vs Short Australian dollar (AUD)) last week but are holding on to the other recommendation (Long CLP vs Short South African rand (ZAR)).

Data Source: Refinitiv; Note: EM FX = equally weighted index of spot returns of 22 currencies

Best Longs / Best Shorts

• The list of underperformers based on our models in the attached FX Dashboard shrunk to just Chilean peso (CLP) and Korean won (KRW) as the z-scores for Peruvian sol (PEN), Thai baht (THB), and Philippine peso (PHP) receded.
• To the list of outperformers, we added Israeli shekel (ILS) as its z-score crossed -1.

Best Crosses

• The list of the preferred relative-value trades based on our models stayed unchanged with Long CLP vs Short Colombian peso (COP) or Russian ruble (RUB) or Israeli shekel (ILS) or Indonesian rupiah (IDR).
• The 3m expected returns for these pairs are in the range of 11.5-13.0% (not annualized), assuming mean reversion.