Chile's peso-denominated bonds face mounting pressure as tensions in the Middle East extend into their sixth month, with the Strait of Hormuz still closed to shipping. The prolonged conflict is raising concerns that borrowing costs for Chile's three-year sovereign peso bonds could climb in August. Analysts and traders surveyed by Bloomberg last week indicate this risk is real, with nine out of 19 expecting a rise in yields of between 5 and 10 basis points this month. Another three respondents see a smaller, but still meaningful, increase between 1 and 5 basis points. The pressure comes even as the Chilean economy shows little momentum, with mixed economic indicators adding to uncertainty.
Inflation climbs as fuel costs surge
Fuel prices in Chile have climbed sharply, with gasoline increasing by 32.9 pesos per liter and diesel by 28.5 pesos last week. These hikes took effect on Thursday and are set to last for three weeks. The government may soon have to decide whether to inject more money into its fuel stabilization mechanism, a move that Finance Minister Jorge Quiroz has warned could become unsustainable if the situation persists.
Annual inflation hit 4.3% in June, well above the 3% target and beating analysts' expectations. Energy costs, which had briefly dipped, are now rising again. Inflation has only met the target in three months since early 2021, raising concerns over Chile's economic resilience. The government's fuel pricing adjustments are adding pressure to an already fragile situation, with the risk of higher oil prices amplifying the effects on the national economy.
Bonds tied to inflation see increased demand
As inflation accelerates, investors are shifting their focus to bonds tied to Unidades de Fomento (UF), an inflation-linked accounting unit. Over half of the respondents in the latest survey now prefer UF bonds with maturities of one to five years, a dramatic shift compared to earlier in the year when peso-denominated bonds were more popular. Analysts are forecasting lower yields for these inflation-linked bonds in the coming weeks as demand increases. This trend reflects the growing uncertainty over inflation and the desire for protection against price rises.
Diego Pino, head of credit and equity trading at Scotia Corredores de Bolsa, explained that the shift toward UF bonds is a direct response to inflation concerns. "With accelerating inflation, demand for inflation-linked UF bonds should increase, pushing down short-term yields," Pino said. His view aligns with the data, with almost 53% of survey participants expecting yields on these bonds to fall by between one and 10 basis points over the next month. The move away from peso-based bonds has become increasingly common, with only about a quarter of respondents still favoring them across all maturities.
Central bank hesitant to raise rates
Despite the rising inflation and economic uncertainty, the central bank decided to hold its benchmark interest rate at 4.5% last week. The decision came as policymakers acknowledged a "higher-than-usual degree of uncertainty" in the macroeconomic environment. However, market expectations have shifted in the past month. While traders previously anticipated a rate cut, most now expect no change in the September meeting. This signals a cautious approach, with central bankers balancing inflation pressures against economic stability.
Still, the risk of tightening remains. The market-implied policy rate shows borrowing costs increasing to 4.73% within a year, a stark contrast to the earlier possibility of a cut of the same magnitude just a month ago. Analysts warn that a more persistent inflation shock could lead to tighter monetary policy, adding further stress on peso bonds. If inflation continues to climb without signs of stabilization, a rate hike could become more likely.
Industrial output in Chile rose 1.3% in June compared to a year ago, the first annual gain since September. However, the broader economic picture remains bleak, with unemployment stuck at a five-year high and manufacturing activity falling for a sixth consecutive month. The government faces a delicate balancing act, trying to manage inflation without triggering further economic instability.
The selloff in peso bonds has closely followed the surge in oil prices. In fact, the correlation between oil prices and Chile's three-year government bond yield has reached its highest level since March 2020. Erick Martinez Magana, a strategist at Barclays in New York, noted that a 10% increase in oil prices could add about 5 basis points to the three-year bond yield. This connection underscores the vulnerability of Chile's economy to global energy market fluctuations.
The oil situation took a brief turn as Brent crude prices dropped on Monday morning after President Donald Trump announced new talks with Iran. The Islamic Republic denied being in discussions with the U.S. This shift briefly alleviated concerns, but the underlying risks remain high. Analysts like Jaime Achondo, executive director at Fynsa, warn that if the Strait of Hormuz remains closed, oil prices could return to $100, fueling continued inflation. "That is definitely a bad scenario for nominal bonds," Achondo said.
Chile's economy is at a crossroads. With inflation climbing, fuel prices spiking, and bond yields fluctuating, the government and investors are bracing for further challenges. The central bank's cautious stance is being tested as market expectations shift toward potential tightening, a scenario that could further complicate an already uncertain economic outlook. The coming months will be critical as Chile navigates these pressures and seeks to maintain economic stability in a volatile global environment.