Argentina Jolts FX Traders by Hiking Rate Above 30% to Buoy Peso

© Bloomberg. The Central Bank of Argentina stands in Buenos Aires, Argentina, on Wednesday, Feb. 1, 2017. The city of Buenos Aires released Argentina’s consumer price index (CPI) figures on Feb. 10, 2017. Photographer: Sarah Pabst/Bloomberg

(Bloomberg) — Argentina’s central bank shook local markets by raising its key interest rate, a surprise move aimed at stemming a record decline in the currency and restoring credibility to its inflation-fighting credentials.

The seven-day repo rate was increased 3 percentage points to 30.25 percent effective immediately, the central bank said in a statement, adding that the objective of the decision was to contain inflation that is near 25 percent. The move was all the more unexpected because policy makers had held borrowing costs in a meeting on Tuesday. The bank said it will act again if necessary.

“They confused the market this week, and they’re paying for that mistake now,” said Edwin Gutierrez, head of emerging-market sovereign debt at Aberdeen Standard Investments in London. “We all know that they don’t have endless firepower.”

Central bank President Federico Sturzenegger has now puzzled markets twice since December, when the government eased the inflation target allowing officials to pursue looser monetary policy to help bolster a nascent economic recovery. The decision was “poorly communicated” and was followed by an ill-timed and controversial 150 basis point rate cut in January in the face of a sharp deterioration of inflation expectations, Goldman Sachs (NYSE:) said at the time.

What followed was a free fall of the peso, making it the worst performing major currency this year. The bank spent more than $3 billion this week, or about 5 percent of reserves, to defend the peso as it hit a record low. Those efforts weren’t enough to offset global pessimism toward riskier assets, renewed dollar strength and an exodus of overseas investors from Argentina after a new income tax for foreigners took effect this week.

The peso, which had fallen as much as 1.8 percent earlier in the day, closed 0.1 percent higher at 20.54 per dollar. Still, its 10 percent plunge this year is the worst among major currencies, and trails only the Angolan kwanza and Venezuelan bolivar globally.

“The pressure on the FX led to a situation where there was a need to give a message to foreign markets,” said Alejo Costa, the head of strategy at BTG Pactual Argentina. “They needed to give a strong additional policy signal.”

The central bank’s spot-market intervention this week accelerated from just $2 billion spent in the entire year until Monday. Analysts questioned how much more the central bank wanted to spend on intervention with downward pressure on the peso mounting.

Policy makers are concerned that a weaker peso will fuel inflation that’s already running at an annual pace of 25 percent. President Mauricio Macri has made slowing price increases one of his top priorities since he took office in late 2015 vowing to jumpstart investment. But that goal has often conflicted with another top goal: ensuring robust economic growth.

The hike is a boon for investors like Gutierrez, who hold local assets, and have benefited from the highest local rates in the world, now 300 basis points higher, and from a stable currency thanks to the central bank’s participation in the market starting in March.

“We still like the medium-term story, but the confused policy and conflict among the economic team has not been positive, and we’re now seeing the end product of that conflict,” he said. “It remains to be seen whether this is enough. That remains a function of what inflation looks like in coming months.”

Even after the plunge this year, the country’s real effective exchange rate — the purchasing power adjusted for inflation — suggests that the peso may still have further to fall. The peso’s equilibrium value should be at 22.45 per dollar, analysts at BNP Paribas (PA:) wrote in a note yesterday that highlighted intervention in the currency market as “a band-aid to a more structural problem.” That’s above the end-year forecast by analysts surveyed by Bloomberg, who expect the peso to end the year at 21.4 per dollar.