(Bloomberg) -- Mounting skepticism over Brazil’s ability to control its fiscal deficit has triggered such sudden changes in investment positions that it has distorted the country’s swap rates market.

Swaps have not only priced out any chance of further interest rate cuts, they now imply the key rate will rise 65 basis points to 11.15% by year end. The central bank has given no indication it will raise rates anytime soon — in fact, it left the door open to cutting borrowing costs when it meets next week. Economists expect the Selic to fall to 10.25% by the end of the year.

Brazilian swaps shifted severely in just a few days. The contract maturing in January 2025, one of the shortest-dated ones, leaped 30 basis points in five sessions. To put that in perspective, Mexico’s one-to-six month TIIE swaps have risen only 12 basis points since the surprise election results roiled the market.

There are legitimate reasons behind the move. Brazil’s two-year inflation breakevens have risen to 4.85%, significantly above the central bank’s 2-4% inflation target for the next few years. Key central bank officials, including governor Roberto Campos Neto, said that the deanchoring of inflation expectations is a challenge, with special emphasis on 2025.

Concern mounted further on Friday after a closed-door meeting between Finance Minister Fernando Haddad’s and representatives of local financial institutions. Attendees left with the impression that the government won’t be able to meet its fiscal target and would likely move to change the fiscal framework approved in 2023.

Haddad tried to mitigate the impact of his comments by saying he was misinterpreted, but the damage was already done — contracts due 2025 jumped more than 20 basis points. The ones maturing in 2027 soared 60 basis points.

“It is now abundantly clear that the new fiscal framework failed as a fiscal anchor, and that the administration shows no inclination to control spending,” said Alberto Ramos, chief Latin America economist at Goldman Sachs. “Given this backdrop, there is some probability that things will get unhinged and force the central bank to hike rates,” he added, making clear that odds of that happening are still low.  

--With assistance from Leda Alvim and Giovanna Bellotti Azevedo.

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