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UPDATE 2-Brazil's biggest interest rate hike since 2002 rattles markets

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By Jose de Castro

SAO PAULO, Oct 28 (Reuters) - Brazil's stocks and currency slipped and its interest rate curve steepened on Thursday after the largest interest rate increase in nearly two decades raised risks of an economic downturn while disappointing traders who had bet on an even bigger move.

The central bank raised its benchmark rate 150 basis points to 7.75% on Wednesday evening, stepping up the world's most aggressive tightening cycle to fight double-digit inflation, after the government unveiled plans to loosen spending limits.

Analysts warned that could tip Latin America's economy into recession, raising risks of more populist policies from President Jair Bolsonaro, who is expected to seek a second term next year.

"We remain cautious on the prospects for the Brazilian real headed into year-end due to these ongoing risks around political uncertainty and the potential impact on inflation and monetary policy that may result in an overtightening," said Emily Weis, a State Street global macro strategist.

The Brazilian real weakened 1.3% against the U.S. dollar in midday Thursday trading and the benchmark Bovespa stock index slipped 0.7%, despite being supported by strong earnings from heavyweight brewer Ambev SA, which rose 8%.

Highlighting competing pressures on the central bank chief Roberto Campos, many traders in interest rate markets had laid bets on even more aggressive tightening, even as most economists expected a more cautious approach.

"The market was pricing 175 basis points while economists' consensus was at 125 basis points," wrote Morgan Stanley analysts led by Andre Loes. "The dovish decision is likely to turn FX into the next pressure point in local markets."

Interest rate futures showed traders paring bets on the size of rate increases in coming months while wagering on higher rates by the end of next year.

Some economists have warned that a spending spree could backfire on the government by forcing the central bank, whose formal autonomy was written into law this year, to hike rates more sharply, tipping the economy into recession next year.

In the central bank's statement on Wednesday night, which signaled another cut by 150 basis points in December, analysts highlighted that policymakers were still treating fiscal policy as a growing risk for inflation rather than a concrete impact.

Last week, Bolsonaro vowed to expand a cash transfer program through next year as allies in Congress proposed a constitutional amendment making space for nearly 100 billion reais ($18 billion) of additional spending in 2022.

($1 = 5.6299 reais) (Reporting by Jose de Castro Additional reporting by Gabriel Araujo in Sao Paulo, Marcela Ayres in Brasilia and Gabriel Burin in Buenos Aires Writing by Brad Haynes Editing by Daniel Flynn and Alistair Bell)

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