MEXICO CITY, June 14 (Reuters) - A precipitous slump in the peso and flight by investors from Mexican debt have put Mexico's central bank on the horns of a dilemma as it considers whether to hike interest rates in an effort to stop the peso's slide or stand pat.
Fund managers and analysts said either way the central bank runs the risk of igniting further selling of bonds.
While higher interest rates could deter currency speculators who have battered the peso, they also make hedging currency risk more expensive for bond holders.
On the flip side, not raising rates leaves unhedged investors without enough yield to compensate them for currency volatility.
Mexico saw the biggest outflow of investors from its sovereign peso bonds in 2-1/2 years in May, according to a Reuters analysis of Mexican central bank data, when the peso suffered its biggest monthly percentage drop against the dollar in four years.
The peso fell sharply again this week toward a record low of more than 19 per dollar. That could prompt the central bank to hike rates again as it did in February to defend the currency and contain inflation fears.
But such a move could backfire. Hedging peso exposure has become expensive for bond holders, and if they flee, a vicious cycle of currency losses and more outflows could follow.
"We are starting to see the nervous nature of investors," said Andrew Stanners, who helps manage $10 billion in emerging market debt at Aberdeen Asset Management in London. "They are looking for other opportunities."
Foreign holdings of peso debt with a maturity of three years or longer dropped by nearly 36 billion pesos ($1.9 billion) in May, or by 2.2 percent, central bank data show. It was the biggest monthly drop in nominal terms since December 2013 and the biggest percentage drop since June 2014.
Global volatility related to expectations about the U.S. Federal Reserve's next move hit the peso last month and now concerns that Britain could leave the European Union are contributing to weakness in the Mexican currency.
Mexico's peso is the most liquid emerging-market currency, making it a popular asset to bet against in times of rising global risk. The peso is the worst performer of the world's 36 most-traded currencies, year to date, down more than 9 percent.
It is the second-worst performer in June, behind the pound.
Now the peso is near its level in February when the central bank intervened with an unscheduled interest rate hike, and many investors believe the central bank could soon act again.
The bank has said it would rather rely on interest rates as a defense tool than currency intervention.
Most analysts doubt the central bank would make another unscheduled rate move, and some expect it could act at its next meeting on June 30, whether the Fed moves or not.
"If they go for another extraordinary meeting, it is very dangerous," said senior economist Gabriel Lozano of J.P. Morgan in Mexico City. "Are you going to decide every other week what to do with monetary policy?"
Yields on Mexican interest rate swaps have spiked as the peso tumbled and investors anticipated a June hike.
While a rate hike could push hedged investors to sell, other investors who don't fully hedge peso risk are demanding higher interest rates to make their holdings profitable.
"Right now anyone who can communicate with the central bank should be telling them to do something," said Roberto Sanchez, who helps manage $4 billion in emerging market debt at Manulife Asset Management in Boston, when asked if the central bank should raise interest rates. ($1 = 18.9689 Mexican pesos) (Additonal reporting by Noe Torres; Editing by Dan Burns, Simon Gardner and Cynthia Osterman)