Galen Stops looks at the drivers behind the appreciation of the Mexican peso and asks whether the rally can continue.

Few, if any, saw this coming. 

After Donald Trump won the US presidential race in November 2016, USD/MXN went from 18.03 up to 20.89, and by the time of his inauguration in January 2017, the exchange rate was up to 21.58.

This depreciation of the peso seemed eminently reasonable at the time, given that on the campaign trail Trump had promised to renegotiate the North American Free Trade Agreement (Nafta) in America’s favour or terminate the agreement altogether, not to mention building a border wall between the US and Mexico at the latter’s expense.

This is why at Profit & Loss’s Latin America conference held in Mexico City in February, economists were wary about the peso’s prospects in 2017, with one of them citing a survey published at the time showing that market participants expected USD/MXN to end the year anywhere between 20.00 to 23.50

And yet, since the inauguration the Mexican peso has been on a rally, reaching 18.05 at the time of writing.

The reasons for this sustained rally are numerous.
“First and foremost, a key reason why the peso has appreciated is because the rhetoric of the Trump administration has been more constructive compared to before the US presidential election,” says Juan Carlos Alderete, an FX strategist at Banorte in Mexico City.
The Trump administration has signaled that it intends to renegotiate Nafta rather than scrapping it altogether and, although these negotiations have yet to begin, early indications suggest that they will not be as adversarial as many had feared previously.
Newly confirmed US trade ambassador Robert Lighthizer sent the US Congress a letter outlining the renegotiation goals, which were significantly watered down from the much longer and more hawkish preliminary version. Moreover, senior trade officials in the US, such as Secretary of Commerce Wilbur Ross have signaled the US administration is willing to fast-track the process, which is also positive for Mexico as it reduces uncertainty about the future of the relationship.
“The US has decided to conduct the negotiations through institutional channels and the current roadmap implies that, in the best case scenario we’ll see an improvement of the free trade agreements, and in the worst case scenario things will remain the same,” says Marco Oviedo, head of Latin America economics research at Barclays.
Meanwhile, building a border wall between Mexico and the US appears to have moved down the agenda for the Trump administration, which seems to have its sights set on healthcare and then tax reform instead. In addition, Republican Senate leader Mitch McConnell publicly said in March that he does not expect that Mexico will pay for the proposed border wall, while Trump himself has begun talking about a wall covered with solar panels, stating at a rally in Iowa this week that such a wall would “pay for itself”.
Signal of intent
Another important factor behind the MXN rally has been the activity of the Mexican central bank.
Banco de Mexico (Banxico) has been aggressively raising interest rates, and on Thursday it increased its key rate 25 basis points to 7%, which was in-line with the consensus opinion from economists.
“In 2016 it was very cheap to short the peso, basically it was a very cheap and liquid instrument for hedging whatever you wanted in EM. But as Banxico has continued hiking rates, it has made it harder to use the peso as a hedge or to bet against it,” explains Gabriel Gersztein, head of FX, IR and commodity LatAm strategy at BNP Paribas in Mexico City.
He continues: “You may argue that the carry of the Mexican peso is not necessarily the highest in the world, which is correct – Turkey, Brazil, Russia and Indonesia for example are all higher carry trades – but there’s something else that you need to take into consideration. Because Mexico is an investment grade country, once you adjust the carry of Mexico by the credit risk it is probably the best bet in the world.”
Similarly, Alderete observes: “It seems that the Mexican peso has gone from a favourite “hedging” vehicle to global factors, to a high-yielder when compared to other EM currencies, with 2016 as the “year of transition” and because of the widening of the interest rate differential. In broad terms, it is just too expensive now to maintain a short peso position as a hedge to all the uncertainty that still prevails in local markets. From the “high-yielder” perspective, the risk-reward has been more attractive as so far, Mexico has not had any major local problem when compared to other EM currencies considered as such, like BRL, ZAR and TRY, so appetite has been very strong as evidenced by portfolio flows this year, which YTD have already surpassed the post-crisis high in 2013.”
In addition to the continued rates hikes, Banxico announced a new FX swap intervention mechanism in March, which Profit & Loss reported was widely hailed by market participants at the time, that provided it with a means to intervene in the FX market without resorting to using international reserves.
“This scheme of FX intervention by Banxico has reduced volatility in the short-term and has also reduced the level of short positions in the market which were part of the reason why the peso behaved so erratically in 2016,” says Oveido.
Alderete comments that Banxico has done “an outstanding job” with its policy announcements, but stresses that the main impact of this intervention mechanism has been to re-assure the markets that it is ready and willing to support the peso.
“I believe that the FX swap auctions have been very effective because it has provided the market with a strong signal the Banxico is willing to enter the market to accommodate some hedging needs,” he says.
This viewpoint was echoed by Gersztein, who says: “The point is that the central bank did not have to resort to the FX swap intervention mechanism intensively, but the mere fact that it had this mechanism in place was an important signal for speculators.”
Finding equilibrium
Local politics have also played a role in MXN appreciation, with another leg of the rally starting when it was announced on June 5 that the incumbent Institutional Revolutionary Party (PRI) had fended off a leftist challenger in an important state election.
“After the State of Mexico election, we saw the peso rally because the result was better than expected for the incumbent party,” says Alderete, noting that both locally and globally, political considerations have been gaining weight as a consideration for investors in the past couple of years.
Another factor that has made the peso appreciation against the dollar so acute this year is that the former now appears undervalued at the start of the year, while the latter has been broadly declining in value over the past few months.
The under-valuation of the Mexican peso was partly what caused the BNP Paribas research team at the start of the year to make a then well out-of-consensus forecast for USD/MXN of 18.45 by the year-end.
“We understood that the real effective exchange rate was an exaggeration,” says Gersztein. “We looked at the labour costs in Mexico and found that the purchasing power of Mexican labour in US dollar terms was below what it was in 1994.”
In 1994 a sudden devaluation in the Mexican peso caused a number of other currencies in the LatAm region to decline, and became known as the “Tequila Effect”.
“So when the Mexican peso hit 22.00 and the purchasing power of labour in Mexico was pretty much at the same level as the time of the Tequila Effect, we realised that this was very much out of equilibrium,” says Gersztein.
As well as being under-valued, the peso has also been boosted by a stronger than expected Mexican economy, helped by the fact that oil prices that have been much more stable than in 2016 and non-manufacturing exports have accelerated in Mexico despite concerns over NAFTA, which has reduced the country’s current account deficit.
In contrast, USD strengthened after Trump’s election victory at the end of 2016, with market participants betting that this would lead to tax cuts and infrastructure spending in the US. However, these gains have since started to reverse.
“If you look at the US Dollar Index it has the same movement as the peso,” says Daniela Blancas, a financial market economist at CitiBanamex in Mexico City.
The US Dollar Index measures the value of USD relative to a basket of foreign currencies, often referred to as a basket of US trade partners’ currencies. After starting the year at 103.21, it is down to 97.38 at the time of writing.
“So the weakening of the greenback has also made the peso’s performance look better, and this weakness has a lot to do with the prospects of the current US administration. Recently, there has been uncertainty about how successful it can be in terms of reforms,” says Blancas.
Headwinds
But what are the potential headwinds for MXN in the second half of the year?
Well, the main headwinds highlighted by economists and strategists are really just reversals of the factors that have driven the peso rally this year.
“Any unexpected problems regarding the negotiation of NAFTA in one headwind, a second one is a possible new leg of US dollar appreciation across the globe as part of a systemic move,” says Gersztein.
Blancas warns that “there are a lot of risks” facing Mexico in the second half of the year.
“The first one will be how well the economy performs in Mexico. We also expect that by the end of the year, the US administration could be more successful in terms of tax reform, so that could put some pressure on the currency,” she says.
Oveido says that a collapse in the price of oil is “probably the most relevant risk for the peso in the second half of the year, although he notes that if the Mexican government struggles in its upcoming budget negotiations, this could also have a negative impact on MXN.
Interestingly, there seems to be little expectation that rates hikes by the US Fed will have much impact on the Mexican currency.
“When the carry of the Mexican peso was very low, like in 2015 and the beginning of 2016, the impact of US monetary policy was higher because if you have an interest rate of two or three per cent and the US hikes 25 basis points, then the impact is considerable. Right now, the interest rate is seven per cent and so the fact that the US is expected to hike 25 basis points is going to have a lower impact than one or two years ago,” says Gersztein.
A slow, steady rates increase in the US seems unlikely to have a dramatic impact on the peso, but Oveido does point out that if the Trump administration signals an intent to introduce more protectionist economic policies or a new tax policy, then this could cause the Fed to accelerate the pace of rates increases due to inflation pressures, which would be negative for the peso.
“One factor that could be important for the peso is what happens in terms of the Mexican presidential election next year,” says Alderete, an assessment that Blancas agrees with.
“The elections might not be in the front of people’s minds right now, but they’re still there,” she says. “What I mean by this is that we expect by the end of the year and going into the first and second quarter of 2018 that the Mexican peso will be more sensitive to the presidential election.”
Prediction time……
In terms of forecasts, there appears to be a bit of disparity between the expectations for the peso by the end of the year.
Oveido predicts that there is actually more room for the peso to continue appreciating, stating that he sees a current fair value for the currency at 17.00.
“There is still some risk priced into the peso, possibly due to the slight probability that an extreme candidate could win the election in 2018, possibly related to some EM risk, to oil, or doubts about the rating of sovereign debt,” he says.
However, based on the chances of some advancement in US tax policy changes, Barclays is forecasting 18.50 for USD/MXN at the end of 2017.
Gersztein, who was recommending that investors go long on MXN when it was at 22.00 and sentiment on the currency was very negative, doesn’t see much room for it to continue appreciating now that sentiment has swung in the opposite direction.
“Now that everyone is enthusiastic about the peso, we are saying that 18.00 is pretty much equilibrium in the short-term, we don’t see a lot of room for appreciation from now on, because whereas in February you had the carry and the peso was under-valued, now the only element that you have is the carry,” he says.
Currently, BNP Paribas has revised its start of year USD/MXN forecast of 18.45 to 18.00.
In contrast, the forecast from Banorte is 19.50 for the year-end, although Alderete emphasises that the bank staff are currently in the process of revising their expectations.
“Global markets have been in a really strong search for yield and that has given the peso a different dynamic than what we saw in recent years, precisely because Banxico has hiked so much and the carry factor is likely to be very important going forward,” he says.
Like BNP Paribas, Citibanamex is expecting USD/MXN to be at 18.00 at the end of December, but Blancas says that “if you just look at the year-end numbers, it won’t tell you much”.
She adds: “It’s more important to look at the trends and pay attention to how performance is likely to develop next year.”
After closing this year at 18.00, CitiBanamex predicts that the peso could give ground between March and May, when markets are anticipating the Mexican presidential election, before rallying after the election to end 2018 back at 18.00.

Galen Stops

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