The Mexican peso has lost about ¼ of its value over the last month against its major peers, recently breaking record lows.
The peso has led losses driven by the coronavirus within the EM space, and its dominant trading volume in Latam has made it particularly sensitive to recent market turmoil in the area. Under current stress levels of global uncertainty and market volatility, the sharp depreciation in MXN has come on the back of a massive unwinding of carry trade flows into the peso, even though the pandemic has not particularly hit Mexico yet.
Since the outbreak of the coronavirus in China on mid-January, the performance of the Mexican peso as a carry currency has been the worst in the EM space, mirroring gains of over a year.
Chart 1. MXN long carry trades bottomed the ranking of EM trades against EUR and USD since the coronavirus outbreak to date.
The clouded uncertainty in the global outlook adds on top of already bleak domestic prospects, in a context where policy choices are tighter than ever. From ample spare room to loosen monetary policy before, at least 200bp to reach the projected neutral rate of interest and extra 500bp until the zero lower bound, Banxico now faces opposition to follow suit with the Fed’ss stimulus and its previous easing trend.
The reason behind this is that the strong currency depreciation poses significant pass-through effects on domestic inflation. According to Banxico´s estimates, in high depreciation regimes, the marginal pass-through on inflation per each percentage point of currency depreciation is around 0.11% and 0.24% after 1 and 2 years respectively.
The significant depreciation of the peso therefore translates into upside pressures on inflation of around 3% and 6% for the next 12 and 24 months respectively, which basically doubles and triples Banxico’s inflation target. These risks set the tone for Banxico’s next policy announcement on March 26th and forward guidance, which is now biased towards keeping the policy rates unchanged. Markets have also drastically reversed their policy implied expectations, with no rate cuts priced in over the next year, from nearly a full percentage point discounted previously.
Chart 2. Markets are no longer pricing in any rate cut by Banxico.
The resulting tighter financial conditions from a wider interest spread with respect to the USD, adds to the downside risks faced both by the Mexican economy and its currency. Increasing risks in the debt dynamics of both sovereign and state-owned oil company Pemex are another major downside risks for MXN.
As a large size of their holdings’ portfolio is denominated in foreign currency, the sharp depreciation of MXN against its main partners multiplies the bulk of the interest payments faced by the issuer. This, in turn, raises the risks for a potential downgrade of both Pemex and country credit rankings, increasing the risk premium in Mexican growth prospects after rating agencies recently downgraded both Pemex’s and the sovereign credit rating.
There are mild hopes against further sharp drops of MXN, however…
The Mexican Exchange Commission, comprised by both Banxico and the Ministry of Finance, engaged on easing some of the currency pressure via direct interventions in FX markets. Last week, they ran auctions of exchange hedges by 2 billion USD and they are likely to keep rolling them if currency pressures build further.
Recent measures implemented by the Fed aimed at easing USD liquidity conditions could also contain the size of MXN depreciation. However, the balance of these risks is pinned on future coronavirus developments and further potential risk-off demand for dollars.
At the moment, MXN price action is markedly biased to the downside, even when the currency has already reached its record lowest in history against both USD and EUR.
Chart 3. 12% of Mexican sovereign debt is denominated in USD or EUR.
Chart 4. 82% of Pemex´s debt is denominated in USD or EUR.
Author: Olivia Alvarez Mendez, Market Analyst at Monex Europe.