The Mexican peso is sitting at a new record low against the US dollar on the back of an increasing risk-off mood. Risk sentiment has caused extreme demand for dollar liquidity and hasn’t been soothed by Banxico’s latest measures, which may be regarded as underwhelming.
However large both the Fed liquidity provision measures and Banxico stimulus might be, we see the bottom for USDMXN nowhere in sight provided the substantial global and domestic recession risks. The increased provision of USD liquidity to domestic Mexican markets funded by the swap line with the Fed may help ease the speed and size of the fall, but the peso faces notably downside risks in front of several policy choices.
Last Friday, Banxico moved forward its monetary policy decision scheduled for March 26th, implementing an emergency interest rate cut of 50 basis points. At 6.5% now, the policy interest rate is still deemed to be restrictive relative to the estimated neutral interest level, which is estimated at around 5%. This restrains the ability of the Mexican economy to navigate through the inevitable recession, especially in a context of constrained fiscal space. One of the committee members even leaned towards a shorter 25bp reduction, suggesting the board is not fully on board with the idea of substantial easing.
There are two reasons for Banxico to stay fairly conservative on its policy stance despite threatening growth prospects:
- The Mexican capital account is largely reliant on its premium payments given the increasing risks of credit downgrade by foreign rating agencies and
- The potentially large pass-through effects on inflation from the policy-induced currency depreciation.
Banxico assessed that upside inflation risks from a weaker currency are broadly balanced with the negative impact of soft demand and lower energy prices under the current policy stance. However, the central bank stated that the uncertainty to the inflation outlook has increased, adding to the prospects of cautious forward guidance.
We now expect Banxico to engage in further easing by at least 150bp of additional cuts over the next two quarters, in line with repriced market expectations of monetary easing after the last Banxico move.
While this size of accommodation could prove insufficient to prevent Mexico from a large recession this year, further moves might be counterproductive for the domestic inflation outlook. Regardless, either policy choice in the cards of Banxico –a sharp or mild monetary easing- poses significantly negative risks for the peso. On one hand, lower interest relative yields on Mexican increasingly riskier assets will force a major sell-off of in the peso. On the other, sticking to a rather conservative stance and refraining from cutting rates aggressively could send the economy into an even larger recession, curtailing demand for MXN too.
The remaining silver lining in the peso’s outlook comes in the form of Banxico directly intervening in the FX market. Last week, the Fed engaged in a swap line arrangement with Banxico for provision of $60 billion of USD liquidity, which Banxico is now injecting in local markets via repo operations. However, in both of the offerings conducted so far of $2 billion each, the market intake of USD has fallen short of the amount offered, about 23% and 76% respectively. This surprising mismatch indicates that the MXN price action might not be driven by USD fund squeezing in full, but rather by a fundamental sell-off of MXN, which may have slightly eased just for now.
Markets are pricing in a more proactive policy stance after Banxico unexpectedly cut rates in an emergency meeting on March 20th.
MXN sell-off has probably surpassed USD fund squeezing limits and is fundamentally trading on risk-off mood.
Author: Olivia Alvarez Mendez, FX Market Analyst