The Mexican peso faces considerable downside pressures from both domestic and external risks.
Yet, the expected sell-off of the currency might be slightly more moderate than previously forecast under the light of a potentially more aggressive Fed easing cycle and a minor rebound in Mexican economic growth by year-end.
Downside headline inflation pressures, disciplined fiscal plans and heavy market expectations will make the case for wider monetary policy support as the main stimulus tool of the economy, thus eroding the currency strength. However, the peso’s attractiveness as a carry trade currency may be sustained.
Rates offered by Banxico still remain elevated, in the top third in the EM bracket. Even with Banxico set to ease policy in the near term, the relative attractiveness of the peso is likely to be maintained given the Feds likely path of further rate cuts too.
Another potential support for the peso is in the form of US ratification of the USMCA trade deal in Congress before the end of the year; even though the Democrats have recently imposed new conditions for the deal to be ratified regarding Mexico´s full implementation of the new labour law.
In particular, concerns were raised on court challenges to the law, a process that could take years. However, House Speaker Nancy Pelosi said Democrats are moving closer to a deal and that the party is able to conduct legislative business regardless of the impeachment investigation; while the White House´s Trade Representative, Robert Lighthizer, raised positive hopes for the deal too.
Meanwhile, the peso can take a leg higher amid stalled US-China trade talks, as failed attempts to close a trade deal could strengthen US-Mexican trade bonds. However, further tariff escalation and trade uncertainty can increase the risk-off sentiment towards emerging markets, rising MXN volatility.
In the domestic scenario, the supportive rate cuts undergone by Banxico have had a positive impact in investor´s sentiment, with the 2Y-10Y bond yield gap reverting its previous inversion.
This is a commonly observed sign of upcoming recessions. With more than 150 basis points of headroom before Banxico enters the region of neutral rates, the weakening effect of a more accommodative monetary policy stance on the currency can be partially offset by an improvement of growth expectations.
A rather rigorous fiscal budget for next year amid a low growth environment, endorses the government commitment to improve Mexico´s financial credibility.
Even though broad underperformance risks also abound in this area, the responsible fiscal stance promised by the government should also ease the pain for the Mexican peso in the short run.
The BCB have joined the heard of EM central banks cutting rates to spur on growth and inflationary pressures.
Since President Bolsonaro entered office, the real has only cracked the 4.00 level twice with any significance. The most recent breach of the psychological level was on August 19th where a bleak trade outlook and poor inflation data lead to the real depreciating 1.92% over the course of the trading session.
Since then, USDBRL has failed to test the 4.00 handle and the current period of real weakness looks set to stay, unlike back in 2018.
That being said, there is substantial resistance at the 4.20 level, suggesting the pair will likely trade in that range until substantial reform progress is made and inflation pressures begin to build.
The COPOM’s appetite for real weakness has shifted under President Neto’s leadership. The Selic rate currently sits at a historic low of 5.5% after the BCB cut rates by 50bps on September 18th.
Economists and option markets alike predict a further 75bps of cuts by the BCB this year, reducing the real’s carry appeal and pushing it to the top of the 4-4.20 range in our view.
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