The volatility experienced by the Mexican Peso (MXN) over the past six months does not reflect the fundamentals in the Mexican economy. Indeed, Mexico’s economy has experienced steady growth with steady inflation over the past few quarters. It is the peso’s use as a hedge for long emerging markets (EM) positions that makes its movement reflective of expectations for global growth, especially in the aftermath of recent geopolitical developments.
The peso’s troubles began soon after the unexpected Brexit vote and were exacerbated by the US election. The peso depreciated over 14% in one day after it became clear that Donald Trump won the election. Within the EM space, Trump’s protectionist stance on trade and immigration will have the biggest negative effect on Mexico’s economy. Indeed, MXN is the worst performing currency in EM since the US election.
A Protectionist Stance and the Mexican Economy
President-elect Trump has backtracked from many of his more extreme proposals but it remains unclear which ones will materialize and make their way into policy. Reviewing Trump’s 100 day action plan as announced in late October provides some insight on the proposals that will have the biggest impact on the Mexican Economy, with NAFTA and immigration policy figuring most prominently.
Mexico has benefitted greatly from NAFTA, and renegotiating the agreement or withdrawing from it entirely under Article 2205 will likely have a significant economic impact. Reinstating tariffs and non-tariff trade barriers will negatively affect Mexico GDP growth, potentially shaving 1% off growth next year to about 1.5%. Cracking down on illegal immigration, including the construction of a wall on the southern border of the US that Mexico will pay for, was a large part of the Trump campaign rhetoric. With the transition from candidate to President-elect, Trump has already softened his tone on both building the wall and trade renegotiation. It is more likely that the new administration will focus on immigration reform overall.
Curbing remittances is another potential measure from the new administration that would have adverse consequences for the Mexican economy. Requiring proof of ID or limiting transfer amounts would result in an estimated increase in Mexico’s current account deficit to 4% of GDP from a current level of 3%. The Mexican government will look to offset some of that by implementing tighter fiscal policy.
Banxico Won’t Be Sidelined
Inflation is likely to move up in Mexico on pass through effects from a weaker currency. This means that Banxico will continue raising rates past its December meeting where the target rate moved up by 50bps. This will drive interest rates higher in Mexico over the medium to long-term. Banxico traditionally keeps its interest rate policy mostly in line with the Fed. However, the current political environment will incentivize the bank to break away from the FOMC and adopt a more aggressive tightening cycle in order to curb currency weakness. Other tools at Banxico’s disposal include selling USD in the open market and utilizing TIIE liquidity swap lines. The central bank may also utilize more extreme measures such as shifting the duration of its portfolio by swapping shorter maturities with longer ones, similar to Operation Twist in the US, or outright quantitative easing.
Peso as EM Proxy Hedge
High liquidity and low borrowing costs drive MXN’s use as a proxy by investors hedging broader emerging markets exposures. In addition to the lower inflation and interest rate environment that Mexico enjoys relative to other emerging market economies, the Peso is one of the most liquid emerging market currencies in the world. The Peso’s average trading volume is about $128 billion, compared with $48 billion for the Brazilian Real and $63 billion for the South African Rand, and trades 24/5 for rapid inflows and outflows of EM investment vehicles.
The highly correlative attributes that allow MXN to serve as a proxy hedge for global emerging economy exposures also leave it highly vulnerable to growing macroeconomic risks, especially compared to other Latin America currencies. In the short run, use of MXN as a proxy greatly increases the currency’s volatility but those influences subside as the hedges are unwound.
2017 Outlook for MXN
Gyrations in the Mexican peso will continue as we head into the first quarter of 2017, but it is clear that the peso has moved into a higher range and is forecasted to stay there throughout the year. Market positioning has remained aggressively short MXN and will probably continue to grow given expectations surrounding US trade and economic policy moving forward. But the blow should be softened by the expectation that NAFTA remains largely intact and new tariffs on manufactured goods are imposed instead.
This article is not a research report under the legal requirements in any country or jurisdiction and is not intended to provide information upon which to base a decision to enter into a financial transaction. It has been prepared for institutional clients, sophisticated investors and market professionals only, and is limited to commentary on economic, political, or market conditions on the basis of publicly available information.