Last week, we witnessed the central bank of Mexico slashing its overnight interbank interest rate by 25 basis points to 7.50%. The Mexican peso traded higher after Banxico lowered the borrowing costs for the third time this year. The key question would be whether will we see another leg higher for the Mexican peso or should we fade the rally. This article will discuss possible reasons why the recent appreciation of MXN should be seen as transitory and USD/MXN should find support and trade higher moving forward.
The Easing Cycle has not ended for Mexico
Banxico started its easing cycle since August 2019 after keeping its overnight interbank interest rate at 8.25% since the start of 2019. During the latest meeting, it has mentioned that in the third quarter economic stagnation still persists which thereby implies that slack conditions have widened more than anticipated. The foreseen trajectory of GDP growth for 2019 and next year has been revised lower due to an environment of significant uncertainty with risks for growth remains tilted to the downside at the current juncture.
Apart from growth, other macro data such as industrial production, unemployment rate coupled with both business and consumer confidence does not look encouraging.
Industrial Production fell 1.8% YoY in September marking the 11 consecutive months of contraction as shown in Figure 1. The unemployment rate has also been ticking higher since the start of 2019 as seen in Figure 2. Moving towards business and consumer confidence, we do see a slight pickup in confidence from July and it peaking in September before it starts to edge lower for both business and consumer confidence as shown in Figures 3 and 4. The loss of confidence from firms and households, sluggish economic activity which is expected to carry on into 2020 together with domestic risk factors such as increasing violence and security problems which could potentially weigh on investment decisions in Mexico suggest that one cannot rule out further rate cuts by Banxico moving forward. This can also be seen from the divided Banxico rate cut of 25 basis points as two of the bank’s five-member actually voted to cut rates by 50 basis points. This suggests that the easing cycle has not ended but rather it is just the beginning which supports the case for MXN appreciation to reverse its course when markets start to price in for more aggressive rate cuts from Banxico.
Potential Downgrade on Pemex and Sovereign debt is still on the table
Pemex’s debt has been downgraded to junk by Fitch in June and there is still a rising possibility for other credit rating agencies to downgrade which presents an inherent risk to Mexico. Despite a slight increase in crude output, Pemex, Mexico’s debt-burdened state oil producer has reported a fourth consecutive quarterly loss which is something that is concerning for investors. If oil production does not pick up and increase promptly to reach Pemex’s business plan projections or should tax revenues keep weakening as the economy slows, then a downgrade of sovereign debt could materialize which inevitably does not bode well for the Mexican peso going forward.
The bar for additional easing from the Fed remains high
During the October Federal Open Market Committee (FOMC) meeting, the FOMC lowered its benchmark funds rate by 25 basis points to a range of 1.5% to 1.75% as expected. The minutes from the Federal Reserve’s October meeting on monetary policy will be due this week to provide investors a better sense of the central bank’s appetite for additional interest rate cuts this year if any. However, the Fed has indicated that the move to ease policy could be nearing a pause. The FOMC removed a key clause that had appeared in post-meeting statements since June saying it was committed to “act as appropriate to sustain the expansion.” Fed Chair Powell was even clearer in the news conference, saying central bank officials “see the current stance of monetary policy as likely to remain appropriate.” This suggests that the threshold for additional easing would remain unless a further deterioration in the economic data or a sharp escalation or break down in the US-China trade war developments which seems to be distant at the moment. Hence, this should continue to keep the greenback supported moving forward.
To conclude, while some investors may argue for the case for buying Mexican peso due to its carry trade appeal, the continued deterioration of macro data coming from Mexico together with the lingering risk of potential downgrades of Pemex and Mexico’s sovereign debt suggests fading MXN’s strength and buy dips for USD/MXN as we march forward.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in USD/MXN over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.