Already hit hard last Spring by the release of weaker-than-expected economic figures, the Mexican peso has suffered a new bout of weakness since Don-ald Trump’s election in November, which the US rate hike in December only exacerbated. Whereas the Mexican economy appeared to recover some mo-mentum last autumn with year-on-year GDP growth of 3.7% for November (2.4% on a seasonally adjusted basis), the weakening peso could undermine this recovery by pushing inflation up. The reason for this is that the two main drivers of Mexican growth remain the tertiary sector and consumer spending, which are both highly price-sensitive. Yet because of pass-through effects, as well as the government’s decision to raise energy and oil prices, inflation has continued to rise and came to 4.72% on a year-on-year basis in January, thus surpassing the upper limit (4%) of Banxico’s target. This marked accel-eration in prices has come in spite of a drastic tightening in monetary policy (Banxico raised its key rate by 250pb to 5.75% in one year) and interventions on the currency market (according to Reuters, Banxico sold at least 1 billion dollars in January).
This week the Banxico was back to maneuverer and increased its rates by 50 bps to 6.25%. Banxico’s challenge in the coming months will be to anchor inflation anticipations through monetary policy but without hindering GDP growth. However, the recent uptick in inflation is due, in part, to higher prices caused by deregulation of administered prices, rather than a generalised increase in prices, and this can be considered a one-time shock. Domestically, inflationary pres-sures should therefore remain under control. On the foreign front, two factors must be taken into account – oil prices and exchange rates. Regarding oil, our baseline scenario is for a stabilisation of prices at current levels. Regarding exchange rates, Mexican authorities have served notice that they won’t try to support their currency in an increasingly difficult environment, given that, as soon as Trump came to office, he announced a series of measures leaving little doubt on his intentions regarding protectionism, the undermining of trade agreements, and the relations he wants to maintain with Mexico. Against this backdrop, central bank interventions would probably have little impact. Meanwhile, with the release of a below-forecast Q4 2016 US GDP figure (+1.9 YoY, vs. 2.2% forecast by the consensus), the dollar has pulled back against almost all currencies, including the Mexican peso. While the possibility of another rally in the dollar cannot be ruled out, due in particular to a change in Fed rate hike expectations, we don’t expect the Mexican peso to return to its post-US election lows, especially as Banxico is likely to track the Fed in order to keep the spread in check.
In conclusion, we believe that Banxico should be able to anchor inflation expectations without otherwise being forced to raise its rates, depending on what the Fed does, i.e., 50bp in our baseline scenario. However, if negotiations on the Nafta agree-ments went wrong and Trump maintained firm positions on the construction of the wall, the peso could be subject to further downward pressures. If these were to lead to an increase in inflation expectations then Banxico could be forced to increase its rates further.
Emerging Markets Senior Economist
Over the past 20 years, FX carry trades have performed superbly while fundamental strategies have produced disappointing results. But the real picture is much more complex, for at least two reasons: carry trading exhibits strong extreme risks, and the track records of both strategies vary considerably over time. In this paper, we show that the carry trade and a fundamental strategy based on purchasing power parity (PPP) have alternated between periods of profitability and underperformance. When carry trade strategies perform well, fundamental strategies do poorly, and vice versa. Crises appear to play a significant role in this alternation. A portfolio that rotates between these two types of strategies, according to a VIX-based risk aversion indicator, would substantially outperform a pure carry trade strategy, with a sharp reduction in extreme risks, and would also be robust to crises.
Marie BRIERE, Bastien DRUT