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Currency Markets Retreat as Peso Plunges

Markets are on edge ahead of a week littered with event risks. The dollar is strengthening and Treasury yields are down as traders brace for politically-driven volatility in the Mexican peso, decisions from the Bank of Canada and European Central Bank, and a series of first-tier data releases in the United States, culminating in Friday’s non-farm payrolls report.

The peso is coming down hard as preliminary results show Claudia Sheinbaum, current President Andrés Manuel López Obrador’s designated successor, on course to win a landslide victory that could give her party the votes needed to remove checks and balances in the political system. Morena and its allied parties look close to achieving the two-thirds supermajority in both houses of Congress that is required to make constitutional changes without opposition support, giving the ruling coalition the capacity to expand the government’s control over the economy – something that markets are unlikely to welcome. Under AMLO, the left-wing coalition had been frustrated in its attempts to increase social spending, reform the Supreme Court, shrink the number of lawmakers, bolster the power of state-owned companies, and eliminate independent regulators. With no major forecasters seeing this as a likely outcome in advance, losses in the currency are now close to 3 percent, and implied volatility is up sharply.

Wide rate differentials should ensure that the currency retains its “superpeso” sobriquet for now, but foreign exchange markets remain wary of downside risks. Options markets – where participants take out insurance against undesired shifts in spot rates – are heavily skewed, with a drop in the peso considered far more likely than an equivalent move higher over the coming twelve months. Domestic issues are a contributing factor – Sheinbaum is inheriting an economy saddled with slowing growth, poor infrastructure, elevated welfare spending, widening budget deficits, and rampant security problems – and there’s little doubt the peso is overvalued at current levels, but we suspect the bulk of the imbalance is driven by perceived negative vulnerabilities to the US economy, financial markets, and political cycle.

Crude prices are down after the OPEC+ group of oil exporting nations said it would begin phasing out production cuts after the third quarter of this year. Under the agreement – which is contingent on changing economic conditions – cartel members and their allies agreed to keep limits in place for now, but to increase the output target for the United Arab Emirates by 300,000 barrels a day and return another 2.2 million in additional production to the market over the subsequent year. The major crude benchmarks have come under pressure in recent months as elevated seasonal inventories, China’s lacklustre recovery, and “higher for longer” narratives from Western central banks have weighed on the demand outlook, but the cartel’s experts see a recovery unfolding in the second half of the year, helping keep prices aloft. We also note that the US National Oceanic and Atmospheric Administration is forecasting an “extraordinary” 2024 Atlantic hurricane season, with between four and seven major hurricanes expected to form – exceeding the number seen ahead of the 2005 season, when Katrina and Rita made landfall and sent oil prices spiralling higher.

Today’s manufacturing survey from the Institute for Supply Management could further muddy the outlook for the economy. Consensus forecasts suggest that the index rose to 49.7 in May from 49.2 in April, suggesting that factories recovered after suffering a brief contraction in the prior month. New orders likely exceeded inventory growth for a 12th consecutive month, and supply chain stress probably remained subdued – consistent with the “soft landing” thesis currently dominating markets. But the headline could surprise to the upside: a raft of other activity indexes – from Redbook same-store sales to the Fed’s manufacturing surveys – have climbed in recent weeks, and an increase in the prices-paid sub-index might point to stubborn inflation pressures under the hood.

The Canadian dollar is lagging its developed-market peers as uncertainties grow in the run-up to Wednesday’s Bank of Canada meeting. To put it bluntly, we have no strong views on whether policymakers will deliver a cut now, or in July.

There’s a strong case for getting a move out of the way: core inflation has subsided for four straight months, unemployment has risen fairly persistently since the autumn, and headline growth has disappointed relative to the Bank’s forecasts, suggesting that rates are in clearly-restrictive territory. Officials could easily opt for a “hawkish cut” – a drop in rates paired with a relatively optimistic set of communications – at this week’s meeting.

However, there’s no evidence of a crisis that requires immediate policy support: housing-market activity indicators have shown signs of accelerating, household spending numbers have risen, and labour markets are delivering upside surprises. We still hold a bearish long-term outlook on the Canadian economy, but domestic final demand – which encompasses household consumption, investment and government spending, and can be considered a cleaner measure than gross domestic product – grew at its fastest pace in two years in the first quarter. With another inflation print, a retail sales update, two more jobs reports, and a round of business and consumer surveys due for release between now and the July meeting, waiting for more information also seems rational.

Markets have had a move priced in for months, and we’re not sure the timing really matters much for the Canadian dollar – but the psychological impact on consumer attitudes could be significant. Contrary to the world’s perception of Canadians as polite, cautious, and prudent, the last two decades have shown that we use housing markets like other countries use casinos, and that we’re willing to spend beyond our means at the drop of a hat – although we are polite. A June cut could easily unleash Canada’s animal spirits and generate an mid-summer economic melt-up that renders current forecasts unworkable.

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