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Persistently-wide rate differentials against the dollar, relative political stability, and significant inward remittance and investment flows helped the “superpeso” maintain momentum climb against its rivals in 2023. But with policy settings the tightest since 2008, growth risks beginning to emerge, and inflation showing signs of cooling, the central bank is telegraphing an imminent dovish shift, and exogenous vulnerabilities - to the US economic cycle, to global financial conditions, and to the evolution of the currency market carry trade - might pose a threat to further gains.





















The peso’s bull run has run out of steam.

After a world-beating drive higher, the Mexican peso lost momentum late in the third quarter and has largely failed to regain it, staging a relatively modest rebound against a retreating dollar. Several factors are in play: A drastic increase in government spending plans – coming ahead of the presidential election in June 2024 – spooked investors. The foreign exchange commission’s decision to unwind its non-deliverable hedging programme put pressure on spot rates. And the Banxico began making dovish noises, suggesting that it might begin cutting rates by March.

Change in spot exchange rates, DXY and MXNUSD

We think markets overreacted to all three: In relative terms, the government’s fiscal position is strong. The decision to shelve a peso-supportive intervention tool should be seen as a vote of confidence in underlying fundamentals. And real rate differentials remain extremely supportive, with authorities still strongly committed to maintaining positive carry.

The fiscal outlook still looks favourable.

Under President Andres Manuel Lopez Obrador’s recently unveiled budget plan, Mexico will run its largest deficit since 1988 next year – amounting to roughly -4.9 percent of gross domestic product, up from this year’s -3.3 percent. With global interest rates holding near post-2000 highs, higher borrowing costs could threaten credit ratings and limit the next government’s room for maneuver. 

But Mexico’s fiscal position remains more positive than many of its peers. After years of relative austerity under Obrador’s pseudo-populist leadership, the government debt-to-gross domestic product ratio compares favourably with most of the country’s less-developed counterparts and is well below those seen in Argentina or Brazil. And in a somewhat-ironic turn – comparatively expansionary fiscal policy in 2024 could limit the Banxico’s room to cut rates, helping preserve higher returns on peso-denominated assets.

Total credit to the government sector at nominal value, % of gross domestic product

With geopolitical tensions between the US and China forcing businesses to diversify supply chains, the country’s stability, low labour costs, and geographic proximity have raised hopes that a “Made in Mexico” moment is at hand. Indeed, the country has displaced China as the United States’ largest trading partner.

Share of US imports, 12-month moving average, %

But under López Obrador, energy policy has become less flexible and even less climate-friendly, limiting the extent to which companies with net-zero commitments can relocate production facilities. Critical regulatory bodies remain captive to political whims. And the country devotes an incredibly low share of gross domestic product to research and development, putting constraints on how far factories can move up the value chain – particularly relative to the Asian tigers located closer to China. As the country’s growing trade deficit with both China and the world shows, a significant share of value-added activity in manufacturing is happening beyond Mexican borders. We suspect that markets will ultimately revise expectations for inward investment flows lower.

Merchandise trade balance by country, 12-month rolling sums, billions US dollars

Most of the factors driving the peso’s post-pandemic outperformance are still in place. Implied interest rate trajectories suggest that Banxico will cut more slowly and more incrementally than its Latin American counterparts, leaving the currency with one of the best volatility-adjusted carry profiles in the region.

Carry Return Index, 1999 = 100

Remittance volumes keep setting new records.

Remittances from workers outside Mexico, millions USD

And – although reshoring flows are likely overhyped – the country is well-placed for sustained economic gains as supply chains are re-routed through geographically-proximate and politically-compatible parts of the world. We think the peso could stage a short-lived rally if US data continues to exhibit “soft landing” characteristics.

A US slowdown remains a clear and present danger.

We think a sustained period of outperformance in the US economy will fade in the coming months, with the peso likely to come under selling pressure in early 2024 as investors brace for a slowing in exogenous capital flows. Inbound investment looks vulnerable, with large multinationals likely to soft-pedal the realignment of global manufacturing footprints in response to a reversion in American consumer demand, and a relatively mild rise in Hispanic unemployment rates could take a serious toll on monthly remittance volumes.

Historically, episodes of Mexican peso weakness have been associated with sharp slowdowns in the US economy – illustrated here using the Sahm Rule, which indicates that a US recession has begun when the 3-month moving average of the national unemployment rate rises by 0.5 percentage points or more relative to its low during the prior 12 months.

USDMXN Exchange Rate and Sahm Rule Measure of US Unemployment

The carry trade – traditionally inversely-geared relative to background volatility levels – might unwind rather swiftly if financial market turbulence increases and typical “dollar smile” dynamics come back into play north of the Rio Grande. Although the peso could temporarily outperform as the Federal Reserve accelerates its communications pivot, fundamental vulnerabilities should exact a toll over the longer run, contributing to generalised weakness toward the latter half of 2024.

Estimated USDMXN Expiration Range By Confidence Interval

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