The Mexican peso enjoyed this century’s second-strongest bull run in the first half of the year, with wide rate differentials, stable public finances, “nearshoring” hopes, and surging inward remittance flows, combining to send the exchange rate soaring.

The Banxico’s commitment to maintaining benchmark interest rates at least 600 basis points above their US equivalents has done much of the heavy lifting, with returns on dollar-funded trades exceeding 19 percent this year. Despite a reputation as a leftist economic nationalist, President Andrés Manuel López Obrador has proven less interventionist and more fiscally conservative than investors once feared. The country has pushed out China as the top exporter to the United States. And income sent home by Mexican workers in the United States is running at more than $5 billion a month.

Remittances sent from workers outside Mexico, 12-month rolling sum, billions USD

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.

But if US demand for tangible goods slows, and vehicle prices flatline, export growth won’t continue at the pace that has been set over the last year. 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. We suspect that markets will ultimately revise expectations for inward investment flows lower.

US imports by country, %

A relative softening in both headline and core consumer price measures has allowed the Banco de Mexico to shift onto a data-dependent footing in recent months, using forward guidance to signal an extended pause ahead. Markets think rapidly-decelerating inflation and a deteriorating growth outlook will force central bankers into a u-turn in the fourth quarter, with implied prices pointing to at least two rate cuts by the end of the year. We aren’t confident this will pan out – Mexican policymakers have traditionally waited for a reversal from the Fed before launching their own easing cycles, and are unlikely to welcome a precipitate loosening in financial conditions – but we also think rate differentials will remain wide enough to maintain the peso’s role as the world’s preferred carry currency.

12-month carry return by funding currency, %

Political uncertainty is growing ahead of the 2024 election, and the ruling Morena party may be tempted to deploy the public balance sheet in drumming up support – but the fiscal outlook should nonetheless remain far stronger than many of Mexico’s emerging market peers.

Instead, we think the biggest threats to the peso’s current valuation could come from abroad. Renewed currency intervention – or a more hawkish reset in Japan’s monetary policy stance – could trigger a surge in the yen and squeeze traders with leveraged positions – forcing a selloff in the peso. Under another scenario, a pronounced downturn in the US economy could derail three of the most powerful exchange rate determinants at once: slower wage growth would limit remittance flows, a drop in expected export volumes could curtail “nearshoring” investment volumes, and a flight to safety might force a violent unwind in dollar-funded carry trades. Finally, the currency’s correlation with US equities represents a vulnerability – if current levels of ebullience in US markets fade and volatility rises, the peso will fall.

30-day correlation, VIX and MXNUSD