FX Dashboard: Mexican Peso Should Continue Outperforming

In a year when EM currencies have not performed well, the Mexican peso (MXN) has been a source of respite. Year-to-date, EM currencies are down 3.7% on aggregate while the peso is flat. Since our note from late May titled “Stay Bullish on Mexican Peso”, the gap between MXN and EM FX has increased (see the chart below) on the back of two events:

• The Fed surprised with a hawkish turn at the June 16^th FOMC, which resulted in an upcycle for the US dollar, hurting EM currencies in the process. Since the June FOMC meeting, EM FX is down 2.6% while MXN is up 0.1%.
• Banco de México (Banxico) delivered a hawkish surprise with a 25 bp policy rate hike at the monetary policy meeting on June 24^th.

Data Source: Refinitiv; Note: EM FX = equally weighted index of spot returns of 22 currencies

Despite the outperformance, we remain constructive on MXN. As we highlighted in a note last week, the currencies of countries where the central banks are either raising rates or on their way to do so have been outperforming. In this regard:

• Banxico is likely to raise rates further by year-end. The curve is pricing in over 100 bp of rate hikes in 6 months and Citibanamex’s most recent survey shows median expectations of another 75 bp of rate hikes by year-end.
• Inflation is running high and likely to persist outside the 3% +/- 1% target band at least through Q1 22 and converge to the target only by Q3 22, according to Banxico. The June headline CPI came in at 5.88% YoY, almost the same as 5.89% in May. Indeed, analysts have raised their year-end inflation forecasts to close to 6%.
• The minutes of the last meeting showed a divided MPC with the two members who voted against the rate increase arguing that the inflation spike is temporary and supply-driven. However, core inflation is also rising driven by services with June core CPI coming in at 4.58% YoY, higher than 4.37% in May. Future rate increases may also come with 3-2 votes, similar to the June meeting, as a member who voted for the hike argued that more hikes may be needed.
• The Finance Minister, Arturo Herrera, who has been nominated to be the next governor has recently made dovish comments. While he may genuinely be dovish, his comments need to be taken with a grain of salt. He is not at the helm yet and from a political standpoint, it is better for him to sound dovish. Moreover, as we have argued before, the current head, Alejandro Díaz de León, is likely to continue raising rates to take the pressure off the incoming governor who only takes over at the end of December.
• Finally, the macroeconomic backdrop remains very supportive for the economic recovery to continue apace. Mexico’s growth forecasts have been revised higher in recent months on the back of expected and ongoing US rebound, and the trade surplus has bounced higher as have remittances. Technical factors are also supportive as foreign holdings of local debt appear to have bottomed in May, after relentlessly dropping from a peak of 65% in 2017.

To capture our view, the trade we have recommended is Long MXN against Short Canadian dollar (CAD). The motivation behind using this cross was the high correlation between the two currencies as well as mitigating the influence of the US dollar and oil prices. While the trade is in the money, we continue to recommend holding it as the gap between the two remains wide despite the recent narrowing (see the chart below).

Data Source: Refinitiv

In addition to the arguments listed above in favor of MXN, with regards to CAD:

• Bank of Canada (BoC) delivered what is widely seen as a dovish taper at its meeting yesterday as it cut weekly bond purchases to CAD 2bn from CAD 3bn. BoC lowered the 2021 growth forecast to 6.0% from 6.5% in April and stated that it expects excess slack to remain in the economy until H2 22. More importantly, it emphasized the slack in the labor market, hinting that it may need to see improvement there before raising rates. CAD weakened following the meeting which indicates that the BoC announcements were broadly in line or marginally less hawkish than market expectations.
• The share of oil in Canada’s export basket is higher than for Mexico. Nevertheless, MXN has outperformed CAD despite high oil prices.
• The carry for the Mexican peso is one the highest among all the currencies, while CAD is on the low end of the spectrum (see the chart below). While real policy rates are negative for both Mexico and Canada, on a prospective basis if the rate hikes are delivered as priced in both curves, then Mexico will have a positive real policy rate by next year but not Canada.

Data Source: Refinitiv; Note: TRY is not shown in the chart.

Best Longs / Best Shorts

• The lists of underperformers and outperformers based on our models in the attached FX Dashboard stayed unchanged.
• The list of underperformers consists of the Peruvian sol (PEN), the Philippine peso (PHP), and the Thai baht (THB) while the list of outperformers has the Brazilian real (BRL) and the Taiwan dollar (TWD) on it.

Best Crosses

• The list of preferred relative-value trades based on our models also remained unchanged with Short BRL vs Long PEN or Chilean peso (CLP) or THB or PHP or Colombian peso (COP) on it.
• The 3m expected returns for these pairs are high in the range of 14-19% (not annualized), assuming mean reversion.