USD/MXN facing a perfect storm in H1 2018?

Overall, the Mexican peso has had a relatively good year in 2017, set to close a shade under 20 to the US dollar at end-December (19.72 at time of writing), having opened at the year at 20.74. This would make for a gain of about 5% for the year.

At the beginning of the year, the peso was still reeling from the election of Donald J. Trump as President of the U.S. on a platform hostile to imports of goods and people from Mexico. There was concern that he may follow through on threats to unilaterally withdraw from NAFTA, tax remittances and build a big border wall, among other measures. It was in the latter stages of a rout which would see the peso climb from a shade under 18 to the dollar in mid-August 2016 to an all-time high of nearly 22 in the third week of January 2017.

A strong nine-month run would see the peso more than retrace this move as the worst fears of a Trump Presidency appeared to have been unfounded, with the Mexican currency dipping back below 18 to the dollar during the summer months.

Q4 2017 has seen a reversal of fortunes, however, with the peso losing 10.7% while climbing from 17.61 in September to 19.72 on December 27. Momentum is against the peso, and further weakness appears likely in early 2018. It would be no great surprise to see the Mexican currency post new all-time highs above 22 to the dollar during the first half of 2018. Here’s why:

Macro:

  • Inflation – consumer prices accelerated further in December, posting an annual increase of 6.69%. This is the highest inflation rate the country has seen since 2001, and remains more than double the mid-point of the Central Bank’s 2-4% target range. Rising energy prices were a big part of Mexico’s inflation story during 2017, with retail gasoline prices being liberalized in the North of the country early in the year, and throughout the rest of the country as the year progressed. While the initial price hikes from January 2017 will fall out of the annual inflation data in early 2018, the combination of strong oil prices in Q4 2017 and the weak currency are likely to continue adding to price pressures in the short term.
  • Growth – GDP contracted by 0.3% in Q3 2017 as the country was buffeted by two large earthquakes as well as weakness in the energy and construction sectors. Although Q3 GDP was 1.7% higher than the corresponding level in 2016, it fell significantly below previous forecasts of growth around 2.6%. This marks a significant deceleration in activity after the economy had proved surprisingly resilient in the early part of the year despite fears and uncertainties surrounding prospects for NAFTA etc. The IMF is forecasting further modest deceleration in GDP growth, from 2.1% for 2017 to 1.9% in 2018.

External:

  • NAFTA – Despite all parties having aimed to conclude the renegotiation of the tripartite trade agreement by end-2017, the fifth round of talks ended in December with few signs that a final deal is close. The parties remain far apart on key US demands like a 5 year sunset clause and more restrictive rules of origin for vehicles and auto parts. President Trump has weighed in periodically on the negotiations, signaling that he is prepared to take steps to unilaterally withdraw the United States from NAFTA. This may be a case of deliberate and strategic ambiguity on the part of the US President, but such brinkmanship does add . While a successfully negotiated deal on NAFTA 2.0 would certainly be ‘peso positive’, ongoing and stuttering negotiations can be expected to weigh on sentiment until then. In a worst case scenario where negotiations breakdown, the peso would be expected to take a significant hit. Talks will reconvene in January in Montreal, but the political climate in both Mexico (Federal elections on 1 July) and the US (primaries ahead of mid-term elections in November) is likely to heat up and complicate efforts to conclude a deal.
  • US fiscal policy – Landmark corporate tax reform enacted by the US government in December 2017 is due to come into force from fiscal year 2018. The headline measure is the reduction in the Federal corporate tax rate from 35% to 21%, while a number of other changes have been made to encourage domestic investment and the repatriation of firms, funds and jobs to the US. While the extent to which the tax changes will achieve their stated aim of boosting domestic investment remains to be seen, they certainly make the US a relatively more attractive destination for investment, whether by US or foreign players, than was the case beforehand. In turn, this should weigh on the peso in the short to medium term. This has led to calls in Mexico, in particular, to respond by slashing its own 30% corporate tax rate and improving its offering of investment incentives. In late December, Mexico’s recently-appointed Finance Minister, Jose Antonio Gonzalez Anaya, acknowledged the challenges posed by the US tax reforms but signaled that it would be as yet premature to introduce a parallel reform south of the Rio Grande. This could become one of the policy battlegrounds in the coming Presidential election.
  • US monetary policy – Having increased the benchmark funds rate  by 25bp three times in 2017, the Federal Reserve has signaled a further three similarly sized moves are in store in 2018 if the economy continues on its current trajectory. Passage of the tax reform bill (see above), which is estimated to add up to $1,5trn in deficits over the next decade, is likely to underpin economic strength in the short term, encouraging the Fed to tilt hawkish and supporting a stronger dollar. In such an environment, emerging market currencies, in general, and the Mexican peso, in particular, do not typically perform well. Meanwhile, the Fed will continue to gradually unwind quantitative easing by shrinking its balance sheet through 2018. The IMF estimates that US balance sheet tightening is likely to see a $55bn reduction in emerging market portfolio investment inflows over the coming two years, while increased rates could reduce flows by a further $15bn. On the front line, boasting one of the most liquid emerging market currencies and being relatively open to investment, Mexico and its currency are likely to be particularly vulnerable to such shifting portfolio investment patterns.

Political:

  • Presidential election – Mexico will go to the polls on 1 July 2018 to elect a new President, the current incumbent being constitutionally barred from re-election (as are all office-holders in the country). While presidential transitions have long been associated with economic volatility in the country, one has to go back to the Tequila crisis of late 1994 to find an extreme example. In the interim, orthodox macroeconomic management has largely ensured relatively smooth political transitions, notably including the ‘democratic transition’ of 2000, when the opposition broke the uninterrupted 71-year stranglehold of the PRI (Partido Revolucionario Institucional) on the Presidency. 2018 could see another historic transition, with Andres Manuel Lopez Obrador, perennial leftist candidate for the Presidency, poised as front-runner in opinion polls at the turn of the year. We have been here before, however. AMLO, as he is known in Mexico, boasted even more impressive polling leads at the same stage in the 2006 election, before ultimately falling narrowly short against Felipe Calderon. Regardless of whether AMLO is ultimately successful in the 2018 election, it is likely to weigh on the peso so long as the prospect remains a live possibility during the first half of the year. Should he lose, one can expect the peso to strengthen in July 2018 as a result. Should he win, further peso weakness can be anticipated through his inauguration on 1 December 2018. But, should markets be so worried about an AMLO Presidency? We have seen this movie before. In 2002, markets woke up to the possibility of another perennial leftist presidential candidate being elected in a leading Latin American economy. Ultimately, Lula da Silva ruled as a moderate, combining strong economic growth with impressive social progress, albeit bolstered by a benign global environment and commodity boom for much of his Presidency. USD/BRL was bid up from about 2.25 in April 2002 t0 peak at 4 in October of that year, on the eve of his election. Most of the spike had been reversed by the middle of 2003, putting the BRL on a path of steady strengthening to fall close to 1.5 to the dollar by August 2008, on the eve of the global financial crisis. There are three reasons why AMLO can be expected to govern in a similarly moderate vein, irrespective of fiery campaign rhetoric: 1. He has governed moderately before, as mayor of Mexico City from 2000 to 2005, 2. his Morena party is unlikely to come close to capturing a Congressional majority, and 3. he has pre-announced a cabinet of experts, including the moderate, experienced and competent Carlos Manel Urzua as a putative Finance Minister.  Certainly, the first half of 2018 will see heightened political risk in Mexico, but there is little reason for panic.
  • New central bank chief – For years one of the most respected central bank chiefs globally, and in emerging markets in particular, Augustin Carstens finally moved to his new role as head of the Bank of International Settlements on 1 December 2017. Having previously been expected to leave his post at the Bank of Mexico in July 2017, he had postponed his departure in light of the challenging economic environment at the request of the Mexican government. Ultimately, the government resisted the temptation to make a political appointment to Banxico, by using it as a ‘runners up’ prize for one of the leading lights of the governing PRI who fell short in the race for the nomination to be the party’s standard bearer in the 2018 presidential election. Such a move would likely have been interpreted negatively by the markets as undermining the central bank’s independence, particularly during the election cycle. In the event, the government decided to make an internal, technocratic appointment, tapping Alejandro Diaz de Leon, formerly a board member at the central bank. While the market reaction has been relatively sanguine, the very fact that he is an unknown quantity compared to his illustrious predecessor means an up-tick in uncertainty through the first half of 2018. The new chief sought to quickly establish his inflation-busting bona fides with a 25bp hike at Banxico’s December meeting. With inflation at its highest level in a generation, however, and the US Fed having signaled three further 25bp hikes of its own in 2018, a hawkish stance will likely remain justified by the data and the global backdrop in the short-to-medium term.

The Bank of Mexico can be expected to continue its periodic intervention to smooth dramatic price moves, but not to change its stance so as to explicitly defend the currency at any given level. However, the central bank has already moved aggressively in its efforts to ward off inflation. Since further currency weakness could be expected to feed through to second round inflationary effects, Banco de Mexico is likely to remain its hawkish stance during the first half of 2018, notwithstanding the economic (softening growth) and political (presidential election) cycles.

Price prediction: Mexican peso to set new all-time record above 22 to the dollar during H1 2018.

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