A hawkish Banxico for now
The balance of risks for Mexican financial assets has clearly deteriorated of late, amid rising global risk aversion, renewed difficulties in the NAFTA negotiations and greater apprehension concerning the upcoming 1 July general elections. As a result, since mid-April, when the USD initiated its latest sustained appreciating trend, the Mexican peso weakened by close to 14%, while local yields surged about 50-60bp across all tenors.
Unlike Brazil, or Argentina, Mexican policymakers have not (yet) reacted by intervening in local markets or changing monetary policy guidance. But heightened uncertainties and prospects for a slightly more hawkish monetary stance by the US Fed next week suggests that Mexico’s central bank (Banxico) should opt for a more vigilant stance and match a US rate hike with another 25bp increase in the policy rate, to 7.75%, on 21 June.
another defensive hike
Banxico continues to list FX and US Fed decisions as primary drivers for their policy decisions and, apart from brief intervals in-between meetings, the Mexican/US interest rate differential has remained unchanged, at 5.75%, for one year now. Failing to hike on 21 June would reduce that differential to 5.5%.
No time to reduce rate differential with the US
Inflation trends have continued to improve, coming largely in line with central bank expectations, which could, in principle, justify no action on the policy rate front. But, we suspect, central bank officials should conclude that now is not the appropriate time to signal a decisive decoupling from the Fed and reduce that rate differential, which is seen as critical to bolster local market stability.
Beyond this meeting Banxico should maintain a defensive (hawkish bias) in the near term, downplaying the risk of rate cuts. The medium-term rate trajectory should be heavily data-dependent however, with inflation and, especially, FX dynamics dominating Banxico’s reaction function.
In principle, with strong prospects for inflation to re-enter the 2-4% targeted range during 1H19, the arguments for Banxico to start considering rate cuts should gain traction. In our assessment, as we discussed before (“Mexico: FX rally brings relief”), room for cuts is relatively limited however. The neutral level for the nominal policy rate should be seen as close to 6% but FX considerations will remain crucial in Banxico’s reaction function.
In this regard, a critical element in Banxico’s assessment of FX risks will be the level of Mexico’s interest rate differential with the US. It’s unclear if an “ideal” rate differential level exists. But, looking over the levels that prevailed over the past decade, two levels stand out to us. The first is 4.25%, which prevailed over a long stretch from 2009-13, and coincided with substantial foreign inflows and a largely stable peso. The second is 2.75%, which prevailed from mid-2014 to early 2016 and was, arguably, seen as too small a differential that left the peso especially vulnerable, coinciding with substantial outflows and the subsequent FX sell-off.
Cuts should be limited by the need to preserve a “healthy” premium vs the US
As a result, in principle, we would expect officials to prefer to keep that rate differential in the 3.5%-4% range. And assuming that the US Fed should aim to hike its overnight rate towards 3%, we suspect the need to bolster FX stability should prevent Banxico from cutting rates below 6.5% over the next two years.
NAFTA, AMLO and the MXN outlook
Near term MXN dynamics should be, to a considerable degree, determined by two key Mexico-specific factors: market reaction to the election results and the outlook for NAFTA negotiations.
After many ups-and-downs, NAFTA has resurfaced as a significant source of uncertainty for Mexico. The tougher US stance, signalled by the insistence of a sunset clause for the treaty and the recent imposition of steel import tariffs, followed by retaliatory measures by Mexico, has increased the risk of an eventual breakdown in the negotiations.
But we still consider the risk of a unilateral withdrawal by the US to be very small. Moreover, the recent escalation may reflect a tactical repositioning by the US, which is fighting several trade battles at once. Specifically in the case of Mexico, the US position may reflect the reality that time has run-out to get a deal sanctioned by the current US Congress and with the current Mexican administration. Starting later in the year, US negotiators will likely face new counterparties representing Mexico, which may help explain a tougher negotiating stance at the outset of the new rounds.
As a result, we believe investors will take recent clashes with a grain a salt and not react as negatively as in the past. The base-case assumption will be that the arguments for the parties to eventually reach an agreement remain fundamentally strong. The agreement has just been postponed.
As a result, we suspect that the elections, which will take place in about three weeks’ time, to be the primary Mexico-specific short-term driver for local assets.
A landslide victory by AMLO is not fully priced-in
Judging by recent polls, Andres Manuel Lopez Obrador (AMLO) will be confirmed as Mexican President-elect on 1 July. Still, we suspect current asset prices have yet to reflect what could be a landslide victory by AMLO. As suggested by the latest polls, AMLO’s lead has increased, with upwards from 50% in voter support, or twice the support received by the runner-up Ricardo Anaya.
Despite the consistency in poll results, many locals still suspect that strategic voting or day-of-election factors, such as local party machinery advantages, along with voter turnout considerations should chip away some support from AMLO.
However, if the recent election in Colombia is any indication, polls turned out to be quite accurate and day-of-election factors, which could benefit the establishment (boosting voter support for Vargas Lleras in Colombia’s case), did not prevail. As the recent truckers’ strike in Brazil also evidenced, anti-establishment sentiment is running deeper than many suspected, and should not be underestimated.
In that case, ie, if polls are right and local investors are underestimating the strength of the MORENA candidacy, the risk of a post-election sell-off is high.
Seismic shifts in Congress
Much of that sell-off should be predicated on the degree of Congressional support AMLO will secure in the race. Seismic shifts are expected to take place in Mexico’s Congressional composition. MORENA is likely to become the largest bloc in Congress, a seismic shift when compared to its less than 10% current share in the Lower House and 0% in the Senate, while Peña Nieto’s PRI share could shrink to about a quarter of its current 40% Lower House share (43% Senate).
Poll assessments regarding future Congressional composition are far less reliable, in part due to Mexico’s mixed semi-proportional election rules. But given the strong and consistent momentum displayed by the MORENA ticket, the balance of risks is that it amasses a larger-than-expected Congressional base.
In our view, a reasonable assumption is that AMLO would obtain a working majority, but not the two-thirds majority necessary to implement constitutional changes such as overturning the energy reform for instance. Defections from other parties post-election and potential alliances with other left-leaning parties in Congress could help boost MORENA’s control of the Lower House and the Senate post-election.
Post-election sell-off could offer a buying opportunity
This suggests that, in our base-case scenario, the USD/MXN should rise above 21 following the election but only reach 22 in case a super-majority is Congress is within AMLO’s grasp.
We would expect the sell-off to be short-lived however. We suspect foreign investors, who typically harbour less concerns vis-à-vis AMLO than locals do, are more likely to add to their positions amid the sell-off under the assumption that AMLO will opt for a more pragmatic and conciliatory rhetoric post-election. In that case, for instance, by appointing a market-friendly economic team, local assets (FX and FI) could rally considerably.
A recent Bloomberg report suggested that AMLO was considering asking former Banxico governor Guillermo Ortiz to join his cabinet. If confirmed, or any alternative high-calibre name joins the economic team, the event could be an important catalyst for a post-election rally.
Key risk factors to watch would be if the risk of a unilateral withdrawal by the US from NAFTA rises materially, which we do not expect, or AMLO decides to ignore market volatility and commits to a highly expansionary fiscal program and reverses the pro-market initiatives implemented by the current administration, notably by freezing the rise in private sector participation in Mexico’s energy sector. This would damage considerably the outlook for activity, fiscal and external accounts.