Wealthy Nations Daily Update - Mexico

On 17 February Banco de Mexico surprised the market with a 50 basis point intermeeting rate hike taking the benchmark rate to 3.75% and the central bank directly intervened in the currency market and announced that the Foreign Exchange Commission would suspend dollar auctions when the peso weakens by more than 1% from the previous day’s fix in favour of intervention on a discretionary basis.  The Central Bank Governor, Agustin Carstens noted that the depreciation of the peso and international market volatility had “increased the probability that inflation expectations are not in line with the consolidation of the permanent objective of 3 per cent.”

But the move was also a clear statement by the Mexican authorities that the recent weakness in the peso, which saw the peso dollar exchange rate weaken as far as 19.4448 intraday, had gone too far.  Shorting the Mexican peso has been a liquid way to short emerging markets but it got to the point that the currency was no longer reflecting Mexico’s fundamentals.  The central bank move has at least increased the cost of shorting the peso with the added risk of further unexpected intervention. The peso appreciated in response to this policy shift and is now trading at 18.0870 to the dollar at the time of writing.  Interestingly, and more likely a better reflection of fundamentals, the government bond market was much less affected with the local currency and USD Mexican 10 and 30 year bonds rallying year to date. 

The rate rise came in conjunction with Luis Videgaray, the Finance Minister, announcing budget cuts of 0.7% of GDP.  The MXN132bn (~USD7.3bn) of cuts is prudent, timely and ‘credit positive’ as, even although Mexico has in place oil hedges at USD49/bbl for 2016, if the oil price were to remain where it is the fiscal adjustment required in 2017 will be close to USD7.5bn.

Despite USD 2bn of foreign exchange intervention last week, Mexico has sizeable foreign exchange reserves of USD174bn; in fact reserves have remained stable since November last year and at the end of 2015 its reserves were just ahead of Germany in size.  Mexico is a ‘wealthy nation’ with net foreign liabilities of 39.5% of GDP using Stratton Street’s 2012 NFA estimates. Our cut-off for countries to be considered a ‘wealthy nation’ is net foreign liabilities of 50% of GDP; IMF research indicates levels above this threshold are associated with increasing risk of external crises.  But even ‘wealthy nations’ can be temporarily caught up in indiscriminate bouts of market volatility.  The World Bank notes that the 2013 Taper Tantrum “initially triggered indiscriminate capital outflows from emerging markets. Over time, greater differentiation emerged.” Countries that faced the greatest financial market disruption had “large current account deficits following a period of rapid real appreciation, modest international reserves, and weaker growth prospects were associated with sharper drops in capital inflows and disruptions in financial markets.” 

The use of unconventional monetary policy for an extended period of time has inflated asset markets.  Thus, the Fed starting to reverse monetary policy in December 2015, combined with a stronger dollar and still weak global growth has increased market volatility.  Moreover, markets are questioning the efficacy of using negative rates to try and sustainably boost aggregate demand.  Faced with this realisation a desire to de-risk has put ‘emerging markets’ under pressure from capital outflows, although it is the debtor nations with excessive net foreign liabilities that will ultimately come under the most pressure.

This backdrop favours positioning in long duration higher quality credits from ‘wealthy nations’ as yield curves continue to flatten.