Currency Forecast - MXN: Strong Fundamentals, But Risks Abound - MAR 2018
|Source: BMI, Bloomberg. Updated January 20 2018.|
|Policy Rate, % (eop)||7.25||7.50||5.00|
BMI View: High real yields and significant undervaluation in real effective exchange rate terms underpin our relatively constructive outlook on the Mexican peso. Nevertheless, downside risks to this view stemming from the NAFTA renegotiation and July presidential election remain considerable.
Short-Term Outlook (Three-to-six Months)
We are relatively constructive on the Mexican peso (MXN) in the short term, expecting that the unit will claw back some of its December losses against the US dollar in the next couple of months. The peso is nearing steep trendline resistance around MXN19.25/USD, a break of which could spell further upside towards its December high of MXN18.63/USD in the first instance. The US dollar is also set for modest weakness against a basket of currencies in the near term, as it unwinds following a sharp run up in 2014-16, which could provide some tailwinds for the MXN ( see ' USD: A Breather Rather Than A Bear Market ' , January 9).
|Upside Potential Following Major Sell-Off|
|Mexico - Exchange Rate, MXN/USD (Monthly)|
|Source: Bloomberg, BMI|
That said, the unit will remain prone to bouts of depreciation. Stalled progress in the sixth round of talks in the NAFTA renegotiation, scheduled for late January, could send the currency back towards its December low of MXN19.90/USD relatively quickly.
Long-Term Outlook (Six-to-24 Months)
We forecast the MXN to remain relatively flat in spot terms in 2018 before appreciating modestly in 2019, which would indicate further gains in total return terms. In line with our long-held view, we expect that high real yields and relative undervaluation will provide support for the currency ( see ' MXN: Short-Term Neutral, Long-Term Constructive ' , October 5 2017). However, we have downgraded our Mexican peso forecasts for 2018 and 2019, reflecting the increased likelihood of a NAFTA breakdown (although not our core view) and our Oil & Gas team's expectation that global crude prices will decline from spot levels this year ( see ' Brent: Heading Lower Into 2018 ' , December 1 2017). We forecast the unit to average MXN18.90/USD in 2018 (compared with a previous forecast of MXN18.60/USD) and MXN18.40/USD in 2019 (versus MXN18.25/USD).
Mexican real yields will remain relatively high over the coming quarters, particularly compared with those on offer in developed markets. While the differential between headline inflation and the spot policy rate has narrowed considerably in recent months, 10-year bond yields adjusted for inflation expectations and default risk indicate a still-significant spread. We expect this trend will continue, in line with our expectations that headline inflation and inflation expectations will decline considerably over 2018. Moreover, the Banco de Mexico will maintain its hawkish monetary policy stance in the months ahead. Following 400bps of hikes over the last two years, we expect a further 25bps increase to 7.50% in early 2018, as the bank looks to contain inflation expectations and stave off a narrowing of Mexico's interest rate differential with the US ( see ' Hiking To Continue With Inflation At 16-Year High ' , January 9).
|Mexico - BIS Broad REER|
|Source: Bloomberg, BIS, BMI|
In addition, Mexico's real effective exchange rate (REER) remains considerably undervalued as compared to five- and 10-year averages. This suggests potential for appreciation without a significant erosion of the country's export competitiveness. Moreover, the MXN's bout of depreciation in Q417 once again exacerbated this undervaluation in REER terms.
Risks To Outlook
The risks to our exchange rate outlook are considerable over the next couple of years, stemming primarily from a breakdown of NAFTA or a shift in policy direction following a victory by leftist populist presidential candidate Andres Manuel Lopez Obrador in the July 2018 presidential election. While we have not yet made a definitive call on the presidential election, our macro forecasts assume broad stability in economic policy direction.
Our core view remains that the trilateral NAFTA negotiations will be concluded with few major changes to the status quo. However, the introduction of hard line proposals by the US in Q417 has reduced this likelihood to no more than 50% ( see ' NAFTA Update: Lack Of Progress Puts Deal In Increasing Jeopardy ' , November 23 2017). Moreover, we place a 30% likelihood on the US withdrawing from NAFTA, which would be a worst case scenario for the peso, quickly sending it past its all-time low of MXN21.59/USD.
A potential victory by Lopez Obrador would also likely result in short-term depreciation of the MXN, towards recent lows. While Lopez Obrador has stated that he will not increase Mexico's debt levels, he has promised to double pension payments and offer free higher education. Moreover, he is a long time critic of energy sector liberalisation. As a result, we would expect selling pressure on the MXN should the former Mexico City mayor prove victorious in July. We will be exploring these outcomes further in future scenario analysis.