Mexico Has Room For More Rate Cuts

With both Mexico’s heavy industry and tourism sectors disrupted by the COVID-19 pandemic, Bank of Mexico has continued to slash interest rates by 50 basis points on March 19, April 21 and May 14.  Even with these cuts and the five smaller rate reductions that preceded them, the central bank’s overnight rate remains far above the trailing 12-month core inflation rate (Figure 1). 

Figure 1: Bank of Mexico’s overnight rate is still far above levels that prevailed from 2009-2016

Moreover, Mexico’s yield curve, which has been a decent precursor for future economic growth, has only steepened slightly in response to the rate reductions and remains relatively flat by historical standards (Figure 2).  Perhaps the good news for Mexico is that its yield curve is no longer inverted as it was for parts of 2017 and 2018 and nearly all of 2019.  Mexico fell into a recession in 2019, well before the pandemic struck. The fact of having relatively high short-term interest rates by the standards of Mexico’s recent history (2009-16), low and stable inflation, a recession that predates the pandemic on top of a relatively flat yield curve, suggests that Mexico’s central bank still has wide latitude to cut interest rates further.

Figure 2: Even after eight rate cuts, Mexico’s yield curve is still relatively flat

Meanwhile, Mexico’s currency has not suffered as a result of Bank of Mexico’s recent rate cuts.  In fact, since the end of April, it has rebounded by over 10% versus USD and remains a strong outperformer among the Latin American currencies (Figure 3).

Figure 3: After catching up on the downside in March, MXN has led the rebound in May

Part of the reason why Mexico’s peso has outperformed the Brazilian real as well as the Chilean and Colombian pesos is that Mexico’s exports are overwhelmingly (71%) manufactured goods and only 19% raw materials (Figure 4).  This contrasts with Brazil, Chile and Colombia where commodities account for 60-90% of exports. Their currencies fell with raw materials prices. Although many people associate Mexico with the oil sector, Mexico has not been a net exporter of oil since 2006.  Likewise, metals exports account for only 4% of Mexican exports, even though Mexico is a top producer of silver.

Figure 4: Mexico’s exports are overwhelming manufactured goods

Most of Mexico’s exports head to the US and Canada (Figure 5).  The pandemic-related shutdowns of large portions of these two nations’ economies has been difficult for Mexico. That said, in the long term, Mexico might prove to a be a beneficiary, if the US and Canada choose to diversify supply lines away from China and localize production.  Mexico has the strongest manufacturing base in Latin America and extremely competitive labor costs.  Moreover, Mexico’s reliance of exports of manufactured goods to its northern neighbors explains why MNX appears to relate more closely to the US equity market than it does to other Latin American currencies (Figure 6).

Figure 5: The USA and Canada absorb more than three-fourths of Mexico’s exports

Figure 6: MXNUSD follows US small-cap stocks more closely than it follows other LATAM currencies

A casual look at MXNUSD’s spot exchange rate shows an on-again off-again pattern of the peso falling versus the dollar. However, spot exchange rates ignore interest rate differentials between countries, like the 5.3% differential that prevails between Mexico and the US currently. Over time, carry differentials add up to tremendous differences in performance (Figure 7).

Figure 7: Interest rate differentials can add up overtime for those long “carry” currencies

Mexico has the additional strength of being among the Organization for Economic Co-operation and Development’s least indebted countries. Mexico’s public debt came to 36.4% of GDP in Q3 2019, lower than in all but a handful of other nations. Moreover, household and non-financial corporate debt are among the lowest in the world (Figure 8). This suggests that not only does Mexico’s central bank enjoy wide latitude to cut interest rates further but that Mexico’s government also has the potential to run fiscal deficits in order to shore up economic growth. Mexico’s low-debt ratios may also explain why its currency has outperformed those of more highly indebted countries in Latin American such as Brazil, Chile and Colombia, where debt totals are as much as 2x as high relative to GDP. Not only is Mexico’s debt much smaller relative to GDP than in these other countries, it has been growing much more slowly as well (Figure 9).

Figure 8: Mexico is among the world’s least indebted countries

Figure 9: Mexico’s debt is growing more slowly than in many other emerging markets

This isn’t to say that Mexico doesn’t have it own concerns. Since 2007, its homicide rate per capita has quadrupled (Figure 10) and is now among the highest in the world. Moreover, there is a risk that economic stress could push it higher still, as happened in the wake of the global financial crisis. That said, so long as Mexico’s security issues do not deter tourism or interfere with business investment in Mexico’s manufacturing sector, a deterioration in public safety measures may not have a direct baring on the currency.

Figure 10: Mexico’s security situation could weigh on MXN if it dissuades tourism and investment

Bottom Line

  • Bank of Mexico’s rates are still above inflation and 2009-16 average levels
  • Despite eight rate cuts, Mexico’s yield curve is relatively flat
  • MXN has been an outperformer among LATAM currencies
  • MXN correlates positively with US equities, the destinations of most of its exports
  • Mexico remains one of the world’s least indebted countries
  • Mexico’s interest rates remain much higher than those in the US

 

All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author(s) and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.

About the Author

Erik Norland is Executive Director and Senior Economist of CME Group. He is responsible for generating economic analysis on global financial markets by identifying emerging trends, evaluating economic factors and forecasting their impact on CME Group and the company’s business strategy, and upon those who trade in its various markets. He is also one of CME Group’s spokespeople on global economic, financial and geopolitical conditions.

View more reports from Erik Norland, Executive Director and Senior Economist of CME Group.

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