Latam Risk appetite continues to be the main driver of LatAm FX. A month ago we highlighted that the pace of MXN appreciation had picked up on improving carry conditions and an improved global growth outlook. While volatility in rates has picked up recently, which normally dissuades investors from building carry positions, and the emphasis on improving global growth conditions moderated somewhat, the Mexican peso continued to rally in February.
Much of this was due to the surprisingly hawkish Banxico rate decision and guidance that rates will be increased further. With USDMXN now close to 2018 lows, the question now turns to how long the peso can remain at these levels. In our view, it is unlikely MXN strength will persist given the increasingly volatile political backdrop, signs that Banxico’s hiking cycle is drawing to an end, and saturated positioning in the market’s favorite carry trade.
First, although it has recorded solid growth data in the fourth quarter of 2022, political noise could weigh on performance towards the end of the first quarter of 2023. While we do not believe that the anti-government protests so far provide a clear source of instability, they could become one if sustained. In this context, even the higher relative carry would do little to further support the peso–just look at BRL!
Secondly, in an interview a few days ago, Deputy Governor Jonathan Heath, previewed the monetary policy path envisaged by the Bank’s Board of Governors. In it, he stated that the reference rate will not reach 12% or fall below 10%, a sign to suggest that Banxico’s hiking cycle is close to completion but that rates would remain elevated for a sustained period of time.
With an upwards reassessment of Banxico’s rate path providing the main impetus for its outperformance in February, Deputy Heath’s commentary suggests that coupled with saturated positioning, the buy-into MXN carry may begin to fade. Things are somewhat different on the BRL front, where domestic political noise has already dulled the benefits of the currency’s similarly high carry.
Increased political uncertainty, driven now by the new fiscal framework and continued uncertainty over the future of the BCB’s mandate, is weighing on the market’s appetite for BRL exposure. Following the intense debate between the National Monetary Council and the Central Bank of Brazil, uncertainty on the possibility of modifying the inflation target level upwards remains. This seems to be the government’s main concern right now.
Recently, Brazil’s Finance Minister, Fernando Haddad, gave an interview where he outlined some ideas regarding the cabinet’s proposal for the new fiscal framework. Among them, he stated that one of the government’s main concerns is the possibility of an excessive fiscal impulse generating upward inflationary pressures in a context where, he says, interest rates in Brazil are currently unsustainably high.
This suggests that the government is doing its part to make a rate cut feasible. However, this comes at a price. Perhaps, given the proximity of the last elections, it is too early to speak of a political price, but we can speak of the cost of trust in both the government and the monetary institution. Given that we do not expect this situation to be resolved in the coming weeks, we foresee the BRL trading within the current range.
This confirms that risk appetite remains the main driver of the foreign exchange market in Latam today.
