The peso has been the FX star for two years. Why the trend might persist in 2024.
The major factors that have driven peso strength remain in place and could push the peso higher throughout 2024.
The Mexican peso’s recent strength has been impressive. From the all-time low set in 2020, the peso has moved up over 35% versus the dollar and more against most other currencies. Many analysts believe that this move has pushed the peso into a state of overvaluation and expect a pullback this year. They may be correct on the fundamentals, but history teaches us that currency trends often persist beyond what most believe to be appropriate valuations. The downtrend in USDMXN remains intact and those with exposure to a rising peso should consider what impact an even stronger peso will have on their business. If a rising peso might cause problems, it’s time to consider an FX hedging solution.
Reasons for Continued Peso Strength:
- Interest Rates: Mexico’s central bank (Banxico) has kept rates much higher than those in the US and other developed economies. At its most recent policy meeting on February 8, rates were left unchanged at 11.25%, maintaining a 600 basis point advantage compared to the US. This differential is likely to persist, despite expectations that Banxico may lower interest rates slightly at its next meeting on March 21 (one day after the next FOMC meeting on March 20). Inflation, though still above target (3%) has been generally easing over the past year, so it appears that Banxico has substantial room to cut rates this year. Rate cuts could pressure the peso in the short term, but the US central bank is also expected to cut this year, so the existing differential may not change.
- Nearshoring: Mexico continues to benefit from ongoing foreign investment as many multinational companies shift manufacturing from Asia to countries closer to the US. Mexican GDP growth is projected to outpace the US in 2024 in data from the IMF (Mexico +2.7%/US +2.1 %) and the OECD (Mexico +2.5%/US +1.5%). A recent example of foreign investment is Tesla’s commitment to build a $5 billion “gigafactory” in Monterrey. The trend toward nearshoring is likely to continue over the next few years, adding to growth in the Mexican economy and lending support to the peso.
- Increased Trade with the US: In 2023 Mexico displaced China as the world’s biggest exporter of goods to the US. Mexico is now the dominant player in bilateral trade with the United States, a trend that could continue, especially if US/China relations fail to improve. Complex supply chains are well-developed and have created an infrastructure that will support ongoing growth in trade over time. More trade with the US could also lead to a stronger peso.
- Mexican election: Ruling party candidate Claudia Sheinbaum has a substantial lead in polling prior to the June 2 election. Sheinbaum is expected to continue the policies of current president Andres Manuel Lopez Obrador who is finishing his constitutionally-mandated single term. Changes in polling as the election approaches could impact the peso. Markets will also be paying closer attention to developments in the US election.
Technical Considerations:
The peso’s recent rally could be considered more of a reversion to the mean than an outright show of strength. In 2020 the peso hit an all-time low (USDMXN 25.26) against the dollar as markets reacted to uncertainty surrounding the pandemic and its economic effects. The recovery over the next several years has brought the peso back to levels last seen in 2015, but still well above the 20-year average for USDMXN. Currently, USDMXN has been holding a 30-year support line on monthly charts (see below). A breach of that trendline could set the stage for a drop to 15 on USDMXN, a move of 12% from current levels.
If USDMXN were to move above 17.50 the charts suggest a retest of the 2023 high of 18.48 (7.5%), with a potential to reach 20 (16.2%) over time. Based on current market conditions this scenario appears less likely than ongoing peso strength.
Hedging Considerations:
The interest-rate differential between the US and Mexico favors strategies to hedge future peso appreciation. Purchasing forwards (or futures) allows hedgers to benefit from higher Mexican interest rates while they are protecting themselves from adverse FX movement. The 6% interest rate difference is reflected in the discounted pricing of pesos for future delivery. A peso hedge could prove profitable even if the spot market remains stable at current prices.
The peso is a very liquid currency in FX markets, with tight interbank spreads and high daily volume. Mexico’s time zones overlap with the US, so markets are most active during traditional US business hours.
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