Tequila Turn: Mexico's Anticipated Rate Cut and Market Spreads
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Tequila Turn: Mexico to front run the US
The market discount sees a Mexican central bank rate cut from November. We agree, and we in fact can see rates being cut faster then the market discounts thereafter. There is a lot of comfort built in. This can be gleaned from the appreciation in the peso and falls in market rates. The next step is to prepare for a marked dis-inversion of the curve, ahead of the US.
There is a high degree of policy comfort built into the Mexican curve (TIIE), so much so that we are more and more inclined to anticipate initiation of a material easing process in the coming months. The policy rate at 11.25% is some 6% above the Fed funds rate, representing quite a large cushion. It has only been wider on two occasions in the past 15 years – emergency Fed cuts during the Great Financial Crisis and the same at the onset of the pandemic. There is no requirement for this spread to be wider. In fact, we believe it will narrow as the Fed hikes some more, while Banxico holds pat.
A glance at the chart below highlights the elevation of the official overnight rate, and its excess over the interest rate differential to the US. That differential is at or about highs. Technically, Banxico started its pause before the Fed did, and is likely to extend it at its August policy setting meeting, while the Fed suspends its pause by hiking at its July meeting. There is a Mexico turning point theme coming from this, in anticipation of something similar from the Fed down the line. Banxico should be in a position to front run the Fed.
Mexico central bank rate is stretched, and also versus the Fed funds rate...
A decent portion of this front running theme is already being seen in market rates. In contrast to the ongoing elevation in the policy rate differential, the 10yr market spread (TIIE vs SOFR) is now at 4.3%, in from a cycle high at 6.75%. The chart below illustrates the contrast, and shows that 10yr spread at the tight end of the range seen over the past decade and a half. Right now, the 10yr market spread looks tight while the policy rate differential looks wide. The tightening in market spreads has correlated with the ongoing appreciation in the peso (MXN), with both reflecting a comfort factor coming from the wide front-end rates differential.
