Mexican Peso New Highs for 2009

An upward revision in the central bank of Mexico's inflation forecasts announced yesterday propelled the peso to new highs for the year on ideas that the new forecasts are a signal of a rate hike early next year. We suspect the market, which the non-commercials (speculators) in the futures market held as of last week a net 89k long contracts, the most in over a year, is seeing what it wants to.

The central bank governor acknowledged that the increase in inflation will be temporary and largely a result of tax increases and administered price hikes. Income, sales and excise taxes were raised as part of the effort to offset the decline in revenue the energy sector. Higher prices for government provided goods like gasoline are also expected, but they have a one-off impact on inflation measures. Moreover these kinds of things, like higher taxes are disinflationary as it reduces discretionary spending.

This is really evident in the central bank's inflation forecasts. Next year's forecast was raised to 4.75%-5.25% from 3.00%-3.50% but 2011 inflation is forecast to be 2.75%-3.25%. It seems that central banker Ortiz is really suggesting that the key to monetary policy will be the secondary round impacts of the tax and administered price increases.

That said, it is not clear that Ortiz will be there to do the monitoring. His term expires at the end of the month and when asked if he will stay, he answered that he would if he were asked. This seems to suggest he has not been asked. Local contacts suggest that Finance Minister Cartsens may be named. Some announcement should be expected in the coming weeks.

The Mexican peso is having a fine quarter, appreciating some 6.3%, despite the fact that Fitch lowered its rating for Mexico to BBB on Nov 23rd. Indeed, since Fitch's decision, the peso has easily been the best performer in the region, gaining 2% against the dollar compared with a little less than a 1% gain by the Brazilian real. Mexico's economy is expected to contract around 7% this year, though a tentative recovery appears to have begun in Q3. Many economists expect growth next year to be closer to 3%. And magnitude of the swing appears to have captured the imagination of some participants.

Mexico's Bolsa rose to its best level since Oct 07 yesterday, led by financial and consumer service sectors. Telecoms, which account for about 30% of the Bolsa, under-performed, losing almost 1%. Of course, year to date, the Brazilian Bovespa has handily outperformed the Bolsa (82.7% vs 43.5% in local currency terms), over the past month, the Bolsa has outperformed (11.2% vs 9.5%). Some observers expect Mexico which has been a laggard to play catch -up. And this may have also helped provide some fuel for the peso's gains.

The US dollar was pushed through MXN12.80 yesterday, new stop-loss selling and the carried the greenback to almost MXN12.70. In thinner Asian and European activity, the dollar has slumped to about MXN12.68. A break now of MXN12.60 could signal a move toward MXN12.40.

We think there is a reason Mexico has under-performed this year. Despite having production in Mexico counting for domestic content rules for North America and Europe, it has failed to diversify its economy away from the United States. Because it has not spent sufficiently on investment, it is not in a position to benefit from the bigger oil prices as output has fallen. Hence it has been forced to raise taxes on consumption as well as income, despite lackluster domestic demand. Politically, the transformation from a one-party state to a multi-party system seems fundamentally incomplete. Moreover, given the high level of violence and war between the drug lords and the government and between the drug lords themselves means that the state does not have a monopoly on the use of force. Lastly, and more fundamentally, it is not clear how Mexico will compete in the world economy. Prior to 2001, when China joined the WTO, relatively cheap labor was its comparative advantage. That all changed as the closing up of furniture, toys, textile, etc labor intensive maquiladora factories illustrate.

The key take away points: 1. the secondary impact of the tax increases and administered price increase are more important for monetary policy than the fact the central bank revised up next year inflation forecast, 2. the speculative market is already long the peso, leaving it vulnerable to profit-taking, 3. the economic recovery is taking hold, but remains fragile, 4. longer-term political/economic challenges remain.