Canada, Mexico, and the USMCA

The US dollar closed today above CAD1.3500 for the first time since January 2.  Despite the setback, the Canadian dollar is the strongest of the major currencies year-to-date with a little less than a one percent gain.  The yen, in second, has is up about 0.2% (~JPY109.50).  Among emerging market currencies,  the Mexican peso's 2.6% gain puts it in in second place behind the Russian rouble's 7.2% appreciation. 

It is a gross simplification to suggest that the currency moves are driven by the S&P 500, but the general risk appetite more than their domestic economic considerations.  Since the end of the tariff truce, the peso has fallen 1.2%, and the Canadian dollar eased 0.7%.  In the fourth quarter last year, as equity markets spiraled lower, the Canadian dollar fell in all but one week. As equities roared by in January and February, the Canadian dollar rose in all but one week. 

We identify three drivers of the Canadian dollar: The broad risk appetite, oil, and the two-year US-Canada interest rate differential.  The S&P 500 set a record high at the start of the month but has fallen nearly six percent in May as trade tensions with China escalate and the economic data points to a sharp slowdown here in Q2.  Oil prices followed a seven-week advance in March and April, to fall four of last five weeks, with the July contract visiting a two-month low below $57 a barrel.  The US offered 85 bp more than Canada to borrow for two years in early March.  It is now a little more than 55 bp.  The narrowing of the spread is largely accounted for by the decline in the two-year yield as the market prices in aggressive easing by the Federal Reserve.

The combination of Mexico's high real and nominal rates and a stable currency creates an attractive opportunity for the leveraged community.  The general risk appetite influences the stability of the peso, which is sometimes used as a proxy for the universe of emerging market currencies.  As equities fell in October and November last year, the dollar rose against the peso every week.   The dollar peaked (~MXN20.66) against the peso a few weeks before the S&P 500 bottomed in December 2018, and continued to disgorge its earlier gain and in both March and April tested MXN18.75.

The Bank of Canada is more confident that the soft patch in last 2018 and early 2019 is temporary.  While it recognizes that the build-up of inventories in the first part of the year may dampen output later, it sees the biggest threats coming from abroad--the US-China trade conflict and China's restrictions on Canadian canola.  In contrast, the central bank of Mexico cut its growth forecast to 0.8%-1.8% from 1.1%-2.1%.  It lifted its year-end inflation forecast to 3.7%, which would seem to push out a rate cut until the very end of the year, or maybe even early 2020.  Banxico targets 3% inflation +/- 1%.  

Shortly after ending the tariff truce with China, the Trump Administration moved to secure its flanks by lifting the steel and aluminum tariffs on Canada and Mexico.  This increased the likelihood that their respective legislatures will approve the new trilateral trade agreement.  The main obstacle is the US Congress.   The Democratic majority in the House of Representatives wants reforms to protect workers and the environment.  The Chamber of Commerce expects it to back-off, and the free-trade wing of the party thinks that approving deal would be to their political advantage in 2020.   

Congress will have 60-days to vote on it once the President formally submits the treaty.  The general understanding is that the vote is needed before the Congressional August recess.  Its return will mark the real start of the 2020 election contests.  That schedule suggests the treaty will be submitted around the middle of June.  

Mexico is better positioned to benefit from the decoupling of the US and China.  US imports from Mexico surpassed its imports from China in March.  Anecdotes suggest a wide range of  Mexican goods--from engine filters, cash registers, to car radios--are seeing better order flow from the US.  There are also companies looking to possible shift production from China to Mexico,  like auto parts, electric vehicles, electronics, and cell phone components, according to reports.    And even without meeting the rules of origin, the tariff would be considerably less than what the Chinese produced good would face.  These are still early days, and foreign direct investment decisions take time.  

The escalation of the trade tensions between the US and China appears to have sparked profit-taking on a strong four-month recovery in equity prices.  The US and the Chinese economy appear to have slowed before the latest tariff escalation.  The truce had helped facilitate the recovery from the Q4 18 meltdown.   The truce ended.  The market seems to be only gradually coming around the strategic importance of the break.  It seems to us that a Trump-Xi meeting on the sidelines of the G20 meeting is more wishful thinking than hard political reality.   This is a moment that defines before and after.

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