How fast will Mexico's benchmark rate come down in 2019-20?

Mexican interest rates may be falling by more than most expect in 2019-20, at least that is the view of Edward Glossop, Latin America economist at research firm Capital Economics, who argued falling oil prices, lower inflation and a more dovish US Fed would send the benchmark rate from the current 8.25% to 6.50% by year-end 2020.

Glossop, in a analysis piece, said CE had penciled in rate cuts totaling 75 basis points in 2019 with a further 100bp in cuts for 2020, adopting an admittedly non-consensus outlook for Mexico that if proven true could also have significant implications for local government debt issuances.

"Once inflation begins to fall sharply and the US Fed formally concludes its tightening cycle, we think [central bank] Banxico will shift into easing mode," wrote Glossop. "While the markets are pricing in (albeit modest) rate cuts now, they have rapidly moved towards our views over the past few weeks."

"Our more dovish outlook than the market means that we expect Mexico's local currency government bonds to perform well relative to those elsewhere in the emerging market world over the next few years," added the analyst.

Markets may already be showing optimism for Mexican debt, with the first bond issuance for President Andrés Manuel López Obrador's (AMLO) administration being well received.

The government sold US$2bn in 10-year bonds on January 16 with investor demand four times higher than the offering.

On the optimistic side

CE's view is among the most dovish among forecasters. Citibanamex's most recent survey of Mexican private sector analysts, released January 22, found that 13 of 24 respondents expect the benchmark rate to end the year at today's 8.25%, with the median forecast calling for 7.75% by December 2020, with only three analysts agreeing with the 6.50% call from CE.

Recent events, however, may have moved opinion towards CE's view, including the low-side surprise for annual CPI for the first half of January (at 4.52% vs. 4.83% consensus) and a nine-week rally for the peso, its longest streak of weekly gains in nearly 18 years. Consequently, the possibility of a rate hike on February 7 now seems remote.

Glossop's argument follows, "First, Mexican inflation expectations have fallen back in recent weeks. The 10-year break-even inflation rate implied by the bond market has fallen from a peak of almost 5% just a few months ago to 4.2% now. And it is likely to fall further as current inflation declines."

The analyst argued that inflation has been held "stubbornly above target" for more than two years - primarily the result of high fuel prices and strong food inflation. However, said Glossop, the impact of lower oil prices "has further to run".

"If oil prices edge down a little further, as we expect, fuel inflation could fall from 17% year-on-year currently to as low as zero by year-end," wrote Glossop, adding that several supply shocks, particularly those related to green tomato and orange prices, should also unwind in the coming months, as poor harvests and heavy frost move into the rearview mirror.

Consequently, CE sees falling fruit and vegetable inflation subtracting a further 0.3% percentage points from the headline rate in the coming months.

Glossop described a fresh drop in the peso as "a key risk" to the inflation outlook, noting "fragile" investor confidence surrounding potential policy shifts with under the leftist AMLO.

CE, nevertheless, builds peso deterioration into its base case, calling for the peso-US dollar exchange rate (currently near 19:1) to reach 21:1, well above the Citibanamex survey median of 20.33:1, suggesting their argument is consistent even with a weaker-than-consensus peso outlook.

The second pillar in Glossop's argument centers on the central bank's need to wrangle headline inflation back to the 2-4% target range.

"While history suggests that Mexico needs high real interest rates [i.e. the benchmark rate less CPI] in order to 're-anchor' inflation expectations, this shouldn't be a barrier to modest monetary easing," noted the analyst. "Real rates in Mexico are among the highest in the emerging market world, and will remain so even if Banxico trims the policy rate."

Finally, for Glossop's dovish outlook to come true, the US Fed would need to step back from the aggressive policy normalization agenda promoted in 2018.

"The US Fed looks set to turn dovish," wrote Glossop. "Markets have taken out their expectations for further US hikes and have now started to price in cuts in 2020."

Noting that CE's US team expects the Fed to ease policy by more than the markets are anticipating next year," Glossop wrote, "A more dovish Fed will provide Banxico with room to trim its policy rate while still maintaining its large interest rate differential with the US."

"Our forecast, which is for the nominal policy rate to end 2019 at 7.50% and 2020 at 6.50%, would still imply real rates rising to around 4.50% in the near term, and falling only modestly thereafter," said Glossop.