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USD/MXN - Returning To A New Normal

by: Dmitry Lifatov

Political factors, which determined the USD/MXN exchange rate dynamics at the end of 2016 and in the first half of 2017, have now lost their significance.

The attention of traders is currently focused on the economic aspects, particularly in anticipation of lower inflation and probable interest rate cuts.

If we see a decline in the inflation rate and an easing of monetary policy USD/MXN should head south, but with much lower volatility than in November 2016 to July 2017.

The probable year-end target is 17.00, meaning a 4.4% decline from current levels.

Following a remarkable downfall in November 2016 through January 2017, the Mexican peso is now among the top performing EM currencies this year, with the USD/MXN exchange rate falling by almost 20% since the January's high. This strength was caused by improving political prospects for the future of U.S.-Mexico bilateral relations, which were severely damaged by Donald Trump's campaign rhetoric. Pretty soon, investors and traders realized that implementation of his campaign promises, particularly the building of the U.S.-Mexico border wall and an exit from NAFTA, is a very lengthy process that can take several years. The elimination of such acute and immediate political risks allowed for traders to focus on macro fundamentals, which have been gradually improving in Mexico.

The IHS Markit Mexico Manufacturing PMI rose this year by only 2.7% -- from 50.8 in January 2017 to 52.2 in August 2017. Moreover, it twisted in a zigzag form, moving up and down. Business confidence is gradually recovering from a significant dip at the beginning of 2017. In August 2017, it increased to 49.08, driven primarily by an improving outlook for Mexican companies on investment opportunities. Consumer optimism also increased in August 2017, as it did throughout the entire year from the January's bottom.

The CPI in Mexico in August 2017 increased to 6.66% y/y, which is the highest rate since 2001. This indicator took off from approximately 3% in November 2016, following the announcement of the presidential election results in the U.S. The core inflation rate in August 2017 stood at 5%, up from 3.29% in November 2016. Such rapid acceleration of inflation in Mexico was caused primarily by two factors: peso depreciation and growing gasoline prices. Many analysts now argue that inflation in Mexico has peaked and should soon stabilize, returning to its normal values around 3% by the end of 2018.

The unemployment rate in Mexico declined in July 2017 to 3.4%, down from 3.59% in January 2017. This decline is not steady, however -- judging from its historical values, it almost returned to its equilibrium. Mexico's GDP annual growth rate in Q2 2017 advanced by 1.8% -- that's less than in Q1 2017 but still pretty high. The Bank of Mexico's research division recently lifted its GDP growth expectations up from previous assessments of 1.5%-2.5% to the level of 2.0%-2.6% in 2017. The interest rate in Mexico was lifted from 3% at the end of 2015 up to 7% in August 2017.

The rationale behind interest rate hikes was to curb rising inflation and prevent rapid devaluation of the peso. This is a common practice among central banks that are experiencing similar problems. However, with a rebound in the USD/MXN exchange rate, all eyes are now on inflation in Mexico. Should it start falling, the policymakers in Mexico will be much more open to the necessity of interest rate cuts.

With leading macro economic indicators signaling improvement of economic prospects in Mexico, low unemployment, and solid growth expectations, the only economic factor that should be carefully tracked is extraordinary high inflation. That's why in the case of a reversal in the movement of inflation, appreciation in the Mexican peso should happen.

From the political side of things, the threats of NAFTA termination and the building of the border wall still exist, but they are muted as for now and do not have a significant impact on the USD/MXN exchange rate dynamics. Following a period of extremely high, politically induced volatility, we can conclude that the U.S. dollar/Mexican peso pair will gradually return to normal trading conditions. We do not expect such wild volatility anymore, waiting only for a modest appreciation of the Mexican peso vs. its U.S. counterpart in case of stabilization of unsustainably high inflation rates and the easing of monetary policy.

Technically, USD/MXN is still in a clear downtrend, with progressively lower lows and lower highs. We do not expect a reversal in this trend, at least as the current bias is on the downside, with 17.00 as a probable year-end target.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.