Historic Devaluation

The Mexican Peso has been under significant pressure over the last year, and the current level of devaluation in the currency is historic in both nominal and real terms.In the first 8 trading days of 2017, the Peso lost just under 14% of its value against the US Dollar.

The sell -off, which was both abrupt and significant, was serious enough to force Mexico’s Foreign Exchange Commission to intervene in the market, selling $2bln. Although the moved into USDMXN from 20.3 to nearly 22 is clearly significant, the sustained devaluation of the Peso over the last 30 months is unprecedented in Mexico’s recent economic history.

MXN has now fallen over 69% against USD over the last 30 months, surpassing the 30% decline during the 1998 Long Term Capital Management-related crisis and the recent global financial crisis in 2008-09. The only comparable decline is the 100% increase in USDMXN over the 1994 Tequila crisis.

So the question is, are things as bad in Mexico now, as they were during the 2008-09 period?

The bottom line is no; they aren’t. In fact, one of the challenging things about the current sell-off is that on paper, the Mexican economy looks fairly robust: growth is at 2%, inflation is being controlled, and both the trade balance and the fiscal deficit are around 3% which is smaller than the average in most OECD countries.

Although the Mexican economy has underperformed in terms of growth and ratings agencies have voiced their concerns relating to the trajectory of the country’s fiscal accounts, economic conditions are significantly different to those of 1994-95 when the economy shrank by 6%, the current account deficit was 6.3% of GDP and inflation was in double digits.

MXN Directional Drivers

In looking for directional drivers that affect MXN, it is vital to think about both structural changes in the economy and the exchange rate framework over the last 20 years. Free trade has also played a central role in altering the structure of Mexico’s economy. Over the last 30 years, exports have moved away from commodities. A buoyant manufacturing industry has developed, and the country’s export basket reflects the increasingly complex products offered.

As the manufacturing sector becomes more sophisticated, this has resulted in an integration of the Mexican economy into production changes of complex manufactured goods.

Changing Drivers

Paralleling the broader changes in the Mexican economy, MXN’s sensitivity to different drivers has also shifted.Mexico’s exports have become increasingly sensitive to faster growth in the US economy as trade ties with the US have deepened. Consequently, MXN has tended to strengthen during periods of a pickup in US growth. Historically, a stronger USD linked to US economic strength, rising equities, and increasing oil prices, have all been linked with a stronger MXN. However, this dynamic has changed recently with MXN now much more sensitive to financial variables over US growth.

Clearly, there was a structural break in the USDMXN relationship around the GFC. This likely reflects the acceleration of financial flows that occurred following Mexico’s integration into NAFTA. It is a well know phenomenon that foreigners meaningfully increased their exposure to local bonds in Mexico and have preferred FX-hedging over changing their bond positions. The post-GFC period, particularly after 2010, saw a significant increase in portfolio inflows and therefore, the inventory of “hedgeable” securities.

As a result of the increased foreign exposure to local markets, USD strength that accompanies rising US yields or safe haven flows tends to be a burden for the Peso.  The strong USD was linked with a strong MXN before the crisis, but this relationship shifted as foreign bond holdings built.Financial considerations are likely to remain dominant over coming years, and so a strong USD is likely to remain a drag on the Peso.

Technical Perspective

The pullback in USDMXN has taken price back down below the broken 2016 high at 21.3790. This is a key level, and the break signals a deeper correction with next support coming in around the 20.86 level.