Mexican STIRS Price Upside Rates Risk

Mexico’s economy was in a recession even before the pandemic struck. Between late 2015 and late 2018, Bank of Mexico, the central bank, raised rates from 3% to 8.25%, which probably contributed to a sharp slowdown in Mexico’s pace of growth. Unemployment remains at around 4.5%, about 1% higher than it was before the pandemic and about 1.25% higher than it was at its 2018 low (Figure 2).

Bank of Mexico began cutting rates before the pandemic, lowering them to 4%. Inflation seems to have given the central bank cause for not lowering them any further. Mexico’s core inflation has now crept above the central bank’s overnight rate for the first time since early 2015 (Figure 3).

South of its border, Brazil’s central bank has found itself in an analogous situation. It too saw core inflation rise above its policy rate. Negative real interest rates have been common in Europe and the U.S. since the global financial crisis of 2008 but are still unusual in emerging market economies where inflation rates have not fallen as low. Faced with negative real rates, Banco Central do Brasil joined Russia’s central bank as one of the first major central banks to tighten interest rate policy since the pandemic began (Figure 4).

Interest rate traders price some risk of Bank of Mexico going in the same direction as Banco Central do Brasil. An implied forward curve of short-term interest rates (STIRS) calculated from Mexican 28-day, 91-day, 180-day and 360-day T-Bills suggests a 50-50 likelihood that Bank of Mexico will begin tightening policy in the next three months. However, Mexico’s interest rate markets imply that traders assume the central bank will have hiked rates by as much as 50 basis points (bps) above current levels between August and October 2021. Furthermore, those same interest rate markets imply a likelihood that interest rates will average about 100 bps higher than current levels between November 2021 and April 2022 (Figure 5).

There are both upside and downside risks to Mexico’s interest rate curve.

Upside risks to rates include:

1. Demand for industrial products remains extremely strong around the world (Figure 6), and 72% of Mexico’s exports are manufactured items, of which 75% head to the U.S. and Canada.
2. High saving rates and increased household wealth in the U.S., Canada and Europe could fuel a surge in tourism to Mexico as and when the pandemic subsides (Figures 7 and 8).
3. Increasing bottlenecks in supply chains and soaring commodity prices could increase inflation further.

Downside risks include:

1. The Mexican peso is relatively strong compared to its Latin American peers and has recovered most of its losses versus the U.S. dollar recorded early in the pandemic (Figure 9).
2. A stronger currency will likely put a damper on inflation.
3. Mexico’s yield curve, while is positively sloped, is among the flattest in Latin America and therefore appears to be among the least optimistic regarding the prospects for near-term growth (Figures 10 and 11). This also suggests that markets may not believe that Bank of Mexico has a great deal of latitude to raising rates further.
4. Mexico still has a high rate of COVID-19 infections.

• Mexico’s economy remains 4% smaller than it was pre-pandemic
• Traders anticipate that Bank of Mexico may start hiking rates later this year
• Mexico’s core inflation rate has crept above Bank of Mexico’s overnight rate
• Mexico’s manufacturing sector is very strong, but tourism has suffered
• The Mexican peso remains the strongest currency in Latin America