That said, there could be storm clouds on the horizon for Mexico.  Sharply tighter monetary policy has inverted Mexico’s yield curve, which might suggest slower growth ahead, or even a downturn. 

MXN’s outperformance of both its LATAM peers and global reserve currencies dates back to 2018, when the U.S. imposed 10-25% tariffs on as much as 60% of the goods that the U.S. imports from China.  The ensuing trade war set off a scramble to diversify supply lines coming from China into the U.S.  Mexico was an obvious investment candidate for both U.S. and Chinese firms.  For starters, Mexico is adjacent to the U.S.  Secondly, Mexico is covered by the U.S.-Mexico-Canada (USMCA) trade agreement, a slightly modified version of its predecessor North American Free Trade Agreement (NAFTA) which facilitates low-tariff trade within the bloc.  These efforts intensified in 2020 and 2021 as COVID-related supply chain disruptions led to a six-fold increase in the cost of shipping goods from Shanghai to Los Angeles.

While the pandemic-related disruptions have largely worked themselves out, many business leaders concerned about ongoing trade and geopolitical tensions are looking to onshore production or bring them close to their borders.  Mexico’s economy already has an extremely strong manufacturing base with intermediate and finished factory goods accounting for 72% of Mexico’s exports.  Additionally, Mexican labor costs remain significantly below U.S. levels.  These factors have made Mexico a prime destination for investment, helping to drive the peso higher relative to other currencies. 

The Bank of Mexico (BOM) eased policy from mid-2019 through 2020, cutting rates from 8.25% to 4%.  However, as inflation began to ramp up, and as the Mexican economy began to recover, BOM began to tighten monetary policy, with the first increase in June 2021.  This move came nine months before the U.S. Federal Reserve (Fed) began to hike rates.  By the time the Fed got into the tightening act, BOM had its policy rates six percentage points higher than the Fed’s, and BOM continued to keep its rates at that level until early 2022 when it continued to raise rates in 50 basis-point (bps) increments even as the Fed slowed to hikes of 25bps.  Now, BOM has rates nearly six-and-a-half percentage points higher than the Fed’s. 

Mexico’s inflation rate rose from 4% to 8%, but that’s comparable to levels in U.S. or Europe, and is lower than that in countries like Brazil, Colombia, Chile or the U.K.  Currently, BOM has its rates significantly above inflation (Figure 3), a sharp contrast with the U.S., Europe or Japan where central bank policy rates remain below core CPI inflation.  Meanwhile, Mexican unemployment remains at its lowest level in decades (Figure 4).

Mexico has the second lowest debt level among the 47 nations whose debt load is measured by the Bank of International Settlements.  Only Indonesia has a lower debt-to-GDP ratio.  Mexico’s public debt amounts to 41.6% of GDP, well below most other emerging market nations.  Public debt is about 58% of GDP in Colombia, 76% in China and 85% in Brazil.  In most developed economies, it is around 100% of GDP, and 230% in Japan, for example.  Moreover, Mexico has been running much smaller budget deficits than peer nations in recent years (Figures 5 and 6).  

Source: Trading Economics

Mexican private sector debt is even lower.  Household debt to GDP is about 16%, among the lowest in the world.  In the U.S., it is 75% of GDP, and 103% in Canada.  In Latin American peer nations like Chile, Colombia and Brazil, household debt is about 29%-46% of GDP.  Finally, Mexican corporate debt levels are also quite low at 24% of GDP, the second lowest among OECD nations. 

Low debt levels might mean that Mexico’s economy won’t be as negatively impacted by higher interest rates as more heavily indebted economies.  Higher Mexican rates may attract capital into the Mexican economy without particularly hurting domestic borrowers, who have kept to low levels of leverage. It also might imply that Mexico has substantial borrowing capacity should its government and private sector choose to take on higher levels of leverage.  That said, Mexico’s exports could still be negatively impacted by higher interest rates elsewhere in the world, including in the U.S., whose debt ratio is more than three times higher than that of Mexico, and where the Fed has raised rates by over 400 bps in the past year.  

Despite Mexico’s various strengths, including strong investment flows and low levels of debt, the country is not immune from the risks of an economic downturn.  For starters, the strength of the currency is a double-edged sword.  While a stronger currency will supress inflation to some extent, it could also render Mexico’s exports to cost more and become less competitive, perhaps hurting Mexico as a destination for future capital investment.  Additionally, the combination of much higher rates in Mexico and in the U.S. could slow the Mexican economy and perhaps even tip it into a recession. 

This possibility is most clearly evoked by the shape of Mexico’s yield curve.  For the past several months, Mexican three-month rates have been trading 2.5%-3.0% above the 10Y rate, the most extreme inversion of the yield curve since 10Y yield data began in 2005 (Figure 7).  In Mexico, as elsewhere in the world, the yield curve has often been a reliable, if imperfect, indicator of acceleration and deceleration in the pace of growth.  In the period from 2005 to 2019, the slope of the yield curve had a +0.4 correlation with GDP growth three to eight quarters in advance.  As such, the steeply inverted curve might be pointing towards a sharp slowdown or a recession sometime later in 2023 or in 2024 (Figure 8).