MNI POLICY: Banxico Split on FX Effects As US Spread Narrows

Dovish board members at the Central Bank of Mexico are arguing that the country’s economic cycle has decoupled from that of the U.S. in recent years and that further peso resilience might point to room for more rate cuts, MNI understands.

Questions around the outlook for the peso are one of the main points of disagreement on the board, with hawkish members also seeing the risk of having to rebuild the rate differential with the U.S., either by holding rates steady as the Federal Reserve cuts or even hiking if the Fed adopts a tighter stance.

Banxico’s September meeting saw heated debate on the issue, with Deputy Governor Gabriel Cuadra, as well as Governor Victoria Rodriguez and board members Galia Borja and Omar Mejia all highlighting how the peso had appreciated since August’s rate cut to 7.75%, MNI understands.

The governor noted the country’s solid macroeconomic fundamentals, which both Rodriguez and Borja said had been supported by Mexican exports to the U.S. under the USMCA. The governor noted that year-to-date peso appreciation exceeded 10%, though she, together with Cuadra and Borja, stressed that this was largely explained by the broad retreat of the dollar.

A credible monetary policy framework has also been positive for the peso, it was noted, with Cuadra observing at the meeting that peso implied volatility has fallen below that of other emerging economies. Expectations for peso depreciation have moderated even as interest rate differentials with the U.S. have fallen below historical averages and are expected to remain relatively stable, Mejia noted.

RATE DIFFERENTIAL

Banxico cut its policy rate by 25 basis points to 7.25% this month, with Deputy Governor Jonathan Heath again dissenting in favor of holding, and the board signaled at least one more reduction ahead. (See MNI INTERVIEW: Banxico Nearing End Of Easing Cycle - Zaga)

The Banxico-Fed interest rate differential is now at 325 basis points, versus an historical average of around 500 points. Markets are pricing an 80% chance of a 25bp cut by the Fed in December.

On the hawkish side, Borja warned of the risk of a reversal in the dollar’s depreciation or a sudden spike in peso volatility from the low percentiles.

Heath, who has voted against rate cuts since July, argued that the broad depreciation of the dollar has made the interest rate differential with the U.S. less relevant. He stressed that although the recent easing by the Fed opens some room, the central bank should react with caution given the possibility that the Fed cuts less than expected.