Mexico’s High Inflation Opens Door to More Rate Hikes, Mexican Peso Outlook Brightens

KEY POINTS:

• Persistent high inflation in Mexico could lead Banxico to undertake an aggressive tightening cycle in the second half of the year
• Markets expect two additional 25bps rate hikes in 2021, although investors are starting to price in a third one
• Tighter monetary policy by Banxico could benefit the Mexican peso against the U.S. dollar

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Earlier today I wrote about inflation in Mexico following the release of the latest data from INEGI. June headline CPI eased slightly to 5.88% y/y from 5.89% y/y in May and remained significantly above the upper limit of the central bank’s target (as a reminder, Banxico seeks to achieve an inflation rate of 3% +/- 1 percentage point above or below that level). Meanwhile, core inflation, a closely watched indicator by policymakers that excludes volatile items such as fuel and agricultural products, jumped 4.58% y/y, its highest level since December 2017.

Looking at the data, there is no doubt that the headline CPI result is worrisome, but what is more troubling is the relentless rise in core inflation, as this points to broadening price pressures in the midst of climbing costs for services. As the economy reopens more fully in the coming months, pent-up demand should exacerbate the observed trend, ensuring the prevalence of elevated inflation levels for the remainder of the year and perhaps beyond.

To ensure that inflation converges to target over the policy horizon and that expectations do not become unanchored by second-round effects, Banxico will have no choice but to raise borrowing costs again in the second half of 2021. The market is currently pricing in two additional 25 basis point rate hikes through the end of the year, although expectations for a third hike are starting to firm. If all three hikes materialize, Banxico’s benchmark rate will end the year at 5.00%.

Tighter monetary policy from Banxico would raise nominal rates in the country and shouldboost the Mexican peso, as long as US treasury yields remain low in relative terms. However, as I argued in a previous article, for the search-for-yield trade to work in favor of MXN, volatility would have to stay subdued (for reference, many traders choose to watch the VIX Index to see how volatility is behaving in the broad market). On the contrary, if investor sentiment deteriorates, markets become defensive and turbulence ensues, nothing would preclude the Mexican peso from weakening against the dollar. Typically, when risk aversion flares up, traders reduce EM FX exposure to rush into safe-haven assets.

USD/MXN TECHNICAL ANALYSIS

From a technical point of view, following a brief jump to the upside, USD/MXN appears to have stalled again in the 20.00/20.20 area after colliding with its 200-day moving average. From here, if selling pressure starts to intensify, the first support appears at the 19.80 mark, followed by the 2021 low near the 19.55 region. Beyond this floor, the 19.00 psychological level comes into play.

Alternatively, if bulls regain control and USD/MXN manages to breach the 20.00/20.20 resistance decisively, buyers could propel the exchange rate towards the 20.75 level, where the June high converges with a 12-month descending trendline.

USD/MXN TECHCNICAL CHART

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—Written by Diego Colman, DailyFX Market Strategist

Follow me on Twitter: @DColmanFX