The Mexican Peso has weakened ~10% following Trump’s presidential election victory given fears of a shift towards a more protectionist trade position by the Trump administration. However, in truth, the Peso has been trending weaker since June 2013 (USDMXN bottomed at ~12 in 2013), and had weakened >30% before Trump’s appointment had become a realistic prospect. No doubt the broad trend stronger in the US dollar has helped push USDMXN higher, but in an environment of US economic outperformance which might be expected to benefit Mexico, it is notable that the Peso ranks towards the bottom of the rankings of emerging market currency performance over the last few years.
So where to from here? There are a number of reasons to be positive on the Peso at current levels, along with a big, but uncertain potential reason to be negative.
On the positive side:
1) The Mexican Peso is now undervalued when viewed from a long-term purchasing power parity (PPP) perspective and towards the lower end of valuation ranges observed over past decades.
2) Banxico has now hiked rates a cumulative 2.25% in response to rising inflation, as a result of pass-through from currency weakness. As such, the positive carry on short USDMXN positions is the most favourable it has been in over ten years (excluding the financial crisis). Even with the current elevated volatility in USDMXN, Sharpe ratios on long MXN positions are towards the upper end of observations seen in recent years.
3) Linked to the Banxico rate hike cycle, along with the negative confidence hit Trump’s policies seem to be generating in Mexico, we anticipate a further improvement in Mexico’s balance of payments position. Developments in Brazil may be instructive here. The severe recession in Brazil during 2015 and 2016 led to a significant retrenchment in domestic demand, which facilitated a rapid improvement in the trade balance as import demand withered.
Our concern regarding the Mexico Peso over recent years had been that although the currency had weakened, until recently Mexico’s balance of payments provided little evidence that the Peso was undervalued, i.e., we had not observed an improvement in the balance of payments that would be expected to be associated with a ‘cheap’ currency. This is now changing as the Mexican non-oil trade balance has now moved into surplus on a 12-month rolling basis, and further domestic demand weakness should see this improve further. We have also seen some positive developments in terms of investment in Mexico’s oil sector, which also suggests that the worst of the deterioration in the non-oil trade balance could be behind us.
The big potential negative for the Peso in the coming months remains what the Trump administration chooses to do on its trade policies, either directly by the imposition of tariffs, or indirectly via a border adjustment tax. Some market commentators believe that the enactment of either could still push USDMXN to new highs. This is of course possible, although we’d note that fiscal reforms seem likely to take longer than was hoped for a few months ago, and price-action in the Peso has proved robust despite last week’s comments from President Trump that an announcement on tax reform would come in the next few weeks, suggesting much is already incorporated in the Peso’s current valuations.
We therefore remain cautiously optimistic on the outlook for the Mexican Peso, although we recognise the road ahead will likely be bumpy.
One of the expectations of a US interest rate analyst is to forecast Treasury yields. Forecasting can be complex and involve a large number of assumptions. But when examining this task from a bird’s eye view, the many dozens of factors considered ultimately boil down to two elements:
Let’s look at these two elements in practice to take a view on where the 10-year Treasury should trade.
Short-Term Rate Expectations:
The shortest of short term interest rates in the United States is the Federal Funds Rate, the rate at which banks borrow reserves from one another on an overnight basis . Surveys of economists and forecasters can provide a fairly comprehensive view for what markets expect over the next handful of years. For instance, the FOMC currently sees the Federal Funds rate around 3% by 2019 while investors in the Fed Funds futures market see the rate in 2019 at 1.5 – 2%.
But what about the average short-term rate over the next 10 years? If inflation and unemployment both reach the Fed’s mandated targets, the Federal Funds rate should be set at a level which encompasses two parts: a real component and an inflation component. We will set the inflation component at 2%, which is the Fed’s target.
Next is the real component. Looking empirically, the average Real Federal Funds rate over the past 50 years has been right around 2%. This average ties in nicely with the FOMC’s pre-2015 SEP forecast of a long-run “dot” of 4% (2% Real + 2% Inflation).
The path in which we get to a level of 4% on the Federal Funds rate will impact the average short-term rate over the 10-year period in which we are forecasting. There are an infinite number of possible paths. I have modeled a few below and calculated the 10-year average short-term rate for these paths.
The second part of this forecast is perhaps more controversial. When we think of term premium, we think of the excess yield provided to a longer-term investor for taking a risk and locking up their money.
Term premium is ultimately difficult to measure in real time because it is the residual of one observable and one less observable factor. The current 10-year interest rate is known but expectations of short-term interest rates far into the future are hard to extract accurately from market participants. We have chosen one measure for the purposes of this blog that happens to be popular, easily assessable and updated daily called the ACM (Adrian, Crump, and Moench) model published by the NY Fed .
Nothing says that term premium has to be positive even though historically it has been. Term premium is ultimately a demand versus supply story. When demand outstrips supply, the term premium can be driven very low, even negative like it was in the summer of 2016. We have identified four major sources of demand which have been influencing the dynamics in term premium. These sources of demand are all to some extent “price indiscriminate” market participants. This means that these purchases are less sensitive to the level of prices/yields compared to other objectives.
These forces, although powerful, ebb and flow during cycles and are unlikely to put downward pressure on yields indefinitely. Therefore, this argues for normalization in term premium over time. From a historical perspective, term premium has ranged from -75bps to 500bps and the average term premium has been around 100 – 200bps. The long term average since 1961 is around 160bps.
We’ve looked at the two components of a simple 10-year Treasury Rate forecast:
This brings us to a conservative estimate of 3.25% (2.25% average short-term rate + 1% term premium) with a range of 2.5% to 5%. This is consistent with GFICC’s year-end 10-year yield forecast of 3 – 3.5%. Today, the term premium is 20bps and the 10-year Treasury is around 2.4%.
We discussed that the forces of demand that have depressed term premium over time are not static and may slowly diminish. If the US economy and financial markets were to evolve back to a more “normal” state, we should be able to look historically in order to draw conclusions about what the normal levels of term structure and term premium should be.
Historically, the Federal Funds rate has spent about 25% of its time around 4% and the 10-year term premium was on average around 130bps. During these same periods, the average 10-year Treasury yield was 5.5% (see table below).
To those who have only been watching the markets in the post-financial crisis world, a forecast of 5% Treasury yields may seem outlandish. But these estimates are well within the ranges of historical experiences and can be forecasted using the simple methodology described above.
 Term premium has been a topic of discussion on this blog before. Portfolio Manager Andrew Norelli has published a number of informative blogs to further put this in context.
 Investors generally use the 3-month T-Bill Rate as a proxy for an investable short term interest rate. In this scenario, we will focus on the Fed Funds rate for simplicity.