Banco de México started the year with an acceleration in its monetary policy easing cycle and signalled that the new pace of cuts could continue in the near term. As inflation has continued to fall and activity has decelerated further, the case for an ongoing easing cycle remains clear, and we expect a year-end policy rate of 7.50%, with the CB delivering a 50bp cut this week.
While local macroeconomic context guarantees much lower real rates, the fact that the Fed has indicated a less dovish stance has raised some concerns regarding the scope Banxico would have were the Fed to maintain a relatively neutral position. In this note, we provide the factors behind our call for a more dovish Banxico and the outperformance of MX rates vs. the US.
Overall, even in the event of a relatively neutral and cautious Fed, we think that Banxico has room to reduce the policy spread by nearly 150bp, which would translate into lower spread levels along the curve.
While the risk premium could rise, we think that the 10Y spread vs. USTs has further scope to narrow, mainly due to a narrowing of the local monetary policy premium imbedded in sovereign long-term bonds. Based on our estimates, we think the 10Y spread vs. USTs could narrow to levels around 430-450bp.
Historically, whenever the MX curve flattens, spreads tend to rise and vice versa. Considering the higher sensitivity of the short end to monetary policy movements, we expect the 2Y/10Y slope to widen by nearly 60bp throughout the rest of the year.
Finally, we note that in the short run, arbitrage condition models suggest that the MXN could withstand further reductions in the interest-rate spread during the cycle. Our model suggests that the currency is currently undervalued, even more so if we only consider inflation differentials. Hence, beyond the immediate reaction, we do not expect MXN depreciation as a result of a lower spread. In the near term, the currency will remain reactive to US trade policies, global volatility and local idiosyncratic risks, but going forward, we would expect a stabilisation around current levels.