Banxico published today its 2Q21 Quarterly Report (QR). The release was accompanied by a press conference by Governor Alejandro Díaz de León
We think the document maintains a hawkish bias. As expected, there were modest revisions to macro forecasts, while those for inflation were unchanged
Specifically, GDP growth is estimated at 6.2% (+20bps) and 3.0% (unchanged) in 2021 and 2022, respectively
The balance of risks for inflation remains skewed to the upside. We also note that:
(1) The expected convergence of headline inflation to the target remains in 1Q23, as already mentioned in the last statement;
(2) Recent changes were mainly on higher core inflation, especially in goods, but also in services; and
(3) The Q&A had several questions about the price ceiling to LP gas, but in our view most Board members are not giving a very elevated weight to this when thinking about the inflation outlook
The trade and current account balances are estimated with a wider deficit this year, while employment affiliated to IMSS is seen stronger. The central bank expects the recovery will continue in the second half of the year, despite COVID-19 risks
There were seven traditional grey boxes. We focus on those related to inflation, including an analysis of the effect of global inflation on domestic CPI and the policy response to different types of inflation shocks
With no significant new information, we maintain our call that Banxico will raise interest rates by 25bps in each of the remaining three meetings of this year, to 5.25%. Nevertheless, they keep stressing their high data dependence, which is key as the Board remains divided
Modest effect in local markets, with the curve’s pricing reflecting two 25bps rate hikes for this year
Few changes to the outlook, with inflation still in close sight. Banxico published today its Quarterly Report (QR) for 2Q21, accompanied with a press conference led by Governor Alejandro Díaz de León. We think the document maintains a hawkish bias. As expected, we had modest revisions to macro forecasts, while those for inflation were unchanged (as they were updated less than a month ago). The mid-point estimate for GDP this year is at 6.2% (+20bps to the previous forecast) and at 3.0% for 2022. Both are exactly in line with our views. On prices, the main highlight were the questions about the possible effect on inflation from the introduction of a price ceiling to LP gas. All in all, and considering that there was no meaningful new information, we maintain our monetary policy call unchanged. Specifically, we expect Banxico to raise interest rates by 25bps in each of the remaining three meetings of this year, to 5.25%. For 2022, we see two 25bps hikes at the beginning of the year and one more at the end, with the rate ending said period at 6.00%.
Inflation forecasts unchanged, with expanded commentary about the drivers of recent revisions. Given that forecasts were updated less than a month ago, they were not modified in the horizon (up to 2Q23). The expected moment of convergence to the target also remained in 1Q23. As a result, we focus on expanded comments about the drivers. Among them, they believe some of the upward shocks to prices because of the pandemic have exacerbated, while those to the downside have tended to reverse, with the main driver being adjustments to the core. They included recent shocks –especially in goods, but also in services– as well as the expectation that they will stay affected by some cost pressures. At the non-core, they anticipate a higher path for agricultural goods prices than in the previous report. Risk factors were also very similar to the last decision, adding only to the downside: (1) That slack conditions and hiring conditions do not pressure prices; and (2) if energy prices are below projections.
The effect of a price ceiling to LP gas. Another key focus, especially in the Q&A, was the view about the recent introduction of a price ceiling to LP gas which reduced inflation in 1H-August. In the document, they said that the previous QR incorporated lower prices than actual data for both June and July. Nevertheless, and because of the new policy, estimates are currently similar to actual prices. Hence, forecasts have “caught up” with data and were not a meaningful driver in the revision. This does not rule out that additional changes have a sizeable impact ahead. When asked about this in the press conference, Governor Díaz de León said they would not give an opinion on what could happen to price dynamics in this good. He only mentioned that they keep looking closely at upcoming inflation data. On the other hand, Deputy Governor Heath did not rule out this measure to influence short-term inflation. Nevertheless, he warned that international experience shows that price ceilings tend not to work and create distortions, among them possible scarcity. Therefore, he argued that its impact is not likely to be permanent. Overall, we think most Board members are not giving a very elevated weight to this when thinking about the inflation outlook.
Slight upward revision in GDP growth this year. The central bank made modest adjustments to their forecasts. For this year, their point estimate for GDP stands at 6.2% (range: 5.7% to 6.7%), just 20bps higher than previously. This is exactly equal to our call. This is based on: (1) Higher-than-anticipated growth in 2Q21; and (2) progress in the vaccination campaign in a backdrop of higher mobility and reopening of the economy, mainly helping services. As mentioned in the last statement, they also forecast that the recovery will continue in the second half of the year. In their central scenario, pre-pandemic levels of activity would be reached in 1Q22, one quarter sooner than in the previous Quarterly Report. Nevertheless, the output gap will remain negative in the forecast horizon. For 2022, the forecast stayed at 3.0%, also in line with our estimate. The central bank keeps warning about very high uncertainty, flagging global supply bottlenecks and the recent rise of COVID-19 cases. To the upside, they talk about a faster dissipation of the pandemic and a positive impact from global and local stimulus measures that in turn boost confidence, as well as an uptick in investment helped by USMCA, among others. Other forecasts also reflect higher activity, highlighting a higher range for employment affiliated to IMSS, along a wider trade and current account deficit in both years –except for the latter in 2022–. In our view, these changes are positive and suggest an outlook in which domestic demand may recover faster than expected, and even the possibility of remittances maintaining brisk growth next year.
Relevant topics in the traditional grey boxes, focused on inflation. As usual, the central bank included a deep analysis of several important issues. In this occasion, they centered on factors associated to price dynamics, both external and domestic, along activity and central bank operational issues. The seven boxes were: (1) Factors related to recent inflation dynamics in the US; (2) Allocation of the IMF’s Special Drawing Rights; (3) Estimates on the impact of supply-chain disruptions on auto production and economic activity; (4) Physical currency demand in Mexico during the COVID-19 pandemic; (5) Influence of global price pressures on Mexican inflation; (6) Progress on the central bank’s communication strategy; and (7) Inflation shocks, anchoring of expectations and monetary policy. Considering prevailing concerns on inflation, we focused on boxes (5) and (7).
Higher global prices taking a toll on Mexican CPI. Using inflation data from 29 AEs and 9 EMs (including Mexico), the central bank tries to identify a global inflation trend. This is done through a Principal Components Analysis (PCA), creating values that capture volatility across the different series. The analysis was applied to both headline inflation as well as the series excluding food prices (both processed and fresh) and energy. The first conclusion is that the current inflation spike is a widespread phenomenon and not explained by a rise in any given country. However, the correlation is higher with the headline index than with the ‘core’ metric, consistent with the tight relation of international energy and commodity markets. Using results from the PCA, a load factor can be calculated for Mexico, allowing the study of this global component on domestic prices. This metric stands around 0.657, which implies that more than 50% of the variation is explained by this factor. This is more comparable with values obtained for AEs (0.696) than EMs (0.251), suggesting a tighter integration to global markets. As a result, the box concludes that inflation during the pandemic has been mostly driven by global factors. Nevertheless, some idiosyncratic pressures have been at play, mostly driving prices higher across this period.
Inflation shocks and the corresponding policy response, along effects on expectations. With a Vector Autoregression model (VAR), the central bank aims to identify the nature of inflation shocks and the corresponding policy response to each one of them. In addition, they also identify the effect of reference rate hikes on inflation expectations. Using activity and price variables, they identify three types of shocks: (1) Demand driven; (2) reversible supply driven; and (3) non-reversible supply driven. They identify them with the interaction between prices and activity levels. The first result is that the central bank responds to both demand and non-reversible supply shocks with some force. Moreover, they also respond to reversible ones, but more modestly. In our view, this might be because of the difficulty in identifying the specific type of shock in real time. Moreover, they mention that the correlation between a rate hike and long-term inflation expectations is negative, with the latter decreasing in the presence of a tighter monetary policy. These results suggest that actions taken by Banxico have bolstered its credibility and that they indeed influence expectations.
Hawkish tone, but highly data dependent. With no significant new information, we maintain our call that Banxico will raise interest rates by 25bps in each of the remaining three meetings of this year, to 5.25%. Nevertheless, they keep stressing their high data dependency, which is key as the Board remains divided. In our view, this was abundantly clear in the latest minutes. Therefore, new developments –especially on inflation– could well tilt the balance in either direction in terms of upcoming policy decisions. In this backdrop, our call rests mainly on the idea that the hawkish wing will stay convinced about the need of further adjustments because of sticky core inflation. Based on our forecasts, the latter will stay above Banxico’s upper bound around the target at least until the end of 2Q22. This is broadly consistent with the central bank’s estimates. On the other hand, it is also relevant that the reference rate is still below the estimated neutral level. Moreover, it is our take that today’s changes to other macro forecasts will not weigh much on this. This is likely even for Deputy Governor Jonathan Heath, who we identify as the current “marginal” voter and that we also think made the argument that the output gap may be miscalculated and in positive territory by now (which in turn, would be hawkish). Nevertheless, we believe he also stated that the new stance could be enough for the time being, increasing the data dependency of future decisions. Hence, in our assessment, he is the one most likely to eventually choose a pause, although this is not our base case, at least for this year. Lastly, for 2022 we expect two 25bps hikes at the beginning of the year and one more at the end, with the rate ending said period at 6.00%.
From our Fixed income and FX strategy team
Modest effect in local markets, with the curve’s pricing reflecting two 25bps rate hikes for this year. The Mexican rates’ market experienced a limited reaction to today’s Quarterly Report, with the Mbonos’ yield curve strengthening by ~3bps in long-term tenors, even when considering a pressured session in other regions leaded by Europe where inflation figures printed above expectations. Meanwhile, TIIE-28 swaps kept modest pressures of 1bp. As a consequence, the market’s pricing on Banxico’s next moves did not changed materially, currently incorporating implied hikes by 47bps for year-end 2021 and 140bps in a 12-month horizon. This expectation is below our estimate of a reference rate closing this year at 5.25%, reason why we expect the curve to correct as the following economic data for Mexico, especially those related to inflation, result in a repricing of further hikes in the year, despite the current division of the Board exposed in the last communications. Moreover, the long-end of the nominal yield curve has depicted a mostly stable performance in the last weeks, although holding elevated premiums against US Treasuries. We think this reflects an interesting valuation at these maturities; however, we prefer to wait for better entry levels for long directional strategies as, in our view, the local yield curve will pressure from the effect of the Fed’s tapering announcement via higher rates in US Treasuries.
In the FX market, the effect for the Mexican peso was muted with the currency trading close to 20.10 (+0.3 d/d) and stood as one of the least benefited from a strong performance in other EM currencies during the day. Recent price action has depicted resistance to extended with more conviction an appreciation below the 200-day moving average currently at 20.12, while next resistance level stands at 20.00. In a short-term view, this week counts the US employment reports, which in case of supporting the view of recovery conditions robust enough to start the normalization of the Fed’s stance, could revert the losses seen since last Friday in the USD. In this sense, we prefer to hold a cautious view for the MXN, biding USD in dips. Moreover, we considering that beginning of the Fed’s tapering will drive a structural strengthening for the USD.