Morning Note /

Mexico may frontload hikes, Peru risks falling behind the curve

  • Talking Points: Brazil and Chile inflation data to test recent policy decisions

  • Forex: BRL correction seen as temporary, PEN may climb on rate hike

  • Fixed Income: Regional inflation data may keep inversion play entrenched into the weekend

Lloyd Miller
Lloyd Miller

Head of Developed Markets and Latin America Research

Daron Hendricks
Danny Greeff
Kieran Siney
ETM Analytics
8 April 2022
Published byETM Analytics

Talking Points: Brazil and Chile inflation data to test recent policy decisions

Brazil: All eyes in the final session of the week will be on the release of the March inflation report. The war in Ukraine and its effects on the global supply chain and commodity prices compounded inflation pressures last month. As such, headline inflation is expected to accelerate further in March, reflecting the double-digit increase in fuel prices on March 11. This comes on the back of soaring international food prices. That said, the rally in the local currency would’ve help offset some of the price pressures, with the BRL staging the strongest rally out of all emerging market currencies this year.

Notwithstanding the sharp rally in the BRL, consensus expectations suggest that headline inflation rose from 10.54% y/y in February to 11.00% y/y in March. If confirmed by the actual print, this would mark the strongest pace of price growth in years. Moreover, it is worth mentioning that core inflation is also expected to remain relatively strong, reflecting the widespread gains in prices. Economists expect core inflation to rise between 0.9% and 1.0% m/m in March.

While a topside surprise in the print would bolster rate hike bets, we are of the view that it would unlikely to result in a shift in the BCB’s monetary policy path. Recall that the central bank said that a rise in oil prices, not current or expected inflation, would be a factor that could push the BCB to depart from its base case scenario of one last 100bps rate hike in its May meeting. That said, we do still see a notable risk that the BCB may have to extend its rate hiking cycle past March if there is an intensification in external price pressures. As mentioned in yesterday’s note, the swap market is still pricing in some substantial rate hike risk for the subsequent two Copom meetings..

Mexico: Mexican headline and core inflation extended its upward trend in March, putting additional pressure on the central bank to continue raising interest rates. Headline inflation accelerated more than expected in March to its highest level in over two decades, coming in at 7.45% y/y following a reading of 7.28% y/y in the previous month. The price growth was driven by increased fuel and food prices from new supply shocks, which spilled over into other goods and services. Notably, core inflation increased further to 6.78% y/y, the highest since June 2001, from 6.59% y/y in February, also above the median Bloomberg estimate of 6.71% y/y. Sustained core price increases have particularly worried policymakers, indicating that elevated inflation in Mexico could be more persistent than previously predicted. Mexico’s central bank has raised interest rates by 50bps in each of its last three meetings, and it is expected to continue increasing borrowing costs to tame inflation expectations.

Mexico’s central bank should consider whether frontloading interest rate hikes would curb inflation faster, a board member said according to the minutes from its latest monetary policy meeting. If yesterday’s inflation figures are anything to go by, the central bank will have to step up its measures to fight the surge in consumer prices. This carries a trade-off as raising the interest rate excessively could affect the country’s growth prospects and its attractiveness for capital flows, with investors seeking high yields in emerging markets. For the first time since its tightening cycle started in June, its members voted unanimously to raise the key rate by 50bps to 6.5% last month, which speaks to a hawkish consensus stance amongst the policymakers. Banxico says inflation would peak in the first quarter, then slow to 5.5% by the year’s end. According to the most recent batch of surveys, economists are more pessimistic. Banxico anticipates that inflation will reach its target rate in the first quarter of 2024. The minutes also mentioned the central bank responding to the Federal Reserve's interest rate hike cycle with comparable hikes in the short term to avoid introducing undue monetary constraints.

In other pressing news, Mexico's Supreme Court endorsed a controversial electricity reform opposed by the US and other major trade partners, a ruling celebrated by President Lopez Obrador's government. In debating a challenge against a March 2021 ruling, the court narrowly failed to reach the two-thirds majority needed to declare unconstitutional a provision in the law mandating that the national power company Electricity Commission (CFE) have priority access to the grid over private renewable projects. In a statement after the decision, US Ambassador Ken Salazar said the US government was concerned that upholding the law could "open the door to endless litigation, creating uncertainty and impeding investment." Salazar added that he hoped the reform would protect US investments in line with a regional trade deal, the United States-Mexico-Canada Agreement (USMCA), echoing recent comments from US climate envoy John Kerry.

Colombia: A quiet end to the week is on the cards, with nothing in the way of market-moving data or events scheduled for today. Accordingly, investors may look to oil-market dynamics for directional cues into the weekend. Oil is trading back at pre-invasion levels, with the front-month Brent contract consolidating around $100 per barrel this morning, while WTI is trading around $97 per barrel. The demand outlook for oil has been hit by stringent lockdowns in China and a hawkish Federal Reserve that has threatened to tighten monetary policy aggressively, which will slow the US economy to bring inflation under control. Meanwhile, the supply side of the equation has been bolstered, albeit temporarily, by a coordinated release of oil reserves from several countries.

This shifting balance between supply and demand has turned the market less bullish over the near term, with Brent’s prompt timespread narrowing to 65 cents per barrel, down from well above $4 seen at the height of the invasion-driven rally. This highlights how supply concerns were overdone last month, especially since Russian oil has continued to find buyers and remain un-sanctioned. Reports suggest that cargoes of Russian Sokol crude have sold out already for next month, with these shipments going to Asia. This may help ease price pressures on oil heading to the West, given that demand from Asia is being fulfilled at lower prices.

Buoyant commodity prices (in particular oil) and Colombia’s relatively strong terms of trade continue to mask many of the risks facing the COP, and disguise an underlying vulnerability that would only become more evident if commodities retreat sharply. This is thus one of the biggest risks to the COP at present, and should be monitored closely in the weeks ahead.

Chile: President Gabriel Boric has unveiled a $3.7bn economic stimulus plan. The aim of the plan is to boost the sectors that have been left behind in the nation’s economic recovery. Bloomberg reported the following - The package, called “Chile Apoya” (Chile Supports), includes about $1.4 billion in measures to generate jobs, $1.3 billion in direct transfers to families and $1 billion in support to small- and medium-sized companies, according to a government statement. This is the first major economic package presented under the administration of Gabriel Boric, who assumed the presidency last month after pledging equal opportunities and greater wealth distribution. The policies hone in on challenges such as low female labor force participation, as well as industries such as tourism that have struggled amid the pandemic. More broadly, it comes as Chile grapples with above-target inflation and declining activity.

The Finance Minister Mario Marcel was quick to point out that the economic plan would not affect the fiscal balances for 2022. He stated that the resources would be made available from money left over from the previous fiscal period’s higher tax revenue. Equally he made it clear that the plan was not presented to override the current debate by certain parliamentarians who are pushing for an additional round of pension withdrawals. To be clear, we view another round as pontentially catastrophic for the health of the pension fund industry and the broader fiscal position of the country on a long term basis.

Today sees the release of the next round of local inflation data and the trajectory is still to the topside as higher commodity prices filter through. The march reading is expected to post 8.7% year on year versus 7.8% in March, and 1.2% month on month versus 0.3% previously, which is a big jump.

Peru: The April BCRP meeting saw rates increase to a 13-year high of 4.50%, keeping to the policy trajectory that was outlined at previous meetings. The forward guidance provided by the central bank was more hawkish, however, suggesting that monetary policy tightening could intensify over the coming months if inflation pressures remain so acute. Policymakers are still aiming to have rates achieve neutral level before the tightening cycle ends. Given that inflation expectations have increased sharply in recent months, this neutral level may need to be adjusted higher, suggesting that a bigger rate hike could come at one of the next meetings, or that the cycle would need to be extended. Currently, the policy rate adjusted by 1-year inflation expectations is below what was seen after the March rate hike, suggesting that the BCRP may be falling behind the curve here.

Forex: BRL correction seen as temporary, PEN may climb on rate hike

Brazil: The BRL suffered a third consecutive session of losses on Thursday as traders cashed in some profit on the currency’s massive that has taken place this year. The BRL ended the session 0.80% weaker against the USD at 4.7536, according to Bloomberg data. Yesterday’s losses put the BRL on track to post its first weekly decline in four weeks. While the course of the BRL appears to have shifted, investors should not be overly concerned as a correction following a rally of this magnitude is normal.

Mexico: Regarding the daily price movements of the USD-MXN yesterday, the pair was little changed as investors responded to the above-estimate March inflation reading, which has bolstered bets for the central bank to continue with its policy normalisation. The meeting minutes reinforced this view, offering some support to the MXN during a session where risk assets came under pressure. The USD-MXN has risen slightly as the weekend approaches, and it is expected to finish the week with gains of close to 2%. The bulls will look for a break above the 20.200 level, which would pave the way higher to the 200DMA resistance at 20.420. After moderating yesterday, the one-month USD-MXN implied volatility index has risen by almost 10bps in pre-market trade to 10.71%.

Colombia: Another 0.50% decline against a strong USD on Thursday meant the COP has now pared all of its early week gains, and is once again trading at more familiar levels between 3750/$ and 3800/$. Notwithstanding this recent decline, investors will recognise that the COP appreciated some 4.40% through March and from levels above 4100/$ in January. So, while his week's losses may feel uncharacteristic, they remain relatively small. While the correction may extend further, it is worth noting that a lot in the way of prospective Fed monetary policy is now priced into the market. Recent USD strength seems fairly sustainable over near term, but further upside potential is becoming increasingly limited. More broadly, much depends on commodity prices and the upcoming presidential elections from here, which will likely determine the COP’s direction into H2.

Chile: The local unit was under the pressure from the get go and touched highs north of 815.00 before finishing the session at 805.93. The range now has moved to between the 200DMA at 801.06, and 100DMA level at 818.15.

Peru: The PEN was the outperformer within the region yesterday, gaining around 0.45% against the USD as traders positioned for the BCRP rate announcement. This bucked the general tone in the Latam region as most currencies there were down on the session. The fact that the BCRP turned more hawkish suggests that we could see the PEN continue to outperform some of its peers over the near term, given that the likes of Chile and Colombia turned less hawkish this month. However, investors will remain wary of the political situation, which remains near its most unstable since Castillo took office last year.

Fixed Income: Regional inflation data may keep inversion play entrenched into the weekend

Brazil: Notwithstanding the announcement by President Bolsonaro of a cut in energy prices and the upward revision to Brazil’s agriculture production amid improved conditions, Brazilian swap rates were paid higher yesterday, tracking the losses in the BRL. The most notable move was on the front-end, with the 2yr rate legging 30bps higher to close the session at 12.24%. Meanwhile, the longer-dated 10yr swap rate ended the session 4bps higher at 11.45%.

Yesterday’s moves resulted in a significant flattening in the swap curve, with the 10v2 spread closing the session at a fresh multi-year low of -79bps. The flattening bias comes on the back of elevated commodity prices and a more hawkish shift in rhetoric from the Federal Reserve. In addition to another rate hike, it is widely expected that the Fed will announce the start of its balance sheet reduction at its May meeting. The big question for traders heading into the May FOMC meeting is whether policymakers decide on a 25bps or 50bps rate hike. Should the Fed go ahead with a 50bps rate hike next month, it will almost certainly result in more payer interest in the Brazilian swap market, notwithstanding the policy measures from the government to ease domestic inflation pressure.

Mexico: Thursday was a bearish day for Mexican bonds, with inflation concerns driving bond yields higher. Yesterday’s CPI print and US Fed officials earlier in the week, which provided hawkish signals, weighed on the local bond market. The MXN benchmark 10yr bond yield rose to 8.60%, tracking the corresponding US Treasury bond yield surge, which rose above 2.66% - its highest level since March 2019. Meanwhile, swap rates rose by more than 5bps along the IRS curve yesterday, with the market positioning for more aggressive policy tightening in the months ahead. The curve is now pricing in 150bps of rate hikes by December, with six regular Banxico meetings scheduled for the remainder of the year.

Colombia: Judging by yesterday’s moves, Colombia’s bonds look set to end the week in a relatively consolidatory fashion. Bonds struggled for sustained direction, while the IRS market was also generally flat. That being said, high and rising US Treasury yields may continue to exert selling pressure on Colombian bonds in the near term. Note that the yield spread between the 10-year Colombian bond and its US Treasury equivalent compressed to its narrowest since December this week. Should this narrowing trend persist, local bonds may lose some carry appeal through the months ahead, which could begin to weigh more heavily on the COP’s resilience.

Chile: The local swap market saw paying interest across the curve however the pressure was certainly more acute at the front end. The dis-inversion pressures have dissipated and we are back on the inversion trade again. The 2v10 is currently quoted at -120 bpts after touching highs of -97.5 bpts last Friday. Granted we are nowhere near the lows of -204.5 bpts which we saw mid-March but the pressures are building again. CPI is going to be watched closely today, how the market interprets the data is going to be critical to the performance of the front end.

Peru: Local currency government bonds took on a more consolidatory tone yesterday, with the market positioning for the BCRP rate announcement that took place after the market closed. The meeting was quite hawkish, suggesting that we could see some selling pressure materialize for bonds today. Direction will, however, be influenced by the central bank's press conference, given that more insight into the forward guidance will be provided. We should see Velarde and co. hint that more aggressive tightening could be on the cards, suggesting that the curve could continue to bear flatten out, especially given looming growth concerns that will drag longer-dated yields lower.