Dovish Banco de Mexico Does Not Derail Bullish MXN Call

Mexico central bank Governor Carstens is sounding very dovish, noting that the economic recovery is not leading to price pressures.  He believes there is enough slack in the economy still to keep inflation near the 3% target.  Comments came after CPI inflation was reported at 3% y/y in March Thursday, down from 3.6% y/y in February and the lowest since May 2006.  Core inflation also eased to 3.2% y/y from 3.3% y/y and is the lowest since March 2006, and so Carstens may be right to be so sanguine about inflation.  PPI rose 4.1% y/y in March and is creeping higher, and so it may be too early to sound the all clear on inflation.  We thought that rate hikes would begin in Q4 11 instead of Q1 12 as market expects, but if inflation continues to trend lower, we may have to rethink.  However, even rates staying at 4.5% for all of 2011 remains attractive, as Mexico is the second highest in the region (only Brazil’s 11.75% is higher).  However, while Chile (4.0%), Peru (4.0%), and Colombia (3.5%) are catching up quickly, Mexico still offers the only freely tradable currency in Latin America and so MXN will remain attractive to investors despite the erosion in yield advantage.

USD/MXN continues to make new lows for the cycle as the EM rally continues.  Mexico officials have stayed quiet about peso strength during this move, and we note that there are not many chart points beyond the 12 area.  11.5 is a round number, and also represents some highs from mid-2006.  A minor retracement target can be identified around 11.21, but beyond 11.5, we may start to see some official “concern” about the peso.  Mexico is no longer just an oil story, but at the margin, high oil prices will unequivocally help the budget and debt ratios this year.  The current account gap is widening modestly, but is fully covered by FDI.  Looking ahead, markets may get more cautious next year as the 2012 presidential elections approaches, but for now, we think the combination of high yields, improving US and Mexican growth outlook, and high oil prices will keep the peso on its upward trajectory.