FX Sell-Off: Higher Stakes For Policymakers In Rebalancing Act

The key drivers of relative exchange rate performance in Latin America will be the quality and reliability of economic growth over the coming quarters. Regular readers will be well aware that we have long been highlighting major shortfalls in Brazil's economic growth model in light of a challenging operating environment and decelerating growth in China. In contrast, we are less concerned about Mexico's economic growth model, having long suggested that the ongoing reform drive by the government and trade integration with the US will see the economy outperform many of its Latin American peers in the near future. As such, we believe that the secular outperformance of the Mexican peso over the Brazilian real will continue over the coming quarters irrespective of the negative implications for the carry trade as Brazil's central bank continues to hike interest rates.

Despite more favourable macroeconomic fundamentals, currencies such as the Mexican peso, have also been hit hard by the latest flight to safety among investors. A more robust growth outlook and favourable business environment have not prevented a spike in volatility given Mexico's deep capital markets and large share of short-term capital in the financial account. From a technical perspective, we take a more cautious outlook on Latin American currencies in the near term in light of notable chart damage.

That said, the peso appears to have come right off the MXN13.60/US$ level in recent trading and could be basing around MXN13.40-13.50/US$ before setting up for another run at resistance near MXN13.20/US$ over the coming weeks. Although major gains against the US dollar are hard to see beyond these levels, we believe that relative outperformance over a basket of EM currencies, particularly those with higher current account deficits and questionable growth dynamics, will continue.

Fundamentals Trump The Carry Trade
Exchange Rate, MXN/BRL, Weekly Chart

FX Sell-Off: Higher Stakes For Policymakers In Rebalancing Act

The key drivers of relative exchange rate performance in Latin America will be the quality and reliability of economic growth over the coming quarters. Regular readers will be well aware that we have long been highlighting major shortfalls in Brazil's economic growth model in light of a challenging operating environment and decelerating growth in China. In contrast, we are less concerned about Mexico's economic growth model, having long suggested that the ongoing reform drive by the government and trade integration with the US will see the economy outperform many of its Latin American peers in the near future. As such, we believe that the secular outperformance of the Mexican peso over the Brazilian real will continue over the coming quarters irrespective of the negative implications for the carry trade as Brazil's central bank continues to hike interest rates.

Fundamentals Trump The Carry Trade
Exchange Rate, MXN/BRL, Weekly Chart

Despite more favourable macroeconomic fundamentals, currencies such as the Mexican peso, have also been hit hard by the latest flight to safety among investors. A more robust growth outlook and favourable business environment have not prevented a spike in volatility given Mexico's deep capital markets and large share of short-term capital in the financial account. From a technical perspective, we take a more cautious outlook on Latin American currencies in the near term in light of notable chart damage.

Damage Done, But Standing Apart From The Rest
Mexico - Exchange Rate, MXN/US$, Daily Chart

That said, the peso appears to have come right off the MXN13.60/US$ level in recent trading and could be basing around MXN13.40-13.50/US$ before setting up for another run at resistance near MXN13.20/US$ over the coming weeks. Although major gains against the US dollar are hard to see beyond these levels, we believe that relative outperformance over a basket of EM currencies, particularly those with higher current account deficits and questionable growth dynamics, will continue.

EM Central Banks Under Greater Pressure To Act

The EM-wide sell-off in currencies, which followed weak manufacturing data out of China and Argentina's decision to temporarily lift its currency controls, leading to a 13.7% devaluation of the official exchange rate on January 23, has upped the stakes for policymakers. Indeed, the pressure on central bankers to keep up with rising US treasury yields amid Fed tapering, has shifted into a higher gear following the Central Bank of Turkey (CBRT)'s decision to hike its policy corridor by 425-550 basis points (bps) at an emergency monetary policy committee meeting on January 28 ( see 'Hike Can't Hide Economic And Political Fragility', January 29).

Regional Policymakers At A Crossroad
JP Morgan Latin America Currency Index, Weekly Chart

For now, several key support levels for most major Latin American exchange rates remain unbroken. Although we currently have only seen Brazil hikes interest rates in the region, we believe that interest rates have mostly bottomed and are likely to begin to head higher in the foreseeable future. We forecast interest rate hikes of 50bps in Colombia and 25bps in Mexico this year, which could potentially prevent additional exchange rate weakness against the US dollar over the coming months, as rate expectations adjust higher, in line with our forecasts.

Running Out Of Options As Reserves Dwindle
Argentina - Official Exchange Rate, ARS/US$, Daily Chart

Changing Gears For Economic Rebalancing

In the case of Brazil, although aggressive interest rate hikes since April 2013 have done little to prevent the exchange rate from weakening, we believe that higher interest rates will eventually succeed in capping the recent sell-off. Higher interest rates and consequently, weaker growth, will see import demand drop and feed through to a narrowing of the current account deficit. Meanwhile, the weakened exchange rate and the prospect of higher unemployment could act as a boon for non-commodity exports that have previously suffered as a result of overvalued exchange rates and a structural lack of economic competitiveness.

Still In A Depreciatory Trend
Brazil - Exchange Rate, BRL/US$, Daily Chart

However, for now, we expect the current depreciatory trend in the real to persist in light of high inflation, weak balance of payments dynamics, and expansionary fiscal policy. The real has remained within a depreciatory trend since October, after the rally on the back a currency intervention programme announced by the central bank in late August 2013, proved short lived. A total of 325bps of rate hikes to 10.50% by monetary policymakers since April 2013, and rising interest rate expectations continue to do little to reverse the recent sell-off in the real, and we believe a break of the unit's recent low of BRL2.455/US$ would be a particularly bearish signal.

Monetary Policy Fails To Gain Traction
Brazil - Exchange Rate & Interest Rate Futures

In Colombia, global investor risk aversion, coupled with political uncertainty, technological difficulties in oil exploration and legal challenges affecting mining exports, have seen the peso turn from one of the most attractive exchange rates in Latin America to a recent underperformer. Indeed, the unit has broken an area of key technical support around the COP2,000 level.

Key Support Breached
Colombia - Exchange Rate, COP/US$, Weekly

Although the central bank has noted that it might cease its daily exchange rate interventions to weaken the currency, we believe that monetary policymakers will be less alarmed by the recent weakness and therefore feel less inclined to take more aggressive steps to prop up the currency. Beyond the near term, we believe that Colombia's still sound economic fundamentals are likely see the peso reverse course.

Ripe For A Bounce?
Chile - Exchange Rate, CLP/US$, Weekly Chart

The Chilean peso has also been hit hard by a recent spike in volatility and a dimming outlook for copper exports. We believe that the latter could continue to weigh on the exchange rate, given that our average copper price forecasts and expectations of demand for copper from China remain below consensus. That said, we believe that the country's solid sovereign credentials will preclude a major blow-out in the exchange rate to the extent that based on the technical picture, we do not rule out a bounce in the peso from key support at CLP550.00/US$.

Slide Against Dollar Continues
Peru - Exchange Rate, PEN/US$, Weekly Chart

Similar to the Chilean peso, Peru's nuevo sol has been hit by lower average industrial metals prices, as well as the collapse in gold prices seen in 2013. Although a bout of risk aversion has seen US treasury yields compress lately, we believe that a continuation of the US Fed's tapering will see yields continue to head higher, putting additional downside pressure on gold prices. As such, we regard the recent technical break through support for the sol as indicative of potential further downside for the unit.

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