Breaks of technical resistance suggest that a relief rally for Latin American FX could have further to run.
However, fundamentals and technicals suggest that upside for regional currencies will be limited to short-term moves.
BRL and CLP will continue to face depreciatory pressures in 2014, with further exchange rate weakness instrumental for economic rebalancing.
COP and MXN face a different macroeconomic reality, with shifting fundamentals and more competitive export sectors suggesting steady appreciation over the medium term.
Latin American FX Rally: Temporary, But Not Negligible
Latin American currencies are among our least favourite emerging market asset classes, particularly relative to Asian currencies and the US dollar ( see our 'Global Strategy - FX', March 25). However, we have previously highlighted that our negative outlook on Latin American FX is nuanced and the impact of additional weakness will depend on market sentiment and, importantly, macroeconomic fundamentals ( see 'Impact Of FX Weakness To Vary Based On Fundamentals', March 24). While we maintain a negative bias on Latin American currencies in 2014, particularly in those economies, which have a high level of exposure to global industrial metals prices and to declining Chinese demand for commodities, we believe that recent technical breaks suggest that the recent relief rally could have further to run.
| On The Verge Of Breaking Higher |
|JP Morgan Latin America Currency Index (Weekly)|
At the time of writing, the JP Morgan Latin America Currency index is on the verge of pushing through trendline resistance around the 93.0 level, with a break higher potentially signalling a continuation of the ongoing relief rally in regional currencies. Having been off to a poor start this year, the index previously tested major support around the 89.0 mark, which coincided with a 2009 low for Latin American currencies. The latest rally and potential break of resistance on the weekly chart ( see above), mean that the ongoing bounce could have further to run in the near term.
While the 95.0 level presents some technical resistance, we highlight 100.0 as a potential next area of significant resistance for the index to test over the coming weeks. However, reaching this level would require major bullish momentum for regional currencies, and a break of the next key resistance area is highly unlikely considering adverse balance of payment dynamics in much of the region, and our expectations for US treasury yields to head higher in the coming months, which could see renewed capital outflows.
Further Rebalancing Required
The Brazilian real has been leading the charge among Latin American currencies in recent trading, appreciating sharply against the US dollar following a break of resistance at BRL2.300/US$. The unit has since come off resistance at BRL2.250/US$, indicating that bullish momentum may be gradually unwinding.
| Only Limited Room To Rally |
|Exchange Rate - BRL/US$ (Daily)|
Even upon a break here, we see only limited room for the real to rally further from current levels. On the one hand, the technical picture suggests major trendline resistance coming up around BRL2.220/US$. On the other hand, we reiterate our view that the Brazilian economy has only tentatively started to rebalance. We forecast a current account deficit of 4.2% of GDP this year, despite major exchange rate weakness in 2013 and tightening monetary policy likely to hurt domestic demand in 2014. Years of high wage growth, inflation and underinvestment in productive capacity, have left the Brazilian economy notoriously uncompetitive. Rapid credit expansion and a reliance on iron ore exports are unsustainable as drivers of economic growth, and we therefore believe that in the absence of a far-reaching reform effort, additional exchange rate weakness in Brazil remains the path of least resistance for the economy to rebalance ( see 'Commodity Currencies Have Likely Peaked As Rebalancing Takes Hold', December 11 2013).
Another currency, which has seen major downside recently is the Chilean peso, and here too we note that bearish sentiment has likely come as far as it will go in the near term, triggering a relief rally in recent trading. The chart below illustrates how the peso has broken its recent steep depreciatory trend, after coming within a hair's length of CLP580.0/US$. Although we would wait for a confirmed break of resistance on the weekly chart to signal the end of the steep depreciatory trend seen since late last year, we note that the next level of resistance comes in around CLP538.0/US$. Loose monetary policy and declining global copper prices suggest that the Chilean peso will likely remain under considerable downside pressure this year. Indeed, little support is likely to be forthcoming from Chile's monetary authorities, given low inflation and the beneficial effect of a weak exchange rate on the non-mining economy.
| Steep Depreciation On Hold For Now |
|Exchange Rate - CLP/US$ (Weekly)|
Time To Differentiate?
The Colombian peso has seen among the biggest depreciation against the US dollar in the region this year, followed by an extensive rally after testing the COP2,050/US$ area in recent weeks. The peso is fast-approaching a major resistance area at COP1,950/US$, which is unlikely to be broken, given the central bank's generally dovish stance and advocacy for a weaker currency.
| Temporary Relief Rally Or Changing Fundamentals? |
|Exchange Rate - COP/US$ (Daily)|
Due to the central bank's reluctance to tolerate a stronger exchange rate, and potential for Colombia to be caught up in broader bearish sentiment towards Latin American FX, we have been wary of assuming an outright bullish stance on the Colombian peso. That said, looking further ahead, we have a more favourable outlook on the Colombian peso, than its Brazilian and Chilean counterparts. This is for a couple of reasons: First, Colombia is less vulnerable to volatility in global metals prices, and thus less exposed to waning demand in China. Second, Colombia is one of a handful of economies in Latin America, set to benefit from stronger US demand for manufactured goods. We forecast a considerable acceleration in real GDP growth in the US from 1.9% in 2013 to 2.8% this year, which should favour Colombia's exporters.
In addition, the government is currently considering cutting a tax on non-residential holdings of government debt securities, which had already been reduced from 33% to 14% in 2013, which has triggered a rally in local-currency government bonds, and by extension, the peso. A break through COP1,950/US$ would confirm a more bullish outlook and signal that a more fundamental shift in investor perceptions of Colombian assets is afoot.
The picture remains less clear-cut for the Mexican peso, given that mixed economic data out of both Mexico and the US since the start of the year, and lower-than-expected bi-weekly inflation in the first half of March paint a more dovish outlook on local rates than we currently envision (we forecast a 25bps interest rate hike to 3.75% by year-end). Moreover, with much of the reform effort of President Enrique Peña Nieto likely exhausted and attention focusing on passing secondary legislation for energy liberalisation, as well as the potential for ruction within the Pact for Mexico coalition, investor sentiment towards Mexico could cool further.
| MXN Waiting For Its Time To Shine |
|Exchange Rate - MXN/US$ (Daily)|
That said, we retain a bullish bias over the medium term, as we largely expect energy sector reform to stand and attract large investment in the midstream and downstream sectors. What is more, we believe that improving competition in the telecoms sector and the economy's high exposure to the economic recovery in the US, in addition to a highly competitive manufacturing sector and low-cost labour force, it is only a question of time before the Mexican peso becomes a clear outperformer in the region. The peso is currently testing trendline resistance around MXN13.70/US$, with a break here potentially setting the unit up for a move back to the MXN12.50/US$ area in the first instance.