Fixed Income Specialist, Saxo Bank
There has never been any doubt that Mexico, country of the lucha libre, colorful skulls and chilli, was a tough cookie. However, after several years spent in the shadows of the United States, it is only in the past few weeks we've seen the country emerging as a proud member of the North American Free Trade Agreement as well as a fierce trading partner.
Everything began in March when tariffs on steel and aluminium where announced, and Canada and Mexico have temporarily been exempt until the end of May as the NAFTA agreement was being renegotiated. As renegotiations didn’t go anywhere, the US government decided not to extend this exemption any further, thereby starting a proper tit-for-tat trade war that nobody yet knows where it will bring us.
The decision of Mexico to retaliate by imposing taxes on steel imports from the US and additional tariffs on a broad range of products ranging from potatoes to bourbon, stunned the entire world. As a matter of fact, if there was any country that many believed would bend to the requests of the US, it would have been Mexico as it relies heavily on the US with 80% of all its exports going to its northern neighbour.
But things don't always play out as one would imagine. What the Trump administration didn’t consider is that its actions would actually further isolate the US from the global economy while motivating countries worldwide to join forces and overcome the difficulties posed by US protectionism.
This is exactly what happened with Mexico. Although the country’s fate has been for years been tied to that of the US, Mexico is now forced to find new partners on the international scene and it finds it convenient to strengthen relationships with those countries that are also effected by US protectionist policies. This ultimately gives more leverage to an economy that seemed doomed to follow the US for better and for worse.
The three key relationships that now Mexico is seeking to develop are those with the European Union and Canada, through which is seeking to put more pressure on the US, and the Trans Pacific Partnership in order to boost imports from other suppliers. Although elections are going to be held this summer on the first of July, it doesn’t seem that candidates disagree on the approach that the Mexican Commerce Department should adopt concerning a trade war with the US. This means that even in the event that the US pulls out its ace card to impose tariffs on autos, the reaction of Mexico will be more likely to be retaliation rather than acceptance, killing NAFTA for good.
AMLO, as Andres Manuel Lopez Obrador is widely known, is the candidate that appears to be leading the presidential polls. He’s seen as a populist, and he could be the candidate that would give the hardest time to Trump’s administration. He’s looking to make Mexico self-sufficient in food and energy. In particular, for energy, he’s planning to build refineries that would process crude for domestic consumption in attempt to cut out transnational companies from oil production, putting at risk the energy trade surplus that the US has with Mexico.
Mexican bonds amid elections and trade war
Something that needs to be pointed out straight away is that the Mexican yield curve is extremely flat. While the 10-year Mexican sovereigns in MXN are trading with a yield of 7.92%, the two-year Mexican yields are quoting around 7.82% which is basically a spread of +10 basis points, 25 bps tighter than the spread between the 10- and two-year US Treasuries.
The main difference between the flat US yield curve and the Mexican one is that while the US yield curve is flattening because short-term interest rates are rising faster than long-term rates (bear-flattener), the Mexican yield curve is flat because it is expected that inflation will decrease in the future (bull-flattener).
Inflation has been rising quickly since 2015 and at the end of last year, the country recorded inflation close to 7%, the highest since 2001. Since then, inflation has been retreating and now stands around 4.5%. Therefore, is clear that the yield curve has flattened due to inflation expectations and not because of concerns of a devaluation in the short term.
We have pointed out several times that an inverted US curve is a sign of an imminent recession, however, this is not the case for Mexico, as the flattening of the yield curve there is caused by decreasing inflation. More importantly, sovereign debt payments are funded for 2018 and as inflation declines we can expect the services sector to accelerate and therefore, the economy to continue growing.
While the Mexican peso has fallen approximately 12% against the dollar since the end of March, Mexican sovereign yields have increased by +60 bps as the fundamentals haven't changed. This movement appears to be a result of the news flows surrounding the potential for trade war as well as the imminent elections.
In the short term, the biggest threat to Mexican bonos remains the upcoming Mexican elections and headlines related to a full-blown trade war.
As we approach the election date and with AMLO looking more and more likely to win the elections, volatility will rise, pushing sovereign yields higher and giving reasons to investors to buy Mexican bonos – especially as valuations are favourable compared to peers. However, the destiny of the Mexican economy will heavily rely on the possible outcome of a trade war and partnership in NAFTA, and this is why it is important to wait and see how this escalates before taking a standing on Mexican bonos.