The world-beating rally in Latin American currencies this year is about to come up against a world-leading round of interest rate cuts.
(Bloomberg) — The world-beating rally in Latin American currencies this year is about to come up against a world-leading round of interest rate cuts.
Latin American currencies represent four of the top five performers this quarter, benefiting from low volatility and sky-high rates. But with borrowing costs now set to fall, probably starting next month in Chile and then followed by Brazil — that may spell the end of the widespread rally.
The Mexican peso and the Brazilian real “already reached our target and I am a little bit skeptical regarding further gains as both central banks will most likely start cutting rates in the second half and there are also medium term downside risks,” said Esther Reichelt, a strategist at Commerzbank in Frankfurt. “To me they are more a hold for now.”
Markets have already turned on the Chilean peso, betting policymakers will kick off the easing cycle as early as next month, with more than 3 percentage points in cuts in the year. Weaker-than-expected economic data and slowing inflation have paved the way to monetary easing. At the same time, falling copper prices are weighing on the currency as China’s economic recovery disappoints.
The combination of negative factors could leave the peso, which has declined about 1% this quarter, under further pressure.
Political Chaos
In Peru, the sol’s 3.6% rally this quarter was stoked by reports President Dina Boluarte would stay in her post until 2026, calming years of political turmoil. But that may prove to be a one-time boost, and with central bank Governor Julio Velarde saying rate cuts may start in the coming months, the rally in the sol is already fading.
Colombia’s peso too is likely to stabilize around current levels after a world-beating 17% rally this year, driven partly by seasonal corporate flows tied to a tax payment window.
“There is a dollar rebound in the making, but Latin American currencies should hold up very well if there isn’t much risk correction,” said Alejandro Cuadrado, head of global FX strategy at BBVA in New York.
While Chile’s peso and Peru’s sol may weaken as rate cuts are imminent, other currencies “can still reach new highs before interest rates start to come down,” he added.
The MSCI Emerging Market Currency Index has fallen about 1% this quarter as the dollar strengthens, its biggest drop since the third quarter of last year.
Carry King
The Mexican peso offers the best carry-to-volatility ratio in the region, with its one-month implied volatility as much as 300 basis points lower than the Brazilian real. Milder swings pared with high liquidity, strong remittances and the so-called nearshoring process are set to keep the peso afloat. Mexico’s exports were $52.9 billion in May, the second largest on record as local companies work to feed the US consumer market.
As for the region’s largest economy, Brazil, larger-than-expected rate cuts are the biggest risk for the continuation of the rally in the real. Still, cheap local stocks, which stand to benefit from the easing cycle, have the potential to sustain dollar inflows. In June alone, the Ibovespa stock index saw a net inflow from foreigners of $1.6 billion, according to data from the local exchange.
Read More: Brazil Keeps Inflation Goal at 3%, Making Room for Rate Cuts
What’s more, the approval of a new fiscal framework and the prospect of frugal government spending keeps the real an attractive bet mid-term.
“Some FX valuations are starting to look extended,” said Bret Rosen, economist and strategist at EMSO Asset Management. “But overall carry should remain favorable for Latin America FX.”
–With assistance from Zijia Song.
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