Many emerging market currencies have seen modest depreciation against the US dollar as the Federal Reserve tightened monetary policy starting in March 2022. However, the Mexican peso has been a notable exception, strengthening by approximately 20 percent against the dollar during this period (Chart 1). This exceptional performance of the peso, a currency that constitutes a significant 13.8 percent of the Federal Reserve’s trade-weighted dollar index, can be attributed to a mix of short-term dynamics, such as attractive interest rate differentials and investor positioning, and robust long-term macroeconomic fundamentals.
Chart 1: Mexican Peso Appreciation Against the U.S. Dollar
The peso’s strength is particularly significant given Mexico’s crucial role in the US economy, especially for states like Texas. Current data indicates that Mexico is poised to overtake China as the leading US trading partner this year, underscoring the importance of understanding the dynamics of the USD to Mexican peso exchange rate.
High Interest Rates in Mexico привлекают Investments
A key factor influencing a currency’s appeal is its associated interest rate compared to other currencies. Exchange rate movements also play a critical role in investor returns. When a currency offers a higher yield than another, and the exchange rate between them is anticipated to remain relatively stable, investors are naturally drawn to the higher-yielding currency.
Investors can capitalize on these interest rate differences through strategies like the “carry trade.” This involves borrowing in a currency with lower interest rates and investing in a currency with higher rates, or utilizing derivative instruments such as futures and foreign exchange swaps.
The real interest rate gap between Mexico and the US began to widen in 2021 as Banco de México proactively increased its policy rate. This monetary tightening started nearly a year before the Federal Reserve’s actions (Chart 2).
Chart 2: Real Policy Rate Differential Between Mexico and the U.S.
Banco de México has raised its policy rate by a cumulative 7.25 percentage points, surpassing the Federal Reserve’s increase of 5.25 percentage points. At its peak in late 2022, this differential allowed carry trade investors to potentially earn around 7 percentage points in real return by borrowing in US dollars and lending in Mexican pesos, assuming a stable USD to Mexican peso exchange rate. While this gap has narrowed from its peak, it remains substantial at approximately 4 percentage points, continuing to support the peso against the dollar.
Compared to other emerging market currencies, Mexico offers a favorable risk-reward balance. Its interest rates are significantly higher than those of lower-risk Asian economies, and its macroeconomic policies are perceived as more stable than many high-yielding Latin American counterparts. Furthermore, the Mexican peso is the third most actively traded currency among developing nations, enhancing its attractiveness for carry trades due to its liquidity.
Fiscal Prudence Bolsters Investor Confidence in the Mexican Peso
Mexico’s fiscal policy response to the pandemic also contributed to the peso’s strength. The country maintained a modest fiscal deficit of about 4 percent of GDP (Chart 3). Mexico’s pandemic-related stimulus measures were comparatively small, equivalent to just 1.1 percent of GDP, significantly less than the Latin American average. This fiscal restraint, while contributing to a slower economic recovery initially, enhanced investor confidence in Mexican government bonds.
Chart 3: Mexico’s Fiscal Deficit as a Percentage of GDP
The combination of high-interest-rate carry and lower fiscal risk has been a key factor in bolstering investor confidence in Mexico, making investments in Mexican pesos more appealing. This perceived stability is crucial for maintaining a strong exchange rate between the USD to Mexican peso.
Strong US-Mexico Ties and Remittances Support External Balance
Remittances from Mexicans living in the US represent a significant economic link between the two countries. In 2022, these remittances reached a record $55.9 billion, accounting for 4.5 percent of Mexico’s GDP, a substantial increase from 2.5 percent a decade prior.
Remittances provide a stable income stream, reducing a country’s reliance on foreign borrowing. The current account balance, which reflects a country’s net demand for foreign currency, is significantly impacted by remittances. Without these substantial inflows, Mexico’s current account deficit would have exceeded 4 percent of GDP in recent years, increasing demand for foreign currencies and potentially weakening the peso (Chart 4). Remittances helped keep Mexico’s current account deficit at a more manageable 1.2 percent of GDP in 2022, supporting the peso’s value against the USD.
Chart 4: Mexico’s Current Account Balance as a Percentage of GDP
Nearshoring Optimism Enhances Mexico’s Economic Outlook
The anticipation of increased nearshoring, as companies look to relocate manufacturing from Asia to be closer to the US market, has further boosted the outlook for the Mexican economy and the peso. Mexico is seen as an attractive alternative for businesses seeking to diversify supply chains, reduce tariffs, and enhance supply-chain resilience.
While aggregate data on foreign direct investment (FDI) has not yet fully reflected this nearshoring trend, with FDI remaining relatively flat in 2021 and 2022, investor optimism remains high. Increased FDI in the first quarter of 2023, although largely driven by profit reinvestment, suggests a potential shift. This positive sentiment surrounding nearshoring, combined with strong macroeconomic fundamentals, contributes to the peso’s resilience and its favorable exchange rate against the US dollar.
Investor Positioning and Reduced Foreign Debt Exposure
Investor positioning has also played a role in the peso’s stability. Foreign demand for government debt can indicate investor confidence, but high foreign ownership can also increase vulnerability to shifts in investor sentiment.
Historically, events like the “taper tantrum” in 2013, triggered by unexpected comments from the Fed, led to significant peso depreciation as investors sold off foreign bonds. At that time, foreign holdings of Mexican government domestic securities were high, around 35 percent.
More recently, foreign ownership of Mexican government debt has decreased from about 25 percent at the start of the pandemic to approximately 15 percent. This decline began following the 2016 US election and ahead of the 2018 Mexican election, reflecting concerns about trade and economic policy.
During the pandemic, foreign investors reduced their exposure to Mexican debt due to its liquidity compared to other emerging markets. This lower level of foreign ownership has likely limited capital outflows and volatility during the current US tightening cycle, contributing to the peso’s strength. Interestingly, the peso’s appreciation has not been accompanied by a significant increase in foreign ownership of Mexican government debt, suggesting that derivative contracts might be a driving factor in the increased demand for pesos.
Return to Equilibrium and Real Effective Exchange Rate
The real effective exchange rate, which adjusts for inflation differences among trading partners, provides insight into a currency’s long-term value. It often tends to revert to its long-term average over time.
Part of the peso’s appreciation since 2020 can be seen as a correction following a sharp depreciation in 2015-16 (Chart 5). Until late last year, the peso’s real effective exchange rate was close to its 30-year average before rising above this long-run average. This suggests that some of the recent strength in the USD to Mexican peso exchange rate reflects a return to a more balanced valuation.
Chart 5: Mexico’s Real Effective Exchange Rate
In conclusion, the Mexican peso’s strength against the US dollar is supported by a confluence of factors, including proactive monetary policy, prudent fiscal management, strong economic ties with the US, investor positioning, and valuation adjustments. While nearshoring could further bolster the peso, its materialization is not guaranteed. Additionally, narrowing interest rate differentials, an overvalued real exchange rate, and potential political uncertainties in both the US and Mexico in 2024 could introduce volatility to the USD to Mexican peso exchange rate in the future.
Updated 9/27/2023: Corrected remittance amount to $55.9 billion.
