Investors wary on Mexico following peso rout

Newly elected Mexican president Claudia Sheinbaum faces a struggle to tempt investors back into the country’s financial markets, amid worries about controversial judicial reforms and the prospect of higher borrowing costs.

The peso has steadied following a sharp post-election sell-off, and was briefly boosted this week by Sheinbaum’s appointment of a business-friendly economy minister.

But, given the scale of the victory for Sheinbaum’s Morena party, fund managers are reluctant to pile back into lucrative bets on the Mexican currency that earlier this year saw it dubbed the “super peso”.

“I don’t think the peso recovers,” said Edward Al-Hussainy, head of emerging market fixed-income research at Columbia Threadneedle. “The assumption that Sheinbaum is going to be softer and more business- friendly is not based on reality. She ran on a campaign that has given her a very, very aggressive mandate.

“We were reducing our Mexican assets across credit and foreign exchange in the run-up to the election and we’ve been doing more of that since the election. The election has really weighed on the fiscal outlook for us.”

Although Sheinbaum has promised fiscal discipline, the Mexican peso last week fell to its lowest level since March 2023 in the days after she said she would push forward with her party’s plans to enact sweeping judicial reforms that would dismiss 1,600 independent judges to be replaced with elected ones.

Efforts by Mexican officials to cool investor fears have had only limited success. Sheinbaum on Thursday appointed six cabinet members, including business-friendly Marcelo Ebrard as economy minister, who will be in charge of attracting foreign investment and promoting industry and trade. The peso strengthened following the announcement before giving back some of its gains.

Karl Schamotta, chief market strategist at Corpay, said markets would be struggling to assess the influence of current President Andrés Manuel López Obrador’s reform agenda in the coming months, but expected Sheinbaum to let her team make more reasonable noises.

“Their voices seem likely to grow louder as Mexico prepares to transition away from the cult of personality-driven politics of the AMLO years. The peso could grind higher as this process unfolds,” said Schamotta.

But even after a modest recovery, the Mexican currency remains roughly 8 per cent weaker against the US dollar compared with pre-election levels, a far cry from the tearing rally earlier in the year.

The reaction has not been contained to the currency market: investors demanded 10.6 per cent, the highest yield on record, at an auction of 30-year Mexican debt on Tuesday.

The election shock came as Mexico’s economy was already slowing. Economists at Citigroup this week downgraded their forecasts for GDP from 2.1 per cent growth to 1.8 per cent growth in 2024 and from 1.5 per cent to 1.2 per cent for 2025. They also raised inflation expectations, though only moderately, and predicted the peso would weaken further to 19.74 per dollar next year from the current level of 18.22. 

Left-wing Sheinbaum is a former academic and longtime political activist who stuck close to the rhetoric and policies of López Obrador during the campaign and since her win. Her expected supermajority in congress and backing for the proposed judicial reform has fuelled the view she will stick to his more radical path.

“The efforts at reassurance from Sheinbaum have stopped the sell-off but they haven’t gotten us back to where we were,” said Kit Juckes, an analyst at Société Générale.

The sharpness of the peso’s decline is in part due to the reversal of a popular foreign exchange strategy known as the carry trade, in which investors borrow in the currency of a country with low interest rates — such as Japan or Switzerland — in order to invest in higher-yielding assets such as Mexico’s. Benchmark interest rates set by the country’s hawkish central bank, which raised borrowing costs early and aggressively to try to tame inflation in the wake of the Covid-19 pandemic, currently stand at 11 per cent.

“You saw the peso plunge while the yen jumped” after the Mexican election, Schamotta said. “It is pretty clear cut that there was a flight to safety and an unwind of speculative positions.”

That yen/peso trade had been wildly popular and profitable in recent years, returning more than 50 per cent from the start of 2023 to May 2024, according to Sam Lynton-Brown, head of global macro strategy at BNP Paribas.

But investors’ appetite for such investments relies on a relative lack of volatility in currency markets. Given the potential for a bumpy ride as Sheinbaum pursues her reform agenda, few analysts expect the enthusiasm for the peso to return in full force.

“The idea of the carry trade assumes you have a stable political and economic framework whereby markets can try and take advantage of large carry differentials,” said Shahab Jalinoos, head of G10 foreign exchange strategy at UBS.

“Once you start getting large idiosyncratic risks the story becomes different. You’re getting paid to take a risk that you may not be comfortable with.”