Mexico peso rally could spur bigger interest rate cut
MEXICO CITY Oct 17 (Reuters) - Mexico's central bank could lower borrowing costs by more than expected next week if the country's currency keeps gaining ground and undercuts the stimulus policymakers delivered to a weak economy with last month's cut.
The peso has firmed about 1.8 percent this week as feuding U.S. lawmakers hatched a deal to raise the government's debt ceiling and avert an unprecedented default.
The Mexican currency could gain more ground as investors eye a slower withdrawal of U.S. monetary stimulus as well as the chance for major economic reforms in Mexico.
A stronger peso, which curbs exporters' profits and dampens growth, could undermine much of the effect of the central bank's surprise interest rate cut in September that was aimed at helping the economy overcome a slowdown.
Meanwhile, Latin America's top economy Brazil is raising its main interest rate to fight higher inflation. While that could boost flows into Brazil, authorities there are prone to intervene and discourage unwanted currency strength.
Mexico's commitment to its freely-floating currency, on the other hand, could boost its appeal to investors.
"The peso will strengthen even more and this is an additional factor that could help the central bank to cut more than the market is expecting," said Gabriel Casillas, an economist at Mexican bank Banorte.
Most economists still see the central bank cutting its benchmark rate by another 25 basis points on October 25 to a record low of 3.50 percent. Casillas was already expecting a 50 basis point cut before the peso's rally, which is adding to reasons for a bigger cut, he said.
The Mexican currency had slumped since May as Mexico's economy contracted for the first time in four years in the second quarter.
A Reuters poll on Thursday showed analysts cut their growth outlook for Latin America's No. 2 economy to 1.3 percent this year, down sharply from 3.8 percent in 2012, and less than half a 2.9 percent rate forecast in July.
Mexico's central bank surprised markets with a 25 basis point cut in early September to counter the economic slowdown. Since then, the economy has been hurt further by massive flooding across the country last month.
At the same time, analysts now expect the U.S. Federal Reserve could wait until early next year to start to withdraw its stimulus after a nasty fight over U.S. fiscal policy that shut the government down for 16 days likely dampened growth.
If the Fed does hold back, it would be due to weaker than expected growth in the United States. And if U.S. growth slows, it will likely drag on Mexico's economy, adding to reasons for lower local borrowing costs.
If the Fed does not move soon to change its easy money policies, investors could pile into Mexico in the meantime to milk the higher yields that are available in local debt compared to returns on government debt in developed markets.
That could leave Mexico in the uncomfortable position of having its currency strengthen while economic growth is sluggish. The peso has gained about 5 percent since early September, when the central bank cut its main rate, and it hit a three-week high of 12.7470 on Thursday.
"With the peso trading well below 13 per dollar, and with momentum to trade even stronger, that increases the probability of a fifty basis point cut," said Benito Berber, an analyst at Nomura Securities in New York, who for now sees the bank cutting by 25 basis points.
The peso could get a further boost on expectations President Enrique Pena Nieto will be able to push an energy reform bill through the country's divided Congress that would open up the state-run sector to greater private investment.
Lower house lawmakers were set to approve a tax reform bill on Thursday. Once tax discussions are done, lawmakers could pass the energy reform bill yet this year.
"If reforms keep advancing, the money will keep coming into Mexico," said Alonso Madero, a fund manager at Mexico's Actinver, who sees the peso at 12 per dollar within a year.
Still, Madero doubted the bank would move to cut by 50 basis points as it eyes the impact to inflation from recent flooding. He expects a 25 basis point cut, the same as all 24 analysts in a poll by Banamex on Oct. 7.
Yields on Mexican Interest rate swaps also point to a 25 basis point cut in October, Thomson Reuters data shows.
However, analysts have had a pretty poor showing in predicting the central bank this year. Cuts in March and September both surprised the vast majority of analysts.
Banorte's Casillas, who was nearly alone in tipping an unexpected interest rate cut back in March, said policymakers are increasingly confident that the economy is handling inflation better than in the past.
"They want to lock in lower borrowing costs now before the Fed ends up raising interest rates," Casillas said. "All the stars are aligned for the central bank to cut by fifty."
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