So What's The Trade, Ponch? Steepeners, Mi Amigo

Ponch...if we get there in time, we can put that hawkish central banker behind bars once and for all!

So what's next for Mex rates? Can Ponch use his street smarts to subdue inflation, capture the gang of hawkish central bankers and bring joy to the hedge fund world? Indeed, the next move for Banxico is a cut.  As discussed yesterday, there is probabilistic path for rate cut, with 50bps gradually priced by the end of 2018. 100bps is in the cards in 1H2018, but it won’t take much to convince the central bank to hold off or slow-play rate cuts to see how the election pans out.

To complicate matters further, we don’t even know who will be running the central bank in 2018 (on either side of the border). The two leading candidates are Alejandro Díaz de León, who is currently on Banxico’s board of governors, and José Antonio Meade, the current finance minister. Both are eminently qualified--one could argue Meade is the more dovish of the two, but he may wind up running for president under the PRI banner.

If Diaz de León is the choice, plenty of influence will be held by Manuel Ramos Francia, Banxico’s current vice-chairman and Mexico’s answer to Stanley Fischer. Ramos Francia places a high premium on financial stability, and together with Carstens can be credited with implementing a number of measures to backstop the Mexican currency and financial system over the past ten years--up to and including the aggressive hiking cycle that took rates 400bps higher since early 2016. That could keep rates higher for longer, especially if the Fed is still hiking in 2018.

Lastly there’s NAFTA. I don’t have anything to add here. I still see little evidence Trump is going to blow up the system--if he were going to do it, he would have done so already. But this time bomb will only be defused by an agreement--one that doesn’t look on the horizon...and the Mexican election clock is ticking.

Which segues nicely into the biggest risk in the market: Victory in next July’s presidential election for Andrés Manuel López Obrador, a leftist candidate that is a weird combination of Donald Trump, Lula and Jeremy Corbyn. AMLO has a small lead in a race that will be splintered between four candidates.

The trouble is...I think he’s going to win. Sure, he could step on a political landmine as he has in past elections, but the recent global record of populist candidates versus either establishment or technocratic candidates is not good at all...Macron might be an exception, but even he was an outsider running against the establishment.  Mexico has all the ingredients for a populist/nationalist victory: a charismatic candidate, an external bully, a stagnant economy, a system rife with corruption, and a long history of poverty, inequality, and large segments of the population that feel “left behind.”

In 2006, Mexico had a long string of strong growth resulting from high oil prices and strong manufacturing demand. Felipe Calderon ran a technocratic “don’t mess this up” campaign, and still only beat AMLO by a whisker (and some think that is overstated by two whiskers). Today, from a political perspective (corruption, crime, education, etc.), pretty much everything Mexico had going for it in 2006 is worse. And AMLO is still here and ready to “drain the swamp”. How will the fractured establishment compete with that?       

The market is underpricing the potential for inflation to come down...yet also underpricing AMLO risk. That points to good value in steepeners.

2x10 TIIE is still really flat--and while that may be true of virtually any curve in the world, there aren’t many curves where one can make a convincing case for significant rate cuts in the next 1-2 years.  The flat curve is also a function of EM local flows at large--a portion of which can and will hit the exits if and when AMLO extends his lead in the polls. 2x10s is currently at 9bps--three months from now 40bps is much more likely than an inverted curve.

In a directional or long-only book it is tough to ignore the risk-reward in buying the front end. At roughly 7.10 in 2y tiie vs. the 28d fixing at 7.36, you’re staking 20bps to make 50-60bps if Banxico cuts 100bps by mid-2018. Yet I can’t help but think there will be a better chance to build a structural position as the election campaign gets into full swing, which also allows you time to let some of that negative carry/roll burn off.  A decent compromise would be to receive in front of potentially positive hard data, while keeping dry powder on had to add on spikes driven by politics or USD strength.

There you have it...Stay safe out there!

Shawn
TeamMacroMan2@gmail.com

@EMInflationista