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Mexico’s Rate Cuts Threaten Buoyant Peso: Decision Day Guide

Nacha Cattan and Justin Villamil

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Mexico’s central bank will probably lower borrowing costs for a third straight meeting Thursday and continue monitary easing into next year as inflation slows, eroding the carry trade appeal of the Mexican peso.

The central bank, led by Governor Alejandro Diaz de Leon, will reduce the key rate by a quarter point to 7.50%, according the estimate of 17 of 26 economists surveyed by Bloomberg. The other nine forecast a half-point cut to 7.25%.

President Andres Manuel Lopez Obrador often points out that the peso is the strongest major currency since he took office in December. But much of its demand is due the carry trade whereby investors borrow in currency where interest rates are low and buy into those with higher rates, such as Mexico.

Mexico currently has the third-highest real interest rate (the gap between the policy rate and inflation) among major economies, exceeded only by crisis-stricken Argentina and Turkey. But as Mexico’s borrowing costs tick steadily lower, the rate differential against other currencies -- and hence the peso’s allure -- becomes less pronounced.

“We believe the peso will depreciate gradually for the rest of the year and into 2020 as the carry advantage of the peso erodes,” said Juan Carlos Alderete, an economist at Grupo Financiero Banorte. The rate will end next year at 6%, and the peso at 21.30 per dollar, he said.

Interest rate cuts may be more important than ever now, as Mexican growth continues to disappoint both investors and the nation’s president. Lopez Obrador has brandished the strong peso as a weapon against critics who worry he’s scaring investors. But an easing cycle that weakens the exchange rate and makes exports more attractive could help Mexico’s economy far more.

Gross domestic product edged up just 0.1% in the third quarter after the economy narrowly avoided a technical recession in the second quarter.

The debate among economists and strategists isn’t whether the peso will depreciate, but how weak it will become. And that depends on where they see the easing cycle ending. After inflation plunged to the central bank’s 3% target, the real rate is now at 4.73%.

Economists forecast borrowing costs will end next year at 6.50% and the peso at 20.07 per dollar, according to the latest survey by Citibanamex. The exchange rate weakened 0.55% to 19.4637 per dollar in early Thursday trading.

For Christian Lawrence, a Rabobank strategist and the peso’s third-best forecaster in Bloomberg’s ranking, the central bank still has a while to go before robbing the peso of its appeal.

“By my estimates, rates can fall to 5% before the peso loses its carry trade shine relative to other currencies,” said Lawrence. But if policy makers cut more quickly than expected, by half a point on Thursday, the peso will weaken, he says.

Bank of America sees the central bank barely cutting rates, and ending the easing cycle at 7%, allowing the peso to remain strong. “We think that the differential with other countries will remain wide,” said chief economist Carlos Capistran.

(Updates with peso move in ninth paragraph.)

To contact the reporters on this story: Nacha Cattan in Mexico City at ncattan@bloomberg.net;Justin Villamil in Mexico City at jvillamil18@bloomberg.net

To contact the editors responsible for this story: Juan Pablo Spinetto at jspinetto@bloomberg.net, Matthew Bristow

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