Date
23 October 2017
Inflation in Mexico has recently spiked due mostly to the depreciation of the peso. Photo: Kuow
Inflation in Mexico has recently spiked due mostly to the depreciation of the peso. Photo: Kuow

Brazil and Mexico make interest rate history

Brazil and Mexico have long battled it out as heavyweights of the Latin American economies. For much of the new millennium, one defining feature of their rivalry is that Mexico has had lower interest rates than Brazil – a rough testament to the less benign macroeconomic conditions in the South American nation.

Now things may be about to take a turn – Brazilian rates are set to fall below Mexico’s for the first time in 16 years.

Improvements in Brazil’s economy and political backdrop have allowed the central bank to cut its policy rate by six percentage points to 8.25 percent over the past year. If current conditions persist, it may be on track to cut it further to match or even go below Mexico’s 7 percent in six months.

Former President Dilma Rousseff’s impeachment last year gave Brazil a confidence boost. The Brazilian real started to appreciate, the new administration emphasized fiscal discipline, the new central bank chief signaled a return to proper inflation-targeting, while a record-breaking harvest sent food prices falling. Inflation expectations plunged, with inflation now running at 2.5 percent, well below the 4.5 percent official target.

As Brazil emerges from recession, price pressures are likely to be contained in 2018, in part due to inflation “inertia” – mostly a result of price indexation in the economy. This positive growth-inflation mix will have a decisive impact on investor interest in President Michel Temer’s privatization program, and possibly result in a market-friendly outcome to the presidential election next year, one that would sustain the economy’s newfound virtuous cycle.

Mexico’s outlook is less rosy relative to Brazil’s. The economy is growing at an uninspiring pace, and some headwinds are on the horizon. While the ongoing NAFTA renegotiations may end favorably for Mexico, little progress has been made and the time to successfully modify the trade deal is getting shorter, with upcoming midterm elections in the US and general elections in Mexico. And although the threat of center-left Andres Manuel Lopez Obrador in the 2018 presidential election could be thwarted, his poll performance has been strong and Mexico’s single-round electoral system could play in his favor.

Inflation in Mexico has recently spiked due mostly to the depreciation of the peso – a temporary factor. But although the central bank may eventually cut rates, it may choose to delay the decision; a new governor will take office in November, and he may wait to see more benign price signals before taking action, in part to cement credibility. The earthquakes that hit Mexico in September could also prevent a faster drop in inflation.

All this gives Brazil the opportunity to make economic history by having interest rates below that of its Latin American competitor. Over the coming years, their interest rates may frequently cross one another – a new era compared to the past 16 years of persistent gaps. This indicates that the competition between the two economies is likely to intensify.

Despite their convergence, rates in Mexico and Brazil remain above those in advanced countries. For investors, this makes the peso and the real attractive relative to the US dollar and the euro on a six-month horizon, and also puts Brazil’s US dollar sovereign and corporate bonds in a good light.

– Contact us at [email protected]

RT/RA

Regional Chief Investment Officer, Emerging Markets, UBS

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