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Mexican yields widen as Banxico sees no urgency for easing

July 6, 2017

The Mexican curve bear flattened amid the market’s hawkish take on Banxico’s minutes.

With information available until 6:30pm Brasilia time

Highlights

  • The Mexican curve bear flattened amid the market’s hawkish take on Banxico’s minutes (see Macro Backdrop). In TIIE swaps, the 2-year widened 9bps to 7.02% and the 10-year increased 4bps to 7.28%. The curve implies 65-85bps in rate cuts for next year (pending on term-premium assumption). Real rates also went up as the Jun-19 increased 3bps to 3.17%. The MXN is trading 0.25% stronger to 18.26/USD.
  • Elsewhere, currencies were mixed. The CLP was broadly stable at 665.75/USD (+0.02%). Then, the COP depreciated 0.32% to 3,094.68/USD and the BRL posted losses of 0.28% to 3.2984/USD.

Macro Backdrop

BRAZIL
  • According to Anfavea, auto production reached 212k in June, below our forecasts (221k). May production was revised upward to 251k from 237k in the first release. We estimate auto production fell 5.3% mom/sa in June following a 15.9% increase in the previous month. Despite the seasonally adjusted decline, the result is not a clear signal that the sector performance was already affected by the recent increase in political uncertainty, given the strong increase in May and the high volatility in the monthly series. Along with other economic activity indicators (such as energy consumption, imports and capacity utilization) our preliminary forecast for industrial production in June is -0.8% mom/sa. Also, the production breakdown shows the decline was driven by light vehicles (-9.7%), while trucks and buses rose 3%, up for the fifth consecutive month. Exports rose 0.3% mom/sa and 49.8% yoy, while domestic sales rose 2.8% mom/sa and 13.5% yoy over the same period. The strong year-over-year figures highlight the improvement from 1H16, yet the sector activity level remains well below 2011-2013. Inventories remain at low levels, not only in absolute terms but also relative to sales. Finally, employment in the auto sector fell to 121.6k in June from 121.9k in the revised May figure. The strong gain in employment shown in the previous release for May was erased in revision. 
  • Why the spending ceiling won’t be a problem next year? Estadão newspaper recently reported that investors are worried with the possibility that the constitutional spending ceiling is breached by 2018. We see problems to comply with the ceiling starting only in 2019 if no measure is taken whatsoever. Also, we highlight that concerns could be postponed by around two years if the government manages to approve the end of the annual bonus (which also usually comes out on the media as being studied, but needs a constitutional amendment to be implemented) and of the payroll tax exemption (which is already being discussed – at least partially – in Congress by an ordinary law) in the meantime. From 2021, complying with the ceiling becomes harder and needs a deep reform in public primary expenditure. Full Report Below
MEXICO
  • The minutes of the most recent policy rate decision in Mexico confirmed the message in the statement: the bar for additional rate hikes is high, but new rate increases are not completely off the table given the still challenging environment for inflation. When discussing future policy decisions, the majority of members - who opted to include in the statement that the 7% policy rate level is consistent with bringing inflation to the target (signaling that the cycle is likely over) - thinks there is room to “pause” in the cycle (which is much weaker wording than “end of the cycle”) given that inflation is evolving in line with forecasts. This suggests, to us, that the majority would be open for new rate increases depending on inflation deviations from the path projected in the most recent inflation report. It is interesting to note that even the board member who voted to keep the policy rate on-hold mentioned the possibility of new rate increases and commented that it could be difficult to implement the rate cuts that markets are expecting for 2018 considering the uncertainties associated with the presidential elections next year. 
  • Our base-case scenario is that Banxico will take a cautious approach, amid Fed rate hikes and uncertainty over presidential elections next year, so the board will likely remain on-hold for long. All-in, by reading the minutes it seems that there is no appetite for rate cuts in the near-term, and we cannot completely rule out additional rate hikes (but that would require more meaningful deviations of inflation from the path projected by the central bank). Overall, our take is that given that policymakers do not see the current real interest rate level as tight and considering that we expect the economy to be growing at a decent pace in early 2018, there would be no urgency for monetary easing. We see rate cuts starting only in the second half of next year. Full Report
  • The monthly proxy for private consumption is showing weaker momentum, as real wages fall (due to higher inflation) and other determinants - with the exception of employment - turn less supportive. Private consumption expanded at a weak 1.4% year-over-year in April, affected by a negative calendar effect, pulling down the three-month moving average growth rate to 2.7% year-over-year (from 3.5% in March). We note that the positive and negative calendar effects of March and April, respectively, given non-overlapping Easter holidays, should largely cancel out each other. At the margin, seasonally-adjusted private consumption grew 0.4% from the previous month, with the quarter-over-quarter annualized growth rate decreasing to 1.1% (from 2.5% qoq/saar in March) which is about one-fifth of the average prints observed in the second half of last year. 
  • We expect private consumption to remain weak in the months to come. Real wages have been falling since the beginning of 2017, when inflation spiked. But the real wage bill has only slowed down moderately because robust formal employment (growing at an average pace of 4.3% year-over-year in the first five months of 2017) has prevented this from happening. Nevertheless, in our view, formal employment creation will eventually deteriorate as investment slows down. In fact, gross fixed investment is weakening substantially (-7.2% qoq/saar in April). Moreover, other fundamental determinants of private consumption have also turned less supportive. Given a stronger MXN, remittances converted into pesos grew 8.1% year-over-year in May (significantly below the 29% average growth rate observed in 2016). Seasonally-adjusted consumer confidence fell 0.8% month-over-month in June (to 84.4), with its current level not far from the average of 2009 (80.5) when the Mexican economy was undergoing a deep recession. Consumer credit, however, has only slowed down a bit (to 10.6% year-over-year in May, from 11.2% in April and an average growth rate of 12.3% in 2016), in spite of much higher domestic interest rates. Full Report
CHILE
  • The institute of statistics (INE) reported nominal wage growth of 4.4% year-over-year in May, broadly stable from the previous four months. Nominal wages grew 4.3% in the quarter ending in May (same as in 1Q17, but a slowdown from the 4.9% in 4Q16 and 5.1% in 3Q16). Adjusted for inflation, wage growth was 1.8% year-over-year in May (1.6% in April), aided by the decline in inflation. In the quarter, real wages grew 1.6%, broadly stable from 1.5% in 1Q17, but remains below 2.0% in 4Q16. The real wage bill growth increased to 3.4% in the quarter (3% in 1Q17 and 4Q17), when total employment growth is considered. Meanwhile, when only salaried employment is included, the real wage bill in the quarter rose 2.8% year over year (1.0% in 1Q17 and 1.9% in 4Q16). A loosening labor market will likely lead to nominal wage inflation staying low, meanwhile the drop in inflation to the lower bound s of the central bank’s 2%-4% tolerance range will support real wage growth.
COLOMBIA
  • Inflation came in below expectations in June. The monthly inflation (0.11%) was below our forecast of 0.19% and the market consensus of 0.20%. As a result, annual inflation re-entered the 2%-4% range around the target for the first time since January 2015. The fall in annual inflation (to 3.99% from 4.37% in May) was aided by base effects and will likely fall further in July, before starting to rise again as base effects become unfavorable. The month-over-month inflation was led by entertainment prices (2.85%), while housing and healthcare inflation (0.08pp contribution) also helped pull prices up in the month. The main drag on inflation in the month was food prices, which declined 0.21% from May (+0.5% in June 2016). The core measure excluding food posted a 0.25% increase, versus the 0.47% rise one year ago.
  • We expect two additional 25-bp rate cuts this year (in the July and August meetings). In line with our view of limited additional easing, on Wednesday (July 5), the Banrep Governor Echavarría warned that room for lower interest rates is getting smaller. Meanwhile, following the release of the inflation figures, finance minister Cardenas (who has been the most vocal board member on the need for lower rates and who has voted for 50-bp rate cuts) raised caution that further rate decreases are going to be more debated, slower, and gradual. Full Report
Market Developments 
  • GLOBAL MARKETS: EONIA rates widened (5-year: +5bps to 0.13% - last seen in September 2015) as markets had a hawkish reading of the ECB minutes. The document highlighted that some members considered altering the bias for QE on this meeting, and though the board ultimately decided to keep it, this could be revisited “as the economic expansion proceeded and if confidence in the inflation outlook improved further”. We believe that the removal of the QE easing bias is unlikely to come anytime soon. Global Markets Tracker
  • CURRENCIES & COMMODITIES: Commodities were mixed in the session. Oil prices pared the post-DOE rally (Brent: +0.23% to USD 47.90/bbl) on Russia’s Energy Minister Alexander Novak remarks. He said that Russia don’t see the need to implement additional steps (such as deepening the cuts or extending them beyond March). On the other hand, iron ore fell 1.18%. LatAm FX were mixed. The CLP was broadly stable at 665.75/USD (+0.02%). Then, the COP depreciated 0.32% to 3,094.68/USD and the BRL posted losses of 0.28% to 3.2984/USD. The MXN is trading 0.25% stronger to 18.26/USD. FX & Commodities Tracker
  • CDS SPREADS & EXTERNAL BONDS: Credit spreads for the 5-year tenor widened across LatAm. In Mexico, spreads inched up 1bp to 116bps and in Chile they went up 2bps to 68bps. In Colombia and Brazil, CDS increased 3bps to 143bps and 245bps, respectively. External Bonds and CDS Tracker
  • LOCAL RATES – Brazil: Brazilian yields marginally fell. In DI futures, the Jan-18 inched down 1bp to 8.80% and the Jan-21 went down 2bps to 9.96%. Likewise, breakevens narrowed as the 5-year fell 5bps to 4.55%. Brazil Rates Tracker
  • LOCAL RATES - Mexico: The Mexican curve bear flattened amid the market’s hawkish take on Banxico’s minutes (see Macro Backdrop). In TIIE swaps, the 2-year widened 9bps to 7.02% and the 10-year increased 4bps to 7.28%. The curve implies 65-85bps in rate cuts for next year (pending on term-premium assumption). Real rates also went up as the Jun-19 increased 3bps to 3.17%. Mexico Rates Tracker
  • LOCAL RATES – Chile and Colombia: In Chile, yields traded range bound. In Camara swaps, the 9-month inched down 1bp to 2.45% and the 5-year stood flat at 3.49%. Chile Rates Tracker In Colombia, rates widened in the session pressured by the rise in core yields. In IBR swaps, the 18-month increased 3bps to 4.98% and the 5-year widened 14bps to 5.51%. Colombia Rates Tracker

Friday Events

  • In Brazil, markets will focus on June's IPCA. We expect a 0.17% monthly decrease. 
  • In Mexico, INEGI will announce June’s CPI inflation. We expect a 0.20% month-over-month print. 
  • In Chile, INE will publish inflation for the month of June. We expect prices to fall 0.1% from May. As a result, annual inflation would dip to 2.0% reaching the lower bound of the 2%-4% tolerance range. Then, the central bank will release the trade balance figures for June. We forecast a USD 100 million surplus.

Latam Macro Calendar

For details, refer to our Monthly Strategy Report.

Today's editors: Eduardo Marza, Pedro Correa


Macro Reports

Complying with the constitutional spending ceiling won’t be a problem in 2018, even considering the strong decline on inflation.  

First, it’s worth remembering that the ceiling was defined as leaving the 2016 federal primary expenditure constant in real terms, with the indexer being June’s IPCA inflation. On one hand, large revenues provided by the repatriation bill boosted 2016 spending at least by 20 BRL bln and hence inflated the ceiling starting point.  On the other hand, inflation will be much lower this June  than it was in the past  years and than it was forecasted when the ceiling bill was approved in December. In our case, we forecast 3.1% y/y for June inflation now, but had forecasted 4.7% y/y in December, meaning a 20 BRL bln decline on the ceiling for 2018. In other words, inflation decline is only cancelling  the artificial room created by a higher spending in 2016.  

Second and most important, the government will spend far below the ceiling this year. As a part of the effort to achieve a very tight primary balance target, the government is implementing a large cut of 39 bn (or 0.6% of GDP) on discretionary spending. The ceiling for 2018 doesn’t change, regardless of the actual spending of 2017. So, given the high magnitude of this cut, if 2018 budget sets expenditure to return to the cap, actual spending will grow much more than inflation this year. Actually, as the economic recovery is lagging, the government will very much likely need to spend less than the ceiling in 2018 and to keep the level of discretionary spending more or less stable in real terms.

We believe problems to comply with the ceiling will start only in 2019 if no measure is taken whatsoever. Social security beneficiaries rise around 3.5% each year due to an aging population and will continue to do so in the short term even if a reform is approved. Hence, the share of this benefits in total spending will keep rising and other expenditures will have to decline in real terms in order to avoid a breach of the ceiling.

Concerns could be postponed by two years if the government manages to approve the end of the annual bonus and of the payroll tax exemption. While the first usually comes out on the media as being studied and needs a constitutional amendment to be implemented, the second is already being discussed – at least partially – in Congress by an ordinary law.

From 2021, complying with the ceiling becomes harder and needs a deep reform in public primary expenditure. Besides the above-mentioned measures and the changes already included as triggers if the ceiling is breached (such as no real increases in the minimum wage and no nominal increases to active public servants), a full social security reform is mandatory. We notice that every social security reform is gradual and hence takes time to generate the desired savings in fiscal accounts, which get lower in the next 10 years in the case of a delay on its approval. Actually, we estimate that a 2 years delay in the current reform proposal takes off around 15% of the estimated impact until 2025.

Pedro Schneider



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