Itaú BBA - Receive 3y and pay 1y rates in Mexico’s local curve – Local Rates Trade Idea

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Receive 3y and pay 1y rates in Mexico’s local curve – Local Rates Trade Idea

February 20, 2018

We recommend paying the 1-year rate at 8.08% and receiving the 3-year rate at 7.89%, DV01 neutral

Mexico’s central bank increased its policy rate by 25-bps in February, extending its tightening cycle (that started in December 2015) to 350-bps. As a result, Mexico’s real interest rate stands at a substantially high level historically. We use the 1-year ahead nominal rate against inflation expectations 12 months ahead to find that the ex-ante real interest rate currently stands at 3.8%, 260bps higher than the post-Lehman crisis average, since January 2009 (see chart).
 

In our baseline scenario, the central bank is unlikely to raise interest rates further, but risks in the short-term are tilted towards more rate hikes. In the most recent monetary policy decision, the central bank downgraded the importance of the Fed for its upcoming meetings, suggesting that the likely March’s rate hike in the U.S. is unlikely to be a trigger for another policy move in Mexico. Still, the central bank did not close the doors for further rate hikes, given on-going risks related to NAFTA renegotiations, Presidential elections, besides monetary policy in the U.S. Furthermore, although inflation is falling, it remains far above the upper bound of the target.

We recommend paying the 1-year rate at 8.08% and receiving the 3-year rate at 7.89%, DV01 neutral (with a small negative carry of -0.15% annualized). The front-end of the TIIE yield curve prices in around 40bps in hikes over the next 6 months and a (very) slow easing cycle thereafter. The curve currently implies that the policy rate will still be close to 7.4% three years from now, just a tad lower than the current 7.50%. The trade reflects our view that amid declining inflation (we expect 3.7% this year, down from 6.8% last year) and growth around potential, the monetary policy rate will likely normalize ahead, while the 1-year paid position hedges against the intensification/materialization of the abovementioned risks in the short-term (which would likely trigger further rate hikes).

We would switch this recommendation to an outright receiving position if/when the risk events (mainly Presidential elections and NAFTA renegotiation) pass without significant changes in asset prices. Then for cash investors, we would recommend going overweight bonds of duration close to 3 years, such as the MBono June 2021.

For other trade ideas in LatAm local rates, please refer to the links below:

Receive Brazilian local rates as inflation remains low and election risk declines (current P&L: +0.66%)

Receive Colombian 18m IBR rates again as yield curve prices in almost no rate cuts ahead (current P&L: 0.08%)



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