Mexico’s headline inflation came in below expectations in May, with prices falling 0.21% versus a forecast drop of 0.12%. The outturn signals a deeper month-on-month decline than markets had projected.
The data point to a softer near-term inflation trajectory for Mexico in May, as the overall price level contracted more sharply than anticipated. With the actual reading undershooting the consensus forecast, attention is likely to turn to whether the disinflation trend persists in the next releases.
Implications For Banxico Policy and Market Rates
Given the surprise deflation in May, we now see a much higher probability of a rate cut from Banxico in the third quarter. This data gives the central bank significant room to ease monetary policy sooner than previously expected. Our focus is now on positioning for lower short-term interest rates.
We believe the market will quickly price in more aggressive easing, with swaps likely moving to price in at least 50 basis points of cuts by year-end, up from roughly 25 points before this report. Derivative traders should consider receiving on the TIIE swap curve to capitalize on this repricing. Historically, Banxico has acted decisively when inflation undershoots this significantly.
Currency Dynamics and Opportunities in Volatility
The effect on the Mexican Peso is less straightforward, creating opportunities in the options market. While lower inflation is fundamentally positive, rate cuts diminish the currency’s carry trade appeal, especially as recent U.S. data shows core inflation there remains sticky at 3.5%. This policy divergence could put upward pressure on the USD/MXN exchange rate, which has already climbed 1.5% in the last month.
It is critical to note that much of this deflationary pressure comes from seasonal government subsidies on electricity tariffs, a pattern observed in previous years during the hotter months. Core inflation, a better indicator of underlying trends, moderated only slightly to 4.1% annually, which will likely prevent Banxico from cutting too aggressively. This suggests the market’s initial reaction might be overdone.
This increased uncertainty about Banxico’s path makes a rise in currency volatility likely. Implied volatility on one-month USD/MXN options is still relatively low at 11%, compared to peaks above 15% seen during previous periods of policy shifts. We see an opportunity to buy near-term volatility through straddles, betting on a larger price swing as the market digests the tension between a dovish central bank and a weakening carry trade.
