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What's Driving the Dollar's Recent Rise Against the Peso?

Updated: Apr 26

If you've ever thought to yourself, wow expats in Mexico sure are fixated on the direction of the dollar-peso exchange rate -- you're mostly right.


And even if you couldn't care less about currency markets, as an expat you're probably affected by the direction of the Mexican peso. This is because many foreigners living in Mexico earn dollars and spend in pesos.  


If that describes you, the past two weeks have been comforting, as the U.S. dollar has appreciated about 5% against the Mexican peso (while rising against the Euro and Yen as well).


why is the dollar rising against the peso
Source: XE. Disclosure: This post contains affiliate links, i.e. if you purchase through them, I earn a small commission. This doesn’t cost you anything but enables me to keep this blog 100% free to read.


Why is the Dollar Gaining Ground Against the Mexican Peso Now?


U.S. GDP growth. The U.S. economy is putting up strong numbers lately, especially when viewed alongside those from Japan, Canada and the EU.


Today's report that U.S. real GDP decelerated to +2.5% in Q1 2024 still keeps U.S. economic growth comfortably ahead of its peers.


why is the dollar rising against the peso
Source: Bureau of Economic Analysis

There are two big drivers of recent U.S. growth. First, consumer spending is still kind of on fire. Economists have been predicting an end to this buying binge (incorrectly) for a while now, and somehow, it's still going.


Second, there is government spending. Emergency spending during the pandemic was unavoidable, while new infrastructure spending was arguably a good idea after decades of neglect. 


But large and sustained budget deficits during the subsequent years of economic strength are unprecedented. At the moment, the U.S. is adding ~ $1 trillion yearly to the national debt.


Whether or not you agree with this spending, the writing's on the wall. Chronic and large U.S. budget deficits must be financed somehow.


Attracting the capital to do so means offering appealing interest rates to these investors and savers. Which leads me to the next huge factor...



The "Fed" won't be cutting interest rates anytime soon. Persistent inflation and large budget deficits have put the U.S. Federal Reserve in a tight spot.


U.S. core inflation (excluding volatile food and energy prices) rose to 3.8% in March, up a little from February, while services inflation (69% of consumer spending!) came in hotter with a 5.3% increase, led by continuing price hikes in housing, auto insurance, travel, and health care services, among other things.


The chart below illustrates how U.S. inflation has gotten stuck recently, with a string of monthly increases slightly below 4%, or nearly twice the Fed's target.


why is the dollar rising against the peso
Source: Bureau of Labor Statistics

Given sticky inflation, the Fed's now signaling that rate cuts are not imminent (after signaling earlier this year that they were), lest they throw more fuel on the fire.


These numbers have jolted the markets and shifted expectations. In addition, with U.S. unemployment sitting at 3.8% and hiring continuing to outpace expectations, there's one more reason for the Fed to stand firm.


And if U.S. inflation remains stuck, interest rate increases may be back on the table for the Fed, providing yet another boost to the U.S. dollar.


The rate spread between the US and Mexico has narrowed. While Banxico (Mexico's central bank) cut interest rates by a quarter-point rate in March (from 11.25% to 11%), progress in bringing down Mexico's inflation rate has also fizzled lately.


In the first half of April, inflation re-accelerated to 4.63% from 4.43% the prior month. As such, more rate cuts from Banxico probably aren’t happening anytime soon.


why is the dollar rising against the peso
Source: INEGI

For those who read my post in early 2024 discussing the peso outlook, you know that the rate spread between two countries influences capital flows, which in turn impacts the exchange rates in those same countries.


As the rate spread narrows between the peso and the dollar, it should benefit the dollar.


Geopolitical risk is increasing globally. When Iran and Israel began trading missile attacks earlier this month and the markets contemplated a wider Middle East conflict, the dollar quickly gained against its peers. This is what's referred to as a “flight to quality."


In this scenario, demand for U.S. dollars spikes because Europe, China, and Japan are seen as more vulnerable economically due to their greater dependency on energy from the Middle East compared to the U.S.


Capital is leaving China at the fastest rate in 7 years. Since the pandemic, manufacturing capacity has been shifting out of Asia (and China in particular) to markets closer to the U.S.


This trend has benefited Mexico (in what's known as "nearshoring") and contributed to an investment slowdown in China, which now appears overbuilt relative to demand. Capital flight from China has subsequently increased demand for U.S. dollars.


And for those who assume that nearshoring should continue to benefit the Mexican peso versus the dollar, you may want to consider Mexico's straining infrastructure.


One headwind for additional nearshoring is a lack of energy capacity due to years of under-investment by Mexico's public utilities, including CFE, Siapa, and Pemex. On top of that has been super-low investment in renewable energy despite Mexico's obvious advantages in this area.


As such, direct investment in Mexico is unlikely to be sustained at the feverish pace of the past few years.


Conclusion


While no one knows exactly where things are headed next, current trends should put a floor beneath the dollar and will likely prevent a return to the lows seen earlier this year against the peso.


Barring more geopolitical shocks, I'd expect things to hold fairly steady between the dollar and peso in the short term, with the potential for further dollar appreciation as we lead up to Mexico's presidential election on June 2.


 

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