By Indrani De, CFA, PRM, and Zhaoyi Yang, FRM, Global Investment Research
Brazilian real and Mexican peso are the only major currencies that have outperformed the strong US dollar YTD September 30, 2022. By the end of Q3 this year, Brazilian real and Mexican peso have gained 2.9% and 1.7% relative to the US dollar, respectively, both helped by the rally in Q1. Even in Q3, which saw a brutal sell-off in almost all currencies except the dollar, peso and real have managed the smallest losses of 0.2-2.9% (Chart 1). The outperformance of these two currencies may seem modest in absolute terms, but it is pronounced in the context of a strengthening US dollar, particularly so since April: The US Dollar Index (DXY), a measure of the value of the USD against a basket of US trade partners’ currencies, is up by 16.8% by the end of the third quarter, despite some criticisms that the content of the currency basket is due to be replaced to represent major US trading partners. But what factors could have been the drivers of the stronger real and peso in 2022? Perhaps the discussion could start with reasons related to the strong export performance benefiting from higher commodity prices, widening interest rate differentials due to their central banks being ahead in monetary tightening for inflation control, and the changes in capital flow following the Russia-Ukraine conflict.
Surging commodity prices helped net commodity exporters like Brazil
Brazilian real has benefitted from its strong exports earlier this year, thanks to the strong demand and higher commodity prices, e.g., price rises in crude oil and agricultural products, amid the global supply disruptions since the Russian-Ukraine conflict started. Total exports of Brazil broadly increased in 2022, as Chart 2 shows, driven by the growth in crude oil and soybeans. Also, Chart 3 shows the positive correlation between commodity prices and Brazilian Real-USD exchange rate in recent years. Meanwhile in Mexico, higher energy prices led the government to reverse its plan to phase out crude oil exports (the plan was to reduce daily exports by more than half in 2022 and eventually end oil exports by 2023) in order to achieve self-sufficiency in the domestic fuel market instead of importing expensive refined products from US refineries. Mexico’s average export of petroleum products and crude oil was 960 thousand Barrel/Day in the first eight months of 2022 (dragged by the cut in January), only a modest reduction from the average 1.02 million in 2021 (Refinitiv). So, the combined effect of stable export in barrels, and surging oil prices, resulted in an upward swing in total values of Mexico’s oil exports and thus the currency value of peso.
Central banks in Brazil and Mexico tightened monetary policies much earlier than the US Fed
In face of the price pressures last year, the Brazilian central bank initiated its first interest rate hike in March 2021 to fight the higher inflation – followed by The Bank of Mexico in June – a year earlier than the US Fed, which didn’t react until March 2022, as Chart 4 shows. The interest rate differentials between these two Latin American markets and the US have remained substantial since then, although the Fed caught up very quickly in 2022, providing investors with an attractive opportunity for carry trades. Carry trade would have implied that the traders borrowed money in the low-yielding US dollar and invested in the higher returning Brazilian real and Mexican peso, and this resulting higher demand for the real and peso may have helped to push these currencies higher in the first quarter.
Capital inflows into the Brazilian financial market following Russia’s exclusion from equity indices
In addition to their higher interest rates, Brazil and Mexico benefitted from being relatively safe markets to invest in during the uncertain global environment since the war in Ukraine and the resulting energy crisis in Europe and attracted capital flows that moved out of Russia. According to data from Factset, USD 15.7 billion of capital moved into Brazil during the period from January 31st to March 8th, and Brazil’s weight in the FTSE Emerging All Cap Index increased to 6.8% on March 8th from 6.4% on March 4th (FTSE Russell deleted Russia from all its equity indices effective March 7th, given the sanctions on Russia). Both active and passive investment strategies were likely to have steered assets under management from Russia into Brazil, helping the currency pick up steam earlier in the year.
The Brazilian real could continue to show resilience, considering the double-digit interest rates and the cooling-down inflation within the country have made it one of the few with positive real interest rates, in sharp contrast with the negative real rates still seen in most developed and other emerging economies. Although a relatively high economic growth outlook in the longer term may also support the currency value, the uncertainty of the Presidential election in October could pose some short-term currency risks.
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Originally Posted October 28, 2022 – Why did the Brazilian Real and Mexican Peso outperform the super-strong US dollar this year?
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