Let’s do a case study on the impact of renegotiating trade deals. Specifically let’s look at Mexico and how the NAFTA talks are impacting their bonds.
Government bond traders are no strangers to macroeconomic shocks, political disruption, and massive swings in the yield curve, so the moves associated with all the NAFTA news – real or speculated – are making things interesting. These phenomena appear quite frequently in the history of the Mexican government. For example, the Mexican peso has depreciated against the U.S. dollar by over 50% over the past 20 years despite having a current account surplus with the U.S.
Currently, the Mexican yield curve is inverted which means that short-term yields are greater than longer-term yields. However, the Mexican yield curve is not strictly inverted. The short-end is kinked upward and then drops sharply, followed by a gradual rise toward the long end. Typically, an inverted yield curve is an early warning of recession in a given country because the bond market believes that the central bank will have to cut short-term interest rates to stimulate the economy. In response, traders push long-term rates below short-term rates.
Government bond yield curves will always price in two primary risks – currency depreciation and real interest rates rising. So what we can interpret from Mexico’s current yield curve is that in the short-term, the market is very concerned with currency depreciation and real rates rising.
The shape of the yield curve tells us that with all the recent conjecture surrounding NAFTA agreements and the U.S. promising to renegotiate trade agreements with major trading partners, the market expects that the Mexican economy will be fine in the longer-term after the NAFTA dust settles.
Despite having a history of currency depreciation Mexico has had a remarkably steady growth trajectory since the global financial crisis of 2008-2009. Real GDP has marched higher by 1-2% since the economy stabilized toward the end of 2010. Looking toward the future, inflation breakevens (the difference between the nominal rate on government bonds and inflation bonds) on the 30-year bond is at 3.7%. This implies a 30-year inflation rate of 3.7%. This forecast is on the low-end of what Mexican history has taught us and suggests the market is expecting forward inflation to be lower than historic norms. One possible trade thesis is that as Mexico becomes a more developed world economy and the currency stabilizes, inflation will revert to a more developed world economy rate such as 2%.
It is worth noting that Mexico’s largest trading partner is the United States- any disruption between the two countries’ current account would deeply affect economic growth.
So if you expect NAFTA to work out in any decent way, the trade to make would be to ride the short-term Mexican bonds down the yield curve. Own the short-term bonds and watch them appreciate as the curve reverts back to a more normal shape. Additionally, when inflation expectations come in below market forecast, an investor can earn the excess returns that come from an appreciation of the Mexican peso vs. the US dollar. The short-term noise surrounding NAFTA can be a huge opportunity.
