2024 is proving to be a difficult year for investors in the major Latin American currencies. The Brazilian real has depreciated over 11% against the dollar so far this year, while the Mexican peso and Colombian peso have lost 12% and 8%, respectively.
There are a number of factors behind this. The monetary policy cycle has, this time, been ahead of that of more developed economies. In Latin America, interest rates were raised earlier to combat inflation, and they have also been cut more quickly, detracting some interest from global investors. Many see politics as another contributing factor. Claudia Sheinbaum obtained a larger-than-expected majority in Mexico in the recent elections, joining Lula and Petro among the leaders who favour higher public spending financed through increases in the deficit.
A third factor—this one directly related to capital markets—has to do with the Japanese yen carry trade crisis that we witnessed in early August. The Bank of Japan surprised the market by raising the interest rate by 15 basis points, enough to trigger a sharp appreciation of the yen. Many investors, who had taken out loans in yen to invest in higher-yielding assets, began to quickly unwind their positions to limit losses. The deleveraging process, as often happens in such cases, amplified the movements. One of the main destinations for carry trade investors has been, and continues to be, Latin American currencies, especially the Mexican peso and the Brazilian real. The massive sell-offs in these currencies to unwind the carry trade operations caused sharp depreciations against the dollar and other strong currencies.
The recent weakness of local currencies presents a dilemma for central banks amid the interest rate cut cycle: continue cutting rates and at a faster pace than the Federal Reserve to stimulate growth and employment, or take a pause to, among other things, support the currency. We will likely find different responses on a case-by-case basis. Brazil, for example, has chosen the second option, setting itself apart from the rest of the region. After cutting the rate from 13.75% to 10.50%, the Central Bank of Brazil decided to raise the reference rate by 25 basis points to 10.75%.
Given the current environment of lower interest rates and expansive fiscal policies, a greater weakness of local currencies in Latin America should not be surprising This is why it is essential to adequately diversify risk in this area, especially for those investors with permanent exposure in these countries.
Date of report: October 7th 2024