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The Problem with Predicting Exchange Rates

Topics: Living | Money

Published: Wednesday, February 25, 2015

USD MXN Chart

In recent years, one of the hardest things to predict has been the Mexican peso/US dollar exchange rate. Just when the peso seemed to be making a comeback from the 2008 devaluation something else happened leading investors to move back into dollars, either buying US Treasury bonds as a safe place to park money (despite very small returns), or buying dollar contracts in futures markets to protect their foreign investments against depreciation of the currencies in which they have invested.

The 10-year dollar-peso chart above illustrates how the peso abandoned its relatively stable trading trading period of ~11 pesos to the dollar in the crisis of 2008 and devalued by over 40%.  During 2009-2010 the currency gradually regained its strength and traded between 11.5 and 13 pesos for most of the period between 2011-2014, albeit with a couple of brief forays into 14.

However, since the autumn of 2014, the Mexican peso has come under renewed pressure and is now selling at rates above 15 pesos to the dollar at retail exchange houses across the country.  Its latest weakness has been attributed to a plummet in world oil prices (Mexico is the world’s ninth largest oil producer) as well a general rise in the value of the US dollar against a basket of world currencies, especially emerging market currencies.

The weaker peso has its advantages and disadvantages. To begin with, it makes Mexico’s exports relatively cheaper, and therefore more competitive in the international market. Similarly, it makes vacationing in Mexico a more attractive option, and retirees living here with dollar-denominated pensions will find that their incomes stretch further when purchasing locally-produced goods.

For people with peso incomes, particularly those who travel frequently to the US, or who buy a lot of imported goods,  the depreciation of the currency is a definite disadvantage.

One thing that has changed in the past 15 years or so, is that currency depreciation hasn’t been reflected in high inflation in Mexico. In earlier decades, when the currency was controlled at a certain level until it became unsustainable and a devaluation was necessary, an immediate reaction in Mexico would be to put up the prices of goods and services even if they weren’t directly associated with the dollar–local rents, for example. This general knee-jerk reaction, with the excuse that “es que subíó el dólar,” would be reflected in general inflation, pushing up the cost of living for everyone.

This exchange rate effect has diminished significantly in more recent times, and today a higher dollar will only add to the cost of things such as imported goods, and products that require imported components.

The frequent and often sharp moves in the exchange rate can also create some difficulty in budgeting when expense planning involves two or more currencies. It would be nice to know what sort of exchange rate to expect.

And that is where there really isn’t a great deal of help forthcoming. Based on what economists call “fundamentals” — which include things like the country’s debt payments as a percentage of GDP, its trade balance (Mexico tends to have very small trade deficits), the rate of inflation, economic growth, etc. — the peso should theoretically recover against the dollar this year.

However, fiscal moves by the US Federal Reserve, or a blowout in Europe such as a debt default by one or more countries (or one or more countries abandoning the euro) would again cause investors to rush for the safe bets, such as the US dollar.  These types of global events would almost inevitably have an effect on the peso which, as an emerging-market currency, would be included in any emerging market sell-off.

The Bank of Mexico keeps regular track of what economists are expecting the peso to do. The Mexican central bank’s December 2014 survey forecast the dollar at $13.74 pesos by the end of 2015. Those estimates are highly susceptible to revisions as the year progresses and more recent polls of currency analysts have already moved that estimate higher, to around $14.80 pesos per dollar by the end of 2015.

See also: The Cost of Living in Mexico

Currency chart via XE.com

Comments about “The Problem with Predicting Exchange Rates”

  1. It seems to me that Canadians vastly outnumber Americans when it comes to snowbirds and ex-pats in the Puerto Vallarta area. Wouldn’t it be more appropriate to do your currency comparisons based on CAD? At the very least it should be included alongside USD when making comparisons.

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