The End of the Golden Era for CETES

Amid the ebb and flow of global economic tides, investors find themselves at a critical juncture in navigating the shifting landscape of monetary policy and investment opportunities. Inflation's unwavering trajectory throughout the year has sparked contemplation among major central banks toward more accommodating monetary policies. Economists foresee the United States and Mexico potentially closing out 2024 with Consumer Price Index (CPI) readings near 3.3% and 4.3%, respectively. Recent developments and CPI data in Mexico have been even better than expected, being on track to aim for CPI numbers by year-end, affirming that Banxico can start cutting rates. Mexico's National Institute of Statistics and Geography (INEGI) surprised investors with a lower-than-expected Consumer Price Index of 4.45% in its year-on-year variation for the first two weeks of February.

The latter assures investors that the National Bank of Mexico (Banxico) is positioned to initiate a series of interest rate cuts starting as early as its next meeting: March 2024. This signals a crucial moment for investors to reevaluate their portfolios and embrace diversification. With these impending cuts set to impact fixed income instruments, such as Certificates of the Treasury of the Federation (CETES), the next meeting could be renamed as the end of the golden era for CETES and short-term interest rates in Mexico, making it a crucial time for a strategic asset allocation review to seize new investment opportunities.

The prospective reduction in interest rates will inevitably affect the yields offered by fixed-income instruments like CETES. For almost two years, the scenario has favored low risk assets. Why take on risk for a 10 to 12% annual return on stock markets, when you can secure almost risk-free, other than country risk, a 11.0 to 11.4% annual rate with CETES?

As investors prepare themselves for lower future returns, the current juncture serves as a crucial inflection point for assessing prospective yields over the next year or more. While one may still secure attractive rates with a one-year CETES investment or any short-term fixed income instrument, the subsequent dilemma arises upon maturity, as investors face the prospect of diminished interest rates and less lucrative alternatives. Not being able to lock in long-term yields limits investors’ ability to generate attractive rates in a low rate environment, such as that which we will enter as central banks start cutting interest rates once again  to boost spending and credit investments, in order to maintain economic equilibrium.

Understanding interest rate dynamics is essential to decipher investor behavior. When interest rates rise, investors tend to flock to lower-risk instruments. This trend stems from the inverse relationship between interest rates and bond prices, where higher interest rates result in lower bond prices and, consequently, higher yields. Consequently, investors seek refuge in safer assets with reduced exposure to interest rate risk, such as government bonds and other fixed-income securities.

Conversely, a decline in interest rates prompts investors to explore higher-risk assets in pursuit of enhanced returns. This phenomenon is driven by the higher discount rate associated with a lower risk-free rate, impacting the valuation of riskier assets like stocks. As interest rates decrease, the opportunity cost of investing in equities diminishes, leading investors to reallocate their capital toward the stock market and other higher-risk assets in search of superior returns.

The global economic landscape significantly shapes investment decisions. Just like BANXICO, the US Federal Reserve  is looking into adopting accommodative monetary policies later in the year. As inflation recedes, these policies, including interest rate cuts, aim to stimulate economic growth, underlining the importance of diversified portfolios to navigate market shifts effectively.

Positive sentiment in the stock market may persist and even amplify in the near term as interest rate cuts loom. As the Federal Reserve prepares to follow with interest rate cuts in the second half of the year, in line with declining inflation, this presents an advantageous moment for investors to remain, or even allocate a higher percentage of their portfolios, in equities. Despite substantial market appreciation observed in the US market since October 2022, the supportive macroeconomic environment and accommodative monetary policies suggest further upside potential for equities. The opportunity cost of waiting to enter the equity market could be higher than that if interest rate cuts were to pause until early 2025.

Now, within a diversified portfolio blending equity and debt instruments, investors should consider extending the duration of fixed income holdings. By migrating toward longer-duration bonds with maturities ranging from five to seven years, investors position themselves not only to lock in current rates, but for potential yield appreciation amid declining interest rates.

Expected interest rate cuts by central banks, including Banxico, alongside global trends favoring accommodative monetary policies, emphasize the need for investment diversification toward riskier assets amid evolving market dynamics. Strategic asset allocation across asset classes is imperative to optimize returns and manage risk effectively, helping investors capitalize on opportunities and achieve long-term financial goals.