Kicking back: peso stronger, stocks face possibility of summer lull.

The global markets of the last few weeks have displayed a growing volatility in response to a wide range of factors. Interest rate hikes seem to be slowing, as economic data in the United States points toward weakening manufacturing data. And in spite of consecutive interest rate hikes by the U.S. Federal Reserve, the U.S. secondary bond market has helped keep a lid on mortgage rates. In other words, not many Wall Street players have a clue where the cost of borrowing is headed.

Additionally, hopes for a European constitution and economic stability on the far side of the Atlantic were dampened by the French and Dutch electorates, whose "no" votes on the bloc's draft constitution helped boost the dollar against the euro.

Against this backdrop, the Mexican peso climbed to levels not seen since early 2004. The strengthening peso, though a clear sign of confidence in Mexico as markets head into an election season, will certainly apply a bit of pressure on the country's export sector.

Mexico's Central Bank, which has been tightening monetary policy during the past few months (12 rate hikes since February), is likely to take it easy during the summer months, according to one local trader. Summer is normally a soft inflation season.

May inflation numbers, officially announced on June 9, came in better than expectations with a deflation of -0.25 percent reported. This, combined with strong expectations on the corporate profit front, will give some hope to market players with regard to a possible summer rally.

This year the summer market will also confront the fast approaching presidential election season.

"There will certainly be political pressure to keep rates low," said one Latin American political analyst. "But much will depend on the direction of U.S. rates. For now they seem to be under control, although Alan Greenspan recently mentioned in public that the rate hike season was not necessarily over," said a local trader.

The Mexican stock market experienced a strong May rally with stocks up over five percent, but volume levels were low. In late May, the IPC closed above 13,000 points--a psychologically important level. Though impressive, the ensuing weeks of trading on the bolsa revealed that investors were quite willing to indulge in profit-taking during the last week of May and in early June.

"Brazil Effect"

Another factor that is rarely mentioned amongst local players is the "Brazil effect." During the past few weeks the Brazilian equity market, facing lower-than-expected growth announcements and a growing political crisis which threatens to undermine confidence in the Lula government, has suffered a sharp drop.

Normally, this type of drop in confidence results in a type of switch play, where capital flows are diverted to a safer port of call. In this case, the natural beneficiary of a decline in Brazil market confidence would be the Mexican capital markets.

To date there has been no evidence of diverted funds into the Mexican markets, but if the crisis of confidence in Brazil should continue, it could prove to be invaluable to Mexico as it heads into what is shaping up to be an unusually warm summer.

To the market's relief, the Central Bank held off raising rates and maintained the interbank daily short money position at -79 million pesos. Important to note: it is in the interests of the PAN to maintain a lid on interest rates to mitigate any negative consumer reactions during the last months of 2005. Let's hope we don't once again find ourselves with an overvalued peso as Mexicans head to polls.

Ramon Ruiz ([e-mail]) is a director of Vintage Partners.