Liquidity remains high: central banks are beginning to ease monetary policies.

The past month has seen relevant economic events that impacted financial markets worldwide. From the reevaluation of the Chinese currency (albeit marginal) to cuts in Brazilian interest rates, repercussions were felt on the global scale. And while the United States attempts to restrain liquidity, Mexico's local markets are looking for how to best seize the opportunity.

On August 9th, the Federal Open Market Committee (FOMC) announced yet another 25 basis-point hike to the Fed Funds Target Rate, sending it to 3.50 percent. This was a most anticipated continuation to the Fed's attempts to move towards more neutral monetary conditions, i.e. close the faucet on the excess liquidity that the United States has poured on global markets since its central bank decided to keep historical lows in the Target Rate (1.0 percent until June last year).

Unfortunately, the reduction in monetary incentives has not achieved the desired effects in the United States or throughout the globe, and other places are already looking the other way and central banks are beginning to ease local monetary conditions. In the United Kingdom, after a disappointing economic performance, interest rates were cut by 25 basis points (to 4.50 percent). Brazil is also on the road to easing its monetary policy. The bullish scenario for the Real (the Brazilian currency) helps the Monetary Policy Committee (Copom) keep inflation in line.

Despite Alan Greenspan's (the U.S. Federal Reserve's chairman) best intentions, liquidity remains high in the U.S. and in the rest of the world. This due to the fact that the 10-year U.S. Treasury bond has not responded to the ten consecutive hikes in the Fed Funds since June 2004. With the gap between short and long-term interest rates getting smaller, demand for loans and mortgages is likely to remain high and not deter U.S. consumption.

The recent performance of local economic indicators in Mexico has been disappointing. The Bank of Mexico, after determining that internal demand would not be enough to drive growth, revised its forecast for economic growth downward, moving from an expected increase ranging between 3.50 and 4.0 per cent, to between 3.25 and 3.75 percent. Compounding this revision, investment and industrial output data fell in seasonally adjusted figures. Furthermore, listed companies' quarterly reports offered mixed-results at best, with the lowest Ebitda (Earnings Before Interest, Taxes, Depreciation, Amortization) growth rate in the last six quarters. Thus, in spite of having reached historical peaks in the Stock Market Index in the past month due to optimistic growth expectations, softer economic data will outweigh the optimism derived from falls in local interest rates towards the last quarter.

The next two months provide an interesting opportunity. Although more monetary restriction in the United States is expected to come in the form of an additional hike to the Fed Funds Target Rate on September 20th (to 3.75 percent), the time seems to be ripe for Mexico's central bank to begin hinting an easing of monetary conditions. In the best case scenario, inflation for the first half of September, to be reported on the 22nd, will be the first reading to come below 4.0 percent year-on-year according to consensus, closer to the official target of 3.0 percent. Following the inflation report, on Friday 23rd, the Bank of Mexico will release its monetary policy announcement. As a result of the anticipated favorable inflation reports and taking into consideration the continued stability in long-term U.S. rates, Mexico should contemplate allowing interest rates to fall modestly. Even though this would mean lower interest rate differentials between Mexico and the United States for short-term instruments, low long-term U.S. yields would continue to set the mood for the peso. Remaining below $11.00 per U.S. dollar, the peso holds a favorable outlook for the remaining of the year.

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With any luck, late September may hold the dawning of gradual reductions to the overnight interest rate from its current 9.75 percent. Chances are that we will see an inaugural drop of 25 basis points.

Adrian Rizo works in Fixed Income and Foreign Exchange Strategy at HSBC Mexico. He is responsible for the development of investment strategies for local debt and foreign exchange markets.