(Bloomberg) -- Turmoil in the US and European banking systems is testing even the most bullish of emerging-markets cases.
Mexico’s currency — which over the past year shocked Wall Street with an astonishing rally — has seen a sharp reversal of fortunes this month. Its 24-hour liquidity left it exposed to a rapid unwind of bets on the “super peso” when investor appetite for risk soured, and it’s now lost about 2.7% of its value against the US dollar since reaching a five-year high on March 3.
Prior to the emergence of banking tremors, what had been the world’s most-punished currency at the onset of the pandemic was supercharged by an aggressive central bank, manufacturing investments amid global supply-chain rebalancing and surprisingly-austere fiscal policy. Now, despite those positives, peso bulls see the outlook hinging on what happens north of the border.
“Once the dust settles down, the peso should recover,” said Marco Oviedo, a senior fixed income strategist at XP Inc., Brazil’s largest brokerage. “The only real risk for the peso is some kind of Federal Reserve policy mistake or another shock to the global economy.”
In the last year, even despite the slide in recent weeks, the peso has risen 9% against the US dollar, making it second only to the Russian ruble in a Bloomberg basket of 23 major EM currencies. The currency edged higher on Monday as one-month implied volatility rose for a second day.
Taking into account the dollar’s own strength makes the peso’s run look even more impressive: Measures of the Mexican currency’s real effective exchange rate, which compares it to a broad, trade-weighted basket of currencies adjusted for differences in inflation levels, rose in early March to the highest levels since 2014.
But leveraged funds quickly dumped long positions in the currency in recent weeks, flipping net short for the first time in a year, according to the latest positioning data compiled by the Commodity Futures Trading Commission.
It’s not just the peso, of course. The turmoil in global financial markets sent shockwaves across developing-nation assets as traders dumped riskier positions. Jitters about global growth and interest rates sent currency volatility soaring, with the Mexican peso and the Hungarian forint seeing the worst of it.
One source of support for the peso has been the Banco de Mexico, which began raising interest rates in 2021 — nine months before the Fed — and took them much higher, from 4% to 11%. It’s expected to authorize another quarter-point increase at Thursday’s policy meeting, which would maintain the spread of Mexico’s benchmark rate over the Fed’s at a record 625 basis points following the US central bank’s hike last week.
Read More: Bond Traders See Fed Rate Hikes Ending Soon as Bank Stress Grows
But emerging risks to the US economy in the form of banking woes are suddenly looming large, highlighting the ultimate importance of the American consumer to the outlook for many emerging markets. Those risks threaten to undercut another important force that has propelled the peso: a rebalancing of global trade and manufacturing patterns amid the war in Ukraine and rising US-China tensions.
A growing number of companies are moving manufacturing to Mexico to be closer to the US market following widespread global supply-chain disruptions in recent years. Most recently, Tesla Inc. said it would invest in a new plant that Mexican officials estimate will cost billions.
That trend may help underpin a structural change in the relation of the peso to the Chinese currency, reversing a 20-year decline against the yuan. But in the near term, the case for the Mexican currency also relies in part on strong exports, which would suffer in a US economic downturn. Strong remittances and tourism flows would also take a hit.
“Mexico and the peso have benefited from a strong US economy so far, but that can change going forward,” Carlos Capistran, the head of Canada and Mexico economics at Bank of America, said.
One source of stability that is set to remain is the administration of President Andres Manuel Lopez Obrador. When he took office in 2018, investors originally viewed AMLO and his left-wing platform as a major risk. Instead, he turned out to be a fiscal hawk, opting for a much more austere budget approach even at the depths of the pandemic in 2020 than many other countries did.
Now, with under two years left in his term and many of his intended reforms already passed, investors aren’t anticipating much more in the way of new policy initiatives. That paves the way for continuation of the status quo until a new president takes office in late 2024 and helps bolster the bull case for the peso.
“I’m not going to say that Mexico doesn’t have risks, but compared with its peers, there are few immediate imbalances,” said Gabriela Soni, the head of investment strategy at UBS Mexico. “Investors start to get worried about elections only in the year they’ll happen, so it won’t be something they begin to talk about until 2024.”
In the meantime, the peso will probably continue to benefit when global investors are in the mood for risk, and suffer when they’re not. For now, that may largely be out of Mexico’s hands, until US and European regulators can assuage concerns over the state of banks in their jurisdictions.
“The Mexican FX market is competitive and almost perfect in terms of the the flows coming in and out freely, without intervention by the central bank. That kind of thing makes it look favorable,” said Gabriel Lozano, JPMorgan’s chief economist for Mexico and Central America.
“In general, I’m optimistic about the recovery to a point,” he said. “There can still be complicated moments, especially as we get nearer to the end of the monetary policy cycle.”
What to Watch
- Brazil’s central bank on March 28 will publish minutes of last week’s policy meeting, at which it left its benchmark rate unchanged but issued a hawkish statement.
- Mexico’s central bank on March 30 will announce its latest interest-rate decision. Bloomberg Economics expects a quarter-point hike and guidance “suggesting the tightening cycle is coming to a close.”
- China will report monthly industrial profits data on March 26, and results of monthly purchasing manager surveys on March 30. Forecasters expect the manufacturing purchasing managers index to fall to 51.8 from last month’s 52.6 reading, according to the median response in a Bloomberg survey.
- Sri Lanka will report monthly inflation data on March 31. Bloomberg Economics expects it to show consumer prices advanced 46% in the 12 months through March, down from 50.6% in the 12 months through February.
--With assistance from Ye Xie, Sydney Maki and Srinivasan Sivabalan.
(Updates with peso volatility trading in fifth paragraph)
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