Mexico has become an emerging markets weak link, with authorities facing mounting pressure to jack up interest rates to defend the peso, viewed by investors as a cheap proxy for taking short positions in other emerging currencies.
Long a favourite with bond investors, Mexico’s fortunes turned this year, with the peso repeatedly under attack, forcing an extraordinary intervention in February along with a 50 basis-point rate rise.
While that move smoked out speculators, pressures are building again. Bets against the peso quadrupled in the week to May 13, according to latest available data from the Commodity Futures Trading Commission (CFTC) which shows 45,000 net short positions, roughly equating to $1.2 billion.
The peso has lost 8 percent this month, the worst emerging currency performer after the rand, this chart shows: tmsnrt.rs/1W2cV3l
That is piling pressure on the central bank to raise interest rates, reflected in the recent swift move higher in Mexican interest rate swaps (IRS), essentially derivatives that reflect market expectations for interest rates in the future.
Three-month IRS for instance has risen to 4.22 percent, up from 4.10 percent two weeks ago: tmsnrt.rs/1Ve0el0
“What the market is saying is the only way they are going to get dollar/peso lower is via an emergency rate hike,” Commerzbank’s head of EM research, Peter Kinsella, said.
“The current base rate is only 3.75 percent so the market is expecting a rate hike of about 50 basis points.”
A raft of factors is conspiring against Mexico these days.
First, more than a third of its local bonds are owned by foreign funds, many of which are hedging this exposure by selling the peso.
Second, Mexican local debt is highly correlated to U.S. yield moves – Citi research identifies it as the emerging markets standout in terms of beta – a volatility gauge – against Treasuries.
Third, funds often trade the peso as a proxy for other emerging currencies – the Bank for International Settlements ranks it as the most-traded emerging currency. Its share of daily global turnover is double that of the Turkish lira and South African rand for instance.
“If the Fed raises rates, all emerging market currencies are under pressure. There are various ways to express this view and one of the cheapest ways to do that is via the Mexican peso,” London-based hedge fund Onslow Capital Management Limited principal, Jason Maratos, said.
And that is because Mexican interest rates and bond yields are low relative to other vulnerable emerging markets.
“Mexico has one of the widest current account deficits in emerging markets and unlike the lira and rand it’s a cheap currency to sell. In those markets you have to pay away 8-10 percent yield but Mexico with only a slightly better deficit than Turkey or South Africa costs less than 4 percent to short,” UBS strategist, Manik Narain, said.
The central bank could also intervene directly in currency markets by selling dollars but analysts reckon it will be keen to protect its reserves and, according to Bank of America Merrill Lynch data, Mexican reserves can pay for five months of imports, just above the three months deemed the safe minimum.
Using another yardstick of reserve adequacy, Mexican reserves are just equivalent to gross external debt maturing over the coming 12 months, BAML calculated earlier this year.
“If you look at Mexican reserves, you see there is only so much the Banxico (Mexico’s central bank) can do before it gets into trouble over short-term debt,” Commerzbank’s Kinsella said. ($1 = 18.5115 Mexican pesos)
(Reporting by Sujata Rao, Maiya Keidan in London and Michael O’Boyle in Mexico City; Graphics by Nigel Stephenson and Christian Inton; Editing by Louise Ireland)