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The Mexican Peso Is at Risk of a Tumble


All it would take for the peso to slip is an interest rate scare here in the US or one of those emerging market panics we see now and then.

I hate to bring it up just a day after a national holiday that either celebrates an 1862 defeat of a French force or the invention of the frozen margarita, but Mexico has been underperforming the US by 33.33% in dollar terms since the end of November 2010.

As I noted in November 2013, there's more to emerging markets than free money flowing from a funding-currency country. You need attractive interest rates in the receiving market to keep the carry trade open. Part of the reason for the rebound in the Latin American markets discussed last month has been higher interest rates in Brazil.    

But to complicate matters, as if I ever would do such a dastardly deed, poor relative stock market returns can outweigh simple carry trade inducements and lead to a weaker currency. The ideal combination for an emerging market these days is short-term interest rates high enough to maintain an open carry trade, but not high enough to choke off the local bourse.
Peso and Performance

Let's revisit a July 2013 analysis of the link between the dollar carry trade into the peso and the relative performance of Mexican equities.

Prior to 2006 and the combined effects of much higher oil export earnings and worker remittances, the carry return into the peso reflected the effects of Mexico's much higher short-term interest rates. Yield hogs could send their funds south of the border, park them in short-term deposits, and pray the peso wouldn't devalue by more than the cumulative interest-rate spread gain.
After 2006 -- and especially after the financial crisis led to a global downward compression of interest rates -- the carry return increasingly reflected relative stock market performance; indeed, relative performance started to lead the carry return by three months on average. If Mexican equities performed strongly, yield hogs' performance-chasing cousins (let's call them performance pigs for lack of a better term) started buying Mexican assets through funds such as the iShares MSCI Mexico Capped ETF (NYSEARCA:EWW) or the ProShares Ultra MSCI Mexico dos-por-uno ETF (NYSEARCA:UMX).
This leading relationship is making the carry trade into the peso vulnerable. It has been able to levitate over the past year on the basis of its historically narrow but relatively attractive short-term interest rate gap, but all it will take for the peso to tumble is an interest rate scare here in the US or one of those periodic emerging market panics we see every now and then. The current level of relative stock market performance implies the carry return is overvalued on the order of 14.25%.
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