Global Optimism Stokes Mexican Peso Rally as Local Risks Remain

(Bloomberg) -- Just one week after analysts declared the Mexican peso’s nascent rally all but dead, Latin America’s most-traded currency is still strengthening as the dollar slides and global risk appetite increases.

The peso gained 8.5% this month, surpassing all other major currencies. Analysts from Rabobank and BBVA say more gains are in store as nations reopen virus-hit economies and Mexico maintains comparatively higher rates than elsewhere.

The peso’s strength will last “a few more weeks,” said Christian Lawrence, a New York-based strategist at Rabobank. “The dollar under pressure is the No. 1 driver, but as of last week, some fast-money players are dipping their toes into the carry trade.”

Bank of Mexico decided unanimously on May 14 to cut interest rates by just 50 basis points, holding onto one of the world’s highest rates and bucking expectations for a shift toward faster easing.

Carry gains are typically eroded by high volatility, which diminished the peso’s appeal in February and March, and contributed to a 20% slump in the first quarter. One-month implied volatility for the currency has fallen by more than half in the past two months.

Still, the currency’s expected swings are well above historic norms. That means peso’s volatility-adjusted carry returns, while higher than the March bottom, remain below levels before the pandemic. Spot prices have rallied at a time when peso’s carry appeal isn’t improving, a situation that may prove hard to sustain.

“Risk assets have been rallying, and the Mexican peso is following that sentiment,” said Danny Fang, a strategist at BBVA in New York. “I’m not sure if I would call it optimism, though.”

Higher risk sentiment and increased liquidity from the Federal Reserve will help the peso for now, Fang said. As the Fed eases the pace of Treasury purchases, though, that support may begin to diminish.

Local risks remain as well. Economists, on average, expect gross domestic product to contract by a record 7.6% this year, for example, even as Mexican President Andres Manuel Lopez Obrador steadfastly resists calls for fiscal stimulus.

Investors, meantime, are the most bearish on the peso in almost two years. Foreign holdings of peso-denominated debt are also at an eight-year low.

Yet as long as global optimism holds out -- emerging-market equities posted their best day in four weeks on Tuesday -- the peso is likely to keep appreciating.

“I’m surprised it’s happening, to be honest, but I suppose risk has been bid in other asset classes for so long,” said Lawrence.

©2020 Bloomberg L.P.