The end of the Mexican carry? Traders smarting from peso crash

MEXICO CITY, March 11 (Reuters) – Global currency investors who piled into the peso through the “carry trade” strategy are nursing a bloody nose after the Mexican currency tanked 12% in three weeks, and analysts are asking if it spells the end of the popular investment tactic.

In a carry trade strategy, an investor borrows money in the currency of a country with low interest rates, such as the United States and some European countries, to buy bonds of a high-yield nation like Mexico.

The juicy returns for investors offered by Mexico’s 5.75-6 percentage-point spread over the U.S. Federal Reserve’s benchmark rate long helped prop up the peso despite a stagnating Mexican economy.

However, the strategy relies on stability, and volatility in recent weeks due to coronavirus fears and a crash in global oil prices makes the carry strategy risky, since returns made on interest rate spreads can be lost in the exchange rate.

In turn, that may leave the peso more exposed in the short and medium term.

“It’s a double-edged sword,” said Juan Carlos Alderete, director of economic analysis at Banorte, saying there were signs investors had been rapidly unwinding their peso positions.

“Typically, currencies that have higher losses when there are volatility shocks are the ones that previously benefited most from a carry strategy,” Alderete added.

The peso had been outperforming emerging market currencies at the start of the year and even touched an 18-month high in mid-February, boosted by investors’ buying Mexican debt and using derivatives to bet on the currency appreciating.

The global wave of risk aversion, sparked initially by the spread of the coronavirus, led to speculators’ selling pesos to cover their losses from the long peso positions.

On Monday, the peso sank to an all-time low of 22.93 per dollar before recovering a chunk of the losses. On Wednesday, the currency slipped 2%. It is now 12.5% weaker against the greenback so far in 2020.

Mexican government debt in the hands of foreign investors was just over 2.17 trillion pesos ($102 billion) as of last week, remaining close to record levels, but that figure could drop in the coming days, according to analysts.

“Fixed-income positioning in Mexico is heavy, and part of (the peso sell off) may be efforts to hedge the FX exposure on the fixed-income holdings,” said Sacha Tihanyi, emerging markets strategist at TD Securities.

Following the U.S. Federal Reserve’s surprise rate cut last week, analysts anticipated a matching 50 basis point cut by Banxico, as Mexico’s central bank is known, at its next monetary policy meeting on March 26. But higher inflation and the collapse of the peso clouded prospects.

Forecasts range from keeping the rate at 7% to reducing it to 6.25%, which would leave Mexico with a spread of between 525 and 600 basis points against the U.S. benchmark rate.

Ahead of the Banxico meeting, the Fed will hold its next scheduled policy meeting March 17-18.

To stop the peso weakening further, the Mexican Currency Commission, made up of the Treasury and the central bank, on Monday increased to $30 billion from $20 billion the foreign exchange auctions program in force since 2017.

“If the exchange rate is stabilized with this, a cut by Banxico on March 26 will depend more on what the U.S. Federal Reserve does next week,” said Gabriel Lozano, chief economist for Mexico at JPMorgan. (Reporting by Abraham Gonzalez; Writing by Drazen Jorgic; Editing by Frank Jack Daniel and Leslie Adler)

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