NEW YORK/MEXICO CITY (Reuters) - For those who like volatility, there’s money to be made on the Mexican peso. It could rally on the hopes of a more robust future for Latin America’s second-biggest economy. Or it might get hammered by U.S. Federal Reserve policy moves. Maybe both will happen in the next six months.
While other regional economies are suffering from China’s slowing demand for commodities, Mexico is humming along. Factory exports to the United States are seen picking up and a series of economic reforms has investors seeing a brighter future.
But confidence in Mexico’s prospects could be pushed to the sidelines by the irresistible force of the Fed as it starts to wind down its unprecedented stimulus. The U.S. central bank’s bond-buying program has encouraged investors into riskier assets such as emerging market debt, including Mexican bonds, and there is a fear that once that stimulus is taken away prices could slide.
“Mexico was basically a victim of its own success,” said Edwin Gutierrez, who manages $10 billion in emerging market debt at Aberdeen Asset Management Ltd. in London. The Fed’s stimulus and the bright outlook for Mexico were a good opportunity for investors seeking returns in emerging markets to target Mexico.
Gutierrez expects an outflow from peso-denominated debt to form a headwind against peso gains: “We have to go through this (unwinding) unfortunately before the solid fundamentals can shine through again and everyone can focus on that.”
Few currencies so clearly exhibit the topsy-turvy aspects of global financial markets as the peso. Good news about the U.S. economy has of late hurt Mexican assets, due to fears that the good data will push the Fed to soon withdraw stimulus.
The peso had been the strongest performing major currency against the dollar early in 2013, reaching a two-year intraday high of near 11.93 on May 9, supported by optimism in the reform agenda of Mexico’s new government.
But hints of a withdrawal of stimulus beginning in late May sparked panic selling around the globe in riskier assets that had been pumped up during the years of U.S. monetary largesse. The peso sank more than 11 percent to an 11-month low.
Speculators bailed on bets the peso would gain more this year. A near-record long position in peso futures on the Chicago Mercantile Exchange worth $5.9 billion vaporized over the last two months.
That move cleaned out many weak-handed investors and now there are signs that some bulls are returning. The latest CFTC data showed the first rise in the net long position in nearly two months.
“Now that the positioning is less skewed, the peso’s upside may be a little easier” to reach, said Win Thin, head of emerging markets strategy at Brown Brothers Harriman. Bearing that view out, the peso whipsawed back 8 percent from its June low to trade at a 7-week intraday high on Thursday.
Fed officials appear to have been taken aback by the selloff their comments unleashed. They have since assured investors that easy money policies will not be quickly withdrawn. That’s helped the peso recover.
Still, dedicated emerging market investors say too many risk-averse funds, such as insurance companies and pension funds, are holding Mexican debt - and they would be likely to throw aside Mexican assets as U.S. yields rise.
Foreign holdings of Mexican peso debt have grown six-fold since 2008 to some $135 billion, or about 37 percent of outstanding local currency debt.
An unknown chunk of funds invested in Mexican bonds will flee Mexico as the Fed deflates its stimulus program and yields rise on Treasuries. Those outflows could pressure the peso, said Benito Berber, an analyst at Nomura Securities in New York.
The foreign position in fixed-rate Mbonos - long-term peso debt - has fallen from a record of 1.16 trillion pesos on May 10, but only by about 6 percent as of July 1. Until data shows a bigger drop, cautious investors won’t be convinced that the time bomb has been defused, analysts said.
As long as there is no big bond retreat, the currency may be in a position for a rally if President Enrique Pena Nieto moves quickly to deliver a long-awaited bill to open up the energy sector to private investment.
Throwing out constricting limits on the state-run energy business would mark the biggest reform in two decades since Mexico signed its free-trade deal with the United States and Canada, said Berber. It could drive the peso toward 12 per dollar on bets the reform would unleash a wave of foreign direct investment into the energy sector, analysts said.
Mexico’s Congress resumes in September, when Pena Nieto is expected to unveil tax and energy bills.
“The reforms may be one of those events where the market trades pretty well into it,” said Dirk Willer, managing director and head of Latin American local strategy at Citigroup. “Then once it happens, markets may get impatient and sell off.”
To be sure, if Pena Nieto fails to deliver an ambitious plan or if he loses support from opposition parties needed to drive legislation through, the peso could suffer.
But for the brave who believe in Mexico’s prospects, coming peso slumps will be a chance to build up positions that could pay off big down the road.
The Fed will only move to remove stimulus if the U.S. economy is getting stronger, which ultimately will bode well for Mexican exports to its northern neighbor.
Mexico’s economy is seen picking up from nearly 3 percent growth this year to about 4 percent next year, and that is without counting on the effect of major energy reform.
“Once fears about Fed tapering subside, Mexico’s fundamentals will favor the peso and it should once again become one of the best performing major currencies,” said Javier Murcio, portfolio manager and senior sovereign analyst at Standish Mellon Asset Management, the Boston-based fixed income specialist for BNY Mellon.
Reporting by Julie Haviv in New York and Michael O'Boyle in Mexico City, Mexico; Editing by David Gaffen and Claudia Parsons