Saturday, 24 September 2016

Trump Bleeds Mexican Peso: a ´Peso Problem´ or Prediction?

According to Deutsche Bank, the Mexican Peso (MXN) is now the world´s cheapest currency on three fundamental valuation metrics: MXN purchasing power beats others; effective exchange rates are at historical lows; and the fundamental equilibrium exchange (external and internal balance) has dropped into the sink. [i] The question is: does the cheap Mexican Peso reflect a “peso problem” or a rising probability of a Trump presidency?
The term “peso problem” is often attributed to Milton Friedman in comments he made about the Mexican peso market of the early 1970s when the interest rate on Mexican bank deposits exceeded the interest rate on comparable U.S. bank deposits, despite a hard peg of the peso to the US dollar since 1954. Peso problems can arise when the possibility that some infrequent or unprecedented event may occur affects asset prices. The event must be difficult, perhaps even impossible, to accurately predict.

The event now is a Trump presidency that hopefully will never materialise. The markets have tended to assume that Hillary Clinton would win the election but the polls have narrowed and some have Donald Trump ahead. No doubt, a Trump victory would be a disaster for emerging market assets. Countries that run a heavy bilateral trade surplus with the United States would suffer from isolationist and protectionist U.S. policies. Countries that rely on financial markets to fund their current account deficits would suffer from a rise in US interest rates as a result of loose fiscal/tight money policy mix under a Trump presidency. Société Générale has found that Treasury bond yields tend to rise when Mr Trump gains in the polls while emerging market currencies (and the Mexican peso in particular) tend to fall. Citicorp economists recommended this summer to short the MXN as a “Trump trade”.[ii]

A Trump victory would be negative for the entire emerging market asset class – with perhaps the notable exception of the Russian market as Western sanctions would likely be withdrawn. So far, however, MXN has priced in substantial Trump risk premia.  MXN has underperformed emerging market currencies (EM FX) since May (use of MXN as a hedge for EM risk), but this underperformance has accelerated recently. According to Deutsche Bank, MXN has decoupled from external factors such as the oil price or the S&P500, being increasingly driven by Trump risk premia.

Scary prospects if the MXN is a reliable predictor of the outcome of U.S. elections to be held in November! By contrast, the MXN risk premia would unwind with a Trump election loss, implying scope for substantial MXN appreciation. Consequently, there is significant room for MXN appreciation (round 20%) if Trump loses the election. So if you like neither candidate – like so many – you can still sweeten the outcome with your personal MXN bet.

[i] Gautam Kalani and Guiherme Marone, “MXN´s Trump Card”, Deutsche Bank Research, 19th September 2016.
[ii] Dimitra DeFotis, „4 Trump Trades For Emerging Market Uncertainty”, Barron´s, 2nd August 2016.

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