Latin America: FX outlook - Carry on, and on
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- Latin American currencies have outperformed USD this year with carry providing a notable boost alongside broad-based USD selling
- There has been greater divergence between currencies however with MXN a notable outperformer
- As long as volatility remains low, we expect Latin American currencies to continue performing well but a surge in risk aversion could lead to rapid carry trade unwinds resulting in a sharp sell-off in Latin American currencies
A good year for returns…
Latin American currencies have outperformed USD across the board this year. Although that statement can also be applied to every currency given the slide in the Greenback seen since its December peak. MXN is the best performing currency in the world year-to-date as it recouped its losses following the all-time high print in USD/MXN seen back in January. Indeed, MXN has now completely unwound the post-US election panic and is sitting at levels not seen since before Trump’s nomination by the Republican party back in July 2016. A look at how LatAm currencies have performed this year relative to the rest of the world shows that with the exception of MXN, most LatAm currencies are sitting in the bottom half of the pack as can be seen in figure 1. If we look at total return, that is to say, spot return and interest rate return, then LatAm fares better given the relative high interest rates on offer in the region. Carry trades have been key in driving the appreciation of high yielding currencies this year. That is not to say that carry has been the only driver supporting LatAm currencies, broad-based USD weakness has certainly played a role as well. Furthermore, LatAm FX has been far from homogenous in 2017 with significant divergence between currencies.
For those unfamiliar with carry trades, a carry trade is the result of borrowing in a low yielding currency and investing in a high yielding currency with the aim of capturing the interest rate differential. Of course, if the high yielder underperforms the low yielder then the interest rate return can be wiped out by the loss on the spot return. As such, carry trades are most popular when interest rate differentials are high and volatility is low. Given this, ‘carry attractiveness’ can be measured by volatility adjusted carry which is calculated by dividing the interest rate differential by the option implied volatility of the pair. Figure 2 below shows the three month volatility adjusted carry of USD crosses (3mth interest rate differential divided by the 3mth at-the-money implied volatility).
TRY maybe the most attractive currency from this perspective but there is another factor that influences carry trade demand, namely liquidity. Many different types of investors, including leveraged players, use carry trades in various forms and the size of positions can be very large. One issue this causes is that while carry trades are put on at different times, when volatility spikes higher, carry trade players all run for the exit at the same time and this can lead to sharp sell-offs in high yielders. As a result of this, liquidity is also an important factor when looking at carry trades as the cost of exiting a position is directly linked to the depth of liquidity in the market. If we take this into account, then we can argue that MXN is the most attractive carry currency as it is the 10th most liquid currency globally and the market is much deeper than TRY, INR, IDR and RUB. This is a very different picture compared to Q4 of last year; at that time MXN was the least attractive carry currency in the LatAm region despite being far more liquid than the rest of the region as can be seen in the table of average daily volumes below (table 1).
The rise of MXN’s carry attractiveness has been a product of both rising interest rates and falling volatility. Although it looks like the policy rate has now peaked and we expect the Bank to cut rates in the middle of next year, at 7% it is now 125bp higher than the start of the year and 400bp above the low of 3% where rates stood in December 2015. Meanwhile, USD/MXN 3mth implied at-the-money volatility has dipped into single digit territory for the first time since July 2015. In contrast, BRL was the most attractive LatAm carry currency at the start of the year but 450bp of rate cuts have reduced the Brazilian SELIC policy rate from 13.75% to 9.25%. Figure 3 shows just how dramatic the shift in carry attractiveness has been with MXN now more attractive than BRL.
It is worth noting that although we have been looking at carry trades using USD as the funding currency, there are far more attractive options available. We chose to look at LatAm currencies against USD as these are the most traded pairs but for those looking to implement carry trades, lower yielders such as EUR, JPY and CHF may be a better option.
The rise of MXN and fall of BRL from a carry perspective was reflected in portfolio flow data this year. According to IIF data, net non-resident purchases of equities (portfolio equity flows) and bonds (portfolio debt flows) looked very different in Brazil and Mexico. In Brazil during H1 there were USD 1.119bn of equity outflows and USD 2.815bn of bond outflows while in Mexico there were equity inflows of USD 4.233bn and USD 2.805bn of bond inflows (figure 4). As figure 5 shows, estimated net capital flows into Brazil turned negative in May and June.
The outperformance of MXN has not just been a story of improving carry attractiveness. Idiosyncratic factors have also played a role with MXN unwinding the ‘Trump Premium’ that had been priced into the currency in light of protectionist rhetoric on the campaign trail. Indeed, we were at pains to stress just how severe the impact of US trade barriers/tariffs could be on Mexico given the heavy reliance of the economy on exports heading north of the border. However, our fears subsided notably as it became clear that Trump is unlikely to risk near term pain for large US businesses which would undoubtedly occur in the short-term should the US take a more protectionist stance. Indeed, the USTR proposal for the renegotiation of NAFTA that was released on July 16th supported this view given the notable absence of tariffs on industry or agriculture. Furthermore, it looks like any plans for a border adjustment tax (BAT) are dead in the water. That is not to say the risk of rising protectionism has disappeared completely, Trump has been vocal of late stating that the US could still terminate NAFTA but we now view this as more posturing than plan. It is not a risk we can ignore however and US trade still poses a risk to EM currencies. For Mexico specifically, any issues with NAFTA negotiations would likely trigger a spike in domestic volatility which could be the trigger for MXN carry trade unwinds. Furthermore, the Presidential elections are due to be held in Mexico on July 1st and when campaigning starts later this year there is the potential for a “war of words” on trade to emerge which could weigh on negotiations. In addition, the current runner in the polls may worry international markets given the candidate’s more populist stance and plans to roll back energy reforms.
The shift in expectations with respect to Trump’s trade plans can be seen in Mexico’s sovereign credit default swap (CDS), a tradeable measure of perceived sovereign risk, which has fallen substantially so far this year (figure 6). This is not just a Mexico story, falling sovereign CDS has been a global phenomenon but as figure 7 shows, Mexico has seen one of the largest declines. Diminishing perception of sovereign risk tends to favour EM currencies over G10 currencies as this component makes up more of the EM FX risk premium.
Outside of Mexico, there have been other country specific drivers of LatAm currency appreciation. Unsurprisingly, commodity prices remain key for the currencies of commodity producing countries. In Chile, CLP has found significant support from the sharp rally in copper prices (figure 8). Indeed, the correlation between copper and USD/CLP on a three month rolling daily percentage returns basis has been rising this year and currently stands in statistically significant territory (99% confidence interval). In contrast, Peru, another copper producer, has seen the relationship between its currency and copper prices start to fade since the middle of the year. As it stands, the correlation is insignificant. To our mind, this breakdown is a result of domestic factors weighing on PEN and thus stifling the rally despite rising copper prices. The central bank has already cut rates 50bp since May and we expect at least one more 25bp cut this year taking the policy rate down to 3.50%. Furthermore, political noise is weighing on growth prospects and in turn the currency. Turning to Colombia, the long held relationship between COP performance and oil prices remains key. It is true that we have seen some divergence of late but this relationship rarely breaks down completely and as Colombia’s easing cycle comes to an end we expect to see COP tracking oil prices more closely.
Looking forward, we expect USD to remain relatively soft in 2017 which should support EM FX globally. Furthermore, we expect carry to remain king for LatAm FX but any spike in volatility is likely to result in a sharp sell-off that could overshoot in the short term. Given the decline in volatility seen so far this year, FX options look relatively cheap and are an increasingly attractive way to hedge. That said, in light of heightened global uncertainty, to our mind it is not a question of if volatility spikes, but when volatility spikes.
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