Mexican peso falls below key level. How a strong currency turned weak in a hurry

By Jamie Chisholm

The Mexican peso weakened to more than 20 per U.S. dollar on Thursday, reaffirming its swift fall from grace after investors dumped carry trades amid concerns about political upheaval in the U.S.'s southern neighbor.

Just a few months ago the peso was riding high.

Investors were attracted to the high yield on offer after the Bank of Mexico sought to damp inflation by pushing its main borrowing cost up from 4% in mid 2021 to a peak of 11.25% until February this year.

That double-digit interest rate was particularly enticing for Japanese investors, who until recently were offered less than zero on their deposits as the Bank of Japan strived to tackle deflation.

As Japanese households and larger speculators sold yen to buy the higher-yielding peso - a strategy dubbed the carry trade - the Mexican unit (MXNJPY) strengthened, brushing nearly 9.5 yen in May of this year, the Japanese currency's weakest peso exchange rate since 2008.

And with U.S. Fed funds rates less than half that of the Bank of Mexico since the spring of 2023, the peso also strengthened against the dollar (USDMXN), with the buck falling to a nine-year trough of around 16.3 pesos in April.

But since those peso peaks its has plunged 25% versus the yen and slipped 23% against the greenback, with three factors cited for its retreat.

The first is concerns about a slowing U.S. economy, with which Mexico is closely tied. The next is worries of a constitutional upheaval as outgoing president Andres Manuel Lopez Obrador seeks to overhaul the country's judicial system by establishing elections for federal judges, a move his opponents say will put democracy at risk.

"The MXN has been buffeted by the prospect of passage of Mexico's judicial reform...which has been overtaken monetary policies and U.S. politics as a source of consternation in recent weeks. It is likely to remain a source of worry throughout September," said Thierry Wizman, forex strategist at Macquarie.

Finally, there is the crumbling of the carry trade. The Bank of Mexico has begun to lower rates and is expected to have them at 10.25% by year-end, while the Bank of Japan may push its main borrowing cost to 0.3% according to estimates on FactSet.

Clearly, that still leaves a wide rate differential in favor of the peso, but it is the direction shift, coupled with broader market anxiety about carry-trade exposure, that has rattled investors since the global stock swoon of early August, according to analysts. The dollar previously briefly popped above 20 peso during the Aug. 5 market turmoil.

"We'd long flagged the fact that the peso was due a correction, and the market shakeup provided a catalyst for bringing it back to a value which we assess is more aligned with its fundamentals," said Giulia Bellicoso. markets economist at Capital Economics, in a recent note.

The main cause "was the unwinding of the yen-funded carry trade, sparked by the appreciation of the yen vis-à-vis the greenback as yields gap shifted in its favor," added Bellicoso, who in August had a target for the U.S. dollar to reach 19 pesos for the end of the year.

-Jamie Chisholm

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09-05-24 0944ET

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