FxWirePro: Banxico and NAFTA keeps Mexican peso stormy - Hedge USD/MXN using digital puts

The peso has eased further against the dollar since the last central bank meeting on 14th December. This is likely to fuel concerns on the part of the Mexican central bank (Banxico) regarding future inflation developments.

In the meeting minutes which were published last Thursday it became clear once again that Banxico is ready to implement further rate hikes should a return of the rate of inflation to the central bank target of 3% during the course of the year be at risk. Some central bank members seemed concerned that inflation expectations which had so far been quite stable might rise further.

The publication of the inflation data next Tuesday is unlikely to end these concerns, as inflation is likely to have recorded levels around 6.8% again in December. Be it with rate hikes or further FX hedging tools: the central bank is at the ready. However, that is no reason for peso optimism, as the 6th round of the NAFTA negotiations is about to start (in January, exact date not yet published).

At the start of the year, the peso recovered against USD again, but this is unlikely to be more than a temporary correction of the recent peso depreciation fuelled by political events.

At spot reference: 19.3926, deploy USDMXN digital put of 6m tenor: A 6m 17.0 strike costs approximately 10% of notional (maximum loss limited to the premium paid). Our base scenario is that NAFTA either:

i) Stays in place – Mexico and Canada bend enough to appease the US, 

ii) The US backs away from its current stance on auto content and the sunset provision, or

iii) A stalemate occurs that delays negotiations closer to end-2018.  Under this situation, the MXN could rally significantly, possibly closing the valuation gap with oil (17-17.5). Given significant two-way risks around NAFTA and the July presidential election, we prefer to express the position via limited loss option structures.