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We believe the worst is now behind for the Mexican peso. The economy is not running nearly the same amount of leverage as most other EM. We find that non-financial corporate debt and household debt ratios to GDP are the lowest in Mexico compared to all other major EM.
Moreover, we also find that the pace of foreign participation in the local bond market has slowed significantly in recent months.
The correlation between EM currencies and equities and oil have been falling (more aggressively in the latter) from a high level. FX and oil could break down, but FX is likely to stay linked to equities as long as top-down macro fears are driving sentiment.
Proxies for risk sentiment – equities and oil – have been strongly linked to movements in FX over the past year, but the relationship is starting to weaken, most noticeably in the decline of oil-FX correlations since April. It is quite possible that the oil-FX correlation will continue to fall further; we expect brent oil to finish the year at $50/bbl.
But testing the 2012/2013 lows in the equity-FX correlation is probably unlikely as long as the macro factor is driving market sentiment. The correlation breakdown between FX and oil is most striking in the MXN. Oil prices edged higher during May, but USD-MXN skyrocketed by 8%.
Episodic correlation breaks can provide opportunities (we recently entered long MXN-RUB to capture a re-coupling in these currencies to oil) but it could also foreshadow a structural shift or at least one that lasts long enough to prevent monetizing the resumption of historical relationships.
However, with macro factors expected to continue driving markets, inter-EM correlations should remain high if at FX baskets to perform better, which is reflected in our forecasts of broad-based EM FX spot depreciation. But in extreme instances, country-specific factors can dominate and lead to interesting relative value opportunities.
In this regard, our commodity strategies expect base and precious metals to be stagnant while oil should be stabilized-to-higher, which fits nicely with our forecasts of the CLP and ZAR underperforming the RUB.
In order to hedge USDMXN upside medium term risks, it is advisable to initiate short call ladder (SCL) option strategy in which the options trader goes long in an at-the-money call and purchases another higher strike out-of-the-money call, and simultaneously shorts an in-the-money call of the same underlying security and expiration date.
