FxWirePro: Intricacies of USD/MXN call spreads on hawkish Banxico

We maintain our MXN forecast of 20.75 for end-2019 and neutral MXN in our GBI-EM portfolio. MXN has performed better than our expectation in December and January, but we expect it to start underperforming this year.

Despite much lower long MXN positions and high carry thanks to a hawkish Banxico, uncertainty regarding AMLO’s policies, combined with large foreign investments in Mexico, could cause MXN weakness this year. 

The USMCA ratification process could also create some market noise, though we expect that it will eventually be ratified by all three countries.

Bearish scenarios of USDMXN at 20.0 if AMLO’s policies seem to put the country’s fiscal balance on an unsustainable path. 

Bullish scenarios of USDMXN at 18.0 if Uncertainty lowers regarding AMLO’s policy mix and EM capital inflows resume. 

OTC FX updates: 

Please be noted that the 3m skews signal upside risks of this pair, hedgers’ bids up to OTM strikes up to 20.200 levels.

With the above in mind, we take the opportunity to analyze what generally works on the MXN vol surface, on a back-tested basis, and from a pure vol standpoint. The above nutshell explains a variety of structures for 3M maturities. For instance, selling RRs (delta-hedged) works orders of magnitude better than selling ATM vol. Better yet, 1*1.5 ratio USDMXN call spreads (delta-hedged) have been notably a high Sharpe Ratio (1.66) trade to hold over the years. Being long ATM vs. short OTM calls at near vega neutral notionals, the 1*1.5 ratio call spread structure is also well positioned to be selling topside OTM vols, which now are priced heftily after the latest vol explosion. 

The peso sell-off triggered a vol surface dislocation, pushing gamma vols to 15.3 handle, the highest since June, and an even quicker reaction of front-end skews, reaching the highest since the 2016 US Presidential elections. The back of the vol curve is lagging the move, with 12M / 3M 25D risk reversals vol ratio at a multi-month low. Courtesy: Sentrix & JPM

Currency Strength Index: FxWirePro's hourly USD spot index is flashing at 159 (which is bullish) while articulating at (14:19 GMT). 

For more details on the index, please refer below weblink: http://www.fxwirepro.com/currencyindex