Report highlights

In this report, Rich analyzes the Mexican peso’s 2023 strength against the USD. He explores potential 2024 drivers and sustainability, along with options market expectations.

Image 1: MXN/USD generic front month future vs. WTI crude front month futures

When I sat down to write about the peso, the first chart I went to was the chart of oil. After all, as a major producer of the commodity, I have often thought of the peso as a “petro-currency” or one that seems to be primarily driven by the direction of the commodity. While that may have historically been the case, as the chart above shows, since the end of 2022, the peso and oil have largely disconnected. Perhaps this is due to the trend of reshoring and nearshoring I have seen in North America post the passage of USMCA and the push to rationalize supply chains. Perhaps it has been the falling volatility of the currency pair and the domestic economy in general. Perhaps it is due to Banco de Mexico work toward strengthening the currency.

Image 2: Mexico central bank interest rates less U.S. central bank interest rates, all overlaid with MXN/USD generic front month futures

One way the central bank has worked to strengthen the peso is to rely on interest rate differentials as a key driver in currency relative price action. Carry is seen as a major driver of currency direction all else being equal. That said, it is not uncommon for traders to consider the relative carry vs. the relative volatility in assessing an information ratio that may lead to a decision to invest or not. In this chart, I have looked at the straight interest rate differential in the top chart compared to PE1 futures. In the bottom chart, I have looked at the aforementioned information ratio. While many would tell you that Banco de Mexico, in raising Mexican rates, is urging investors to strengthen the peso, the relationship is there, but it is a bit looser. However, if I take that same interest rate differential and divide it simply by the one-month implied volatility of the currency pair, I can see that it is not just carry, but low volatility carry that drives this currency pair. Thus, it was not just increasing interest rates but also policy that led to a falling implied volatility that may have attracted investors to the peso in 2023. 

Image 3: MEXBOL year-over-year returns less SPX year-over-year returns overlaid with MXN/USD generic front month futures

In my days in the FX market, I would see mutual funds and hedge funds setting up large FX trades. One of the key drivers for them was investment returns. When they could make money in stocks or bonds, it generally led to an interest to be long the currency. In this chart, I take the year-over-year returns of the MEXBOL Index and subtract the year-over-year returns of the SPX Index. I then compare this return differential to the generic front month Mexican Peso futures. I can see that in 2021 to early 2023, as MEXBOL returns were stronger than the SPX, the currency benefitted. However, these relative returns have fallen quite substantially in the last six to 12 months. Will investors still want to be long peso if they can generate higher returns in the U.S.?

Image 4: Trump less Biden polling average compared to MXN/USD generic front month futures

U.S. politics could play a role on the domestic Mexican economy and the peso. Being an election year, I may expect some catalysts coming from both parties. The index I constructed in white is simply the difference between the Real Clear Politics average polling for Trump less the Real Clear Politics average polling for Biden. As this index moves higher, it means Trump is polling better. As it moves lower, it means Biden is polling better. I honestly don’t know which president the Mexican market would prefer, and it isn’t entirely clear from looking at this overlay. In early 2023, it seemed that as Trump polled better, the peso strengthened. Then from May through October of 2023, Biden polling seemed to be a more positive correlation to the peso.  However, from October of last year until lately, the peso again seems more correlated to Trump. Part of me wants to say that this shifting correlation suggests no real relationship. However, there appears to be more clear cycles of when one is preferred to the other. Again, if there is going to potentially be shifting correlations, with primaries ongoing and the focus on the conventions in July (GOP) and August (Democrats), this could be a potential catalyst for the currency pair.

Image 5: Combined positioning from the Commitment of Traders vs. futures

How is the market positioned? For this I refer to the Commitment of Traders report that I can access on the CME Group website. For many products, I will look only at how levered investors are positioned because I feel these investors are more likely to change their mind in the short term, leading to a more rapid shift in futures prices. However, for this report, I look at all investor bases. I can see as the net longs grew, futures responded in kind. The growth of this net long came primarily from “Other.” More recently, this “Other” category is reducing the net long while Leveraged investors are stepping in to fill the gap. However, despite that, the net long in the market has started to diverge from the strength of the peso. Is this a possible negative divergence suggesting Mexican Peso futures could weaken?

Image 6: All FX currency pairs CVOL levels

Looking at positioning, and looking at some potential catalysts, I am starting to feel that Mexican Peso futures could see some downward pressure. Before I look at specific ideas, I want to have an idea of where implied volatility is generally. For this, I look to the CVOL tool on the CME Group website or in QuikStrike. As I look at the broader FX space, I see that almost all volatilities are not just near, but at their lows of the last 12 months. While low does not mean cheap, it does suggest to me that the reward to risk ratio may favor being long options as I look to find an expression for my bearish peso view.

Image 7: CVOL level vs. futures price for MXN/USD

The previous chart does indicate that we are at the lows of CVOL for the last year. However, I also like to look at CVOL vs. the futures on an overlay basis to see if there is a directional consideration. The chart above shows that as the peso weakens, CVOL moves higher, and then as the peso strengthens, CVOL moves lower. The one year low for CVOL coincides with the peso being near one-year highs. If the peso were to weaken, as is my developing view, this would suggest CVOL moves higher. This is another potential reason to position long options in my trade idea.

Image 8: CVOL Skew vs. futures for MXN/USD

The CVOL Index uses all options across the volatility surface to make the calculation. However, I can also break it down to upside options and downside options only. Then, I can look at the ratio between upside options (variance) and downside options (variance) to create a measure of skew. I also see that as the peso strengthens, skew moves higher, and as the peso weakens, skew moves lower. I can see that skew is not quite at the highs of the last 12 months, but it is close enough to suggest that I would prefer to lean long via downside options, which would do relatively much better if there were a move lower in the peso.

Image 9: Expected return and option Greeks for a short June 5.80-6.00 call spread vs. a 5.60 put

I put this all together to look for a trade that would take advantage of a weakening of the peso. I want to lean long options, particularly downside options. I would like to go a little further out to capture some potential catalysts: (i) More central banks meetings (Mexico in March and May, U.S. in March, May and June); (ii) U.S. election primaries and the lead up to the conventions; (iii) OPEC+ meeting in April. I look at the June expiration to give this idea some time to play out. I can see that the currency is more prone to trends than near term volatility, so looking at short-term catalysts may not be the optimal idea. A little further out, I can potentially capture a change in trend with the catalysts I mentioned. 

I want to lean long options, particularly downside, even though the downside is priced higher than the upside. The relative pricing is at a recent low, so there is a reason to do so.  The upside options are cheaper than the at-the-money so I can cover the upside risk at a lower implied volatility than the option I sell. In this strategy I sell the 5.80 calls, which are a 42 delta. I then buy the 6.00 calls to cover my risk in case I am wrong on my view. My total risk in this spread is 200 ticks, the difference between the strikes. I take in 60 ticks to sell this call spread. My next step is to turn around and buy the 5.60 puts for 66 ticks. There is a small net outlay of premiums, but it is reasonably close to zero cost. I can see from the payoff diagram that this position will behave exactly as a short futures would on a move below 5.60 but be more protected in the event there is a move higher in futures. 

For this idea, I looked for a trade that would give me a better reward to risk vs. simply selling futures. I believe I have accomplished the idea here, having a defined risk of 200 ticks, but participating one for one on the downside. My net cost is close to zero so if I sit here and do not move, my risk is also limited. 

I always like to use option ideas when possible when I am considering counter trend moves around a catalyst. For one reason, I can define my potential loss. Another reason is to gain leverage on a move in the direction I am leaning toward. I think this trade, while it does have risk, is one way to play potential peso weakness. 

Good luck trading!

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