The Mexican Peso (“MXN”): arriba, arriba, ARRIBA !


Buenos Noches readers.  This article’s purpose is to convince you why the Mexican peso (“MXN”) is going to rise against the almighty U.S. dollar.
As a background, we all know who won the U.S. Election.  The victory of Donald Trump was a seismic event in history.
  • Stocks are rising
  • Commodities and precious metals are stumbling 
  • Bonds are falling                                                                                                                                                                                                                                                                                                                               
  • The smell of inflation is back in the air
  • And the U.S. dollar is within arms-reach of parity with the Euro
Together these changes in Capital Markets are called the “Trump Trade.”  One victim not just in the markets but in geopolitics, has been Mexico.  Mexico has been the “poster child” for everything that has gone wrong with the United States.  According to Trump, the NAFTA trade agreement has taken jobs away from hardworking Americans, resulting in a lower standard of living.  Did you know that 9 out of 10 cars produced in Mexico get shipped to the U.S. (data sourced from UBS)? And then there’s the issue of immigration.  Trump wants to keep Mexicans out.  How’s he gonna do that?  Well I think we are know that answer!
Despite haven’t become President yet, there has been a real fallout on the Mexican economy and the MXN currency.  With every tweet, the Peso keeps declining.  It is now conventional wisdom that the MXN will continue to weaken over the next year.
I don’t believe that to be the case.  While there’s the Trump Trade, and that’s powerful.  There’s also something called the “Madness of Crowds.”  This is when every one of us agrees on something whether or not it’s based on logic.  There have been examples of Manias in the past, of which some were based on faulty-logic.  They include:
·      Tulip mania (1637)
·      Roaring Twenties (1922-1929)
·      Dot-Com Bubble (1995-2000)
·      Real-Estate bubbles (2006-2009)
·      Bitcoin (present day)
Bubbles usually end badly.  The Trump Rally too, will bust. If this happens, it will be the end for the almighty dollar.  I would like to give you five reasons why the Mexican peso will reverse course and RISE against the U.S. dollar.
1.     First, is something called “selling on the news.”  This is a reversal of a market price which goes in complete opposite of what was expected.  One often sees this when a company’s share price declines after reporting excellent earnings.  This is due to the news already being factored into the share price.  Once Trump becomes President, I expect the Peso to reverse its downtrend if rise in earnest by First Half 2017 (think Cinco de Mayo).
2.     The U.S. economy won’t move from 2% GDP growth to 4% just because there’s a different guy in the White House. Running the U.S. government is not the same as running the Trump business empire.  You don’t just give marching orders and have your plan executed.  There’s a whole process to the process, with pushback from Congress, lobbyists, etc.  In fact, according to a WSJ survey of economists, 2018 GDP was upwardly revised by just one-quarter of a percent (to 2.4%).
3.     Differences in real interest rates affect currencies.  The currency with the higher interest rates attracts more investments of which causes an increase in demand for investments denominated in that higher yielding currency. Mexico’s funding rate, for example is nearly double that of U.S 30YR rates.  It is true that a proportion of the higher rate is attributed to inflation, though the Bank of Mexico has aggressively raised rates (in each of its last three meetings) to nip it in the bud.  One can determine whether or not the difference in interest rates is affecting the currency by looking at forward currency rates.  Presently forward currency rates are slightly higher than present rates indicating traders expect to decline slowly.
4.     Oil prices are rising:  After plunging in 2015, oil prices rose 45% in 2016.  Oil prices are expected to remain elevated due to the Nov’16 OPEC agreement.  Mexico’s budget is highly dependent on taxes it receives from PEMEX, the national oil company. PEMEX provides nearly 20% of Mexico’s budget and 5% of exports (mostly to the U.S.). Oil is priced in USD so the net effect could be substantial.
5.     Purchasing Power Parity:  This is an economic theory that determines what the exchange rate should be based on a basket of goods of one country divided by a basket of goods from another country.  The Economist magazine popularized using the price of a Big Macin one country over that of another country to determine the exchange rate.  Its index shows that the Mexican Peso is over 50% undervalued compared to the USD (and its data was before the U.S. election).
Factors working against a stronger Peso are the continuing Drug Warin Mexico and risk to the Current Account surplus with the U.S.  According to the New York Times, in the first 10 months of 2016, there were 17,063 homicide cases in Mexico, already more than 2015’s total and the highest 10-month tally since 2012.  The Drug War has become an almost civil war on the country resulting not only in lost innocent lives but in lower potential economic growth.
Mexican’s trade surplusor Current Account could also hamper a strengthening Peso if Trump initiates trade tariffs onto Mexican imports.  Exports are typically good for the local peso as U.S. importers would have to convert their dollars in order to pay for the Mexican exports, hence more demand for pesos.  However, I believe import tariffs are doubtful as this could lead to a trade war with Mexico.
The currency market is complex and not every factor I have stated to you will affect the Peso.  In summary, I believe the peso will rise due to changing investor expectations, slower U.S. economic growth compared to Mexico, higher interest rates in Mexico, a stronger economy in Mexico due to greater oil exports, and due to Purchasing Power Parity which shows that Big Macs cost just 50% of what they cost here in the U.S.  The peso will reverse its downtrend by 1H’17 – think Cinco de Mayo!

EUROPE’s reached the “POINT of NO RETURN”

The time is near.  The EU’s game of Chicken is ending.  In fact, Europe’s just reached…

The Point of No Return

When will the European Crises hits its nexus?
According to behavioral finance, trend theory, etc.., I believe this will most likely occur during the second week of February 2012.

Market indices (both equities, bonds and capital markets overall) are likely to have their usual Christmas Rally and January Effect during the next several weeks. Then sometime after January it’ll all be over. 

Background to the Euro-Crises:
Many reasons have been cited for the Euro-Crises, with the “blame-game” starting in the U.S.  (i.e, Wall Street exported it’s derivatives/mortgage mess) to changes in regulations, i.e., the Basel Accords.  Basel II essentially said that Banks didn’t need to set aside any capital for sovereign debt, but lots of capital for most other debt.  This diverted loans from corporates towards Sovereigns.

However, we do not accept these arguments, as most just look to shift blame. We
believe the Euro Crises stems from economic mismanagement and lack of fiscal discipline.  In the same light of weight-gain, we believe the aptly-named PIIGS of Europe were glutenous for debt.

thanks to Mighty Lists blogs!

Individual countries are accountable for their actions.  However, the root cause perhaps came from a “Group Think” mentality, whereby the Eurozone was created with a Monetary Union (i.e, European Central Bank, Euro common currency) but no fiscal union.  We believe fiscal integration and intergovernmentalism is a political impossibility.  The Maastricht Treaty via its “convergence criteria” limits budget deficits to 3% of GDP and Debt to 60% of GDP.  However, this is not legally enforceable, and so failed (see chart).  (All of the charts can be enlarged by clicking on them.)

Source: Eurostat, WSJ

Further, a Monetary union without a Fiscal union is a fundamentally flawed model. This led to many consequences including a large current account (i.e. trade balance) in Germany and negative current accounts with the PIIGS.  Historically, the German D-Mark would have risen, while the others would decline, thus realigning trade flows. Germany is a clear beneficiary of this model’s flaw.

The EU has given the world a daily dose of ideas that increased capital market volatility. Two examples are listed below:

  • Expansion of the EFSF (“European Financial Stability Fund”) which sells bonds to investors and uses proceeds to provide loans to Eurozone countries in need.  Unfortunately, the fund is too small (up to EUR 750Bn including IMF monies) and loan guarantees are too low (20-30%).   Also, note that S&P recently (12/6/11) placed the EFSF on Negative-CreditWatch.  On 12/7/11, it was proposed that the existing or another bailout fund’s ceiling be increased to EUR 750Bn.  Failure to secure backing by all 27 EU (which we view unlikely) nations would likely weaken credibility among investors.
  • Moves towards more Fiscal Integration, as per the 12/8/11 Brussels summit are not feasible.  The 27 EU governments would effectively be ceding greater control of their national budgets including penalties to budget “sinners.” We doubt that all 27 will agree to “fine print” details by March’12.  This is not the United States, where us Americans feel part of one country/culture.  It is doubtful that 27 countries will subjugate their fiscal sovereignty to German rule!

    Below are listed recent data suggesting Europe’s Crises will soon worsen:

    1.) Italy’s Term Structure of Credit Risk has inverted.  That is, Italian short-term sovereign bond yields (and CDS prices) are higher than its long-term yields.  (Note that typically yields/CDS prices rise as tenures lengthen).  So what’s happening?   When ST yields (or CDS prices) are > LT yields this means investors are looking for a near-dire situation short-term, but expecting LT improvement.  This phenomenon is an inversion of the Term Structure of Credit Risk.  See charts below:

    source: WSJ, November 30, 2011

    Republic of Italy:  CDS Term Structure of Credit Risk

    Source: Bloomberg

    According to the table below, Italy’s near-term CDS is trading at approximately the “Ba” equivalent rating, however, note the sample size is small below Baa.

    2.) European banks are insolvent as per Basel III regulations:  This means not only lower capital, but a reverse multiplier-effect (i.e., less lending).  Even officials from the IMF are worried.Article I, Article II.

    3.) Asset Correlations increase significantly during Crises.  This is occuring now.Article.  Higher correlations (and market volatility) typically surround a Crises.  In fact, S&P is now rating European economies in one basket, placing 15 EU nations on Negative-CreditWatch.

    4.) The US equity market declined during Thanksgiving week, the worst since 1942.  (Thanksgiving wasn’t recognized as an official holiday until 1942.)  Such abnormal price-action is usually indicative of worse times to come.

    5.) European Bond Yields and Credit Default Swaps are significantly higher, and rising rapidly.  CDS prices for Europe should be under 100bps.  Italy’s bond yields and CDS are hovering at 7% and 470bps, respectively.  Note that Italy is the third largest bond(Article) market in the world.  Italy is also subject to “hot money” as over 40% of bond market participants are outside the country including Hedge Funds and Asset Managers.  Italy is too big to Bail.

    6.)  The mighty Germany had a failed Bond Auction two weeks ago.  See foxbusiness story.  Again, fundamentally this shouldn’t have happened, indicating cracks in the internals of the market.

    7.)  Austerity plans won’t work as tax revenues are likely to decline due to recent evidence Europe is rapidly falling into recession.  Lower economic growth will cause sovereign borrowing rates to rise,  in turn choking economic growth (i.e, a negative feedback loop). We base this on data provided by OECD and Markit Economics.

    Source: OECD

    8.) Since June’11, liquidity has declined rapidly.  Money Market funds that buy USD commercial paper have changed their purchasing behavior due to new Basel regulations that require they hold shorter-term securities, and that they have higher cash reserves.  (We note though that the recent USD/EUR currency swaps recently set up with Central Banks appear to be temporarily alleviating the situation.)

    8a) Further, Asset Managers, Commercial Banks and other long-term holders of debt are also expected to drain liquidity from the global market.  This is because as part of the Greek bailout (and quasi-bankruptcy)  Greek Credit Default Swaps could not be redeemed, as a Credit Event would not be triggered under ISDA. Click Here for Press Release.  Consequently, professional investors can no longer hedge their European exposure.

    9.) Counting on China as a European savior is no longer an option. China’s “growth-at-all-costs” model is showing signs of fatigue, according to Markit.  The government just lowered reserve-requirements(link) to keep its own Bubble from bursting.  Politicians must also deal with social unrest, especially as its economic growth nears the key 7% level which is needed to maintain social stability, according to Time Magazine.

    While the Euro-Crises has evolved over the last two years, the Crises has worsened to the Point of No Return.  The EU can no longer continue “playing chicken” with the market.  Times have changed – China can no longer afford to save Europe, borrowing rates are unaffordable and the Eurozone is entering recession just as austerity plans are kicking-in.  Europe can no longer save the world from itself !

    Call Now Button