Trump Trade Risks Seen Spreading Peso Woes to Canadian Dollar

  • Mexico’s currency has taken the brunt of trade policy risks
  • Banxico intervention tools could limit further decline

Wilbur Ross: Nafta Logically First Thing to Deal With

While the currency market fixates on the Mexican peso every time U.S. President Donald Trump tweets about trade, the Canadian dollar may have more at stake if protectionist policies materialize.

Both currencies fell roughly 2 percent against the U.S. dollar after commerce secretary nominee Wilbur Ross said Wednesday the new administration will start the process of renegotiating Nafta soon after the inauguration. But while the peso has sunk 15 percent since Trump’s victory, the recent weakness has so far left the Canadian dollar little changed.

The peso has suffered the most even though both nations could be hurt by changes to the North American Trade Agreement in favor of the U.S. The Mexican currency fell more than 3 percent in the two days after Ford Motor Co. said it would scrap plans to build a $1.6 billion plant in the country, while the loonie rose 1.6 percent.

Aside from the possible impact from taxes on trade with America, the loonie is also vulnerable because of the widening gap between the performance of the U.S. and Canadian economies. Bank of Canada Governor Stephen Poloz said Wednesday the central bank has "room to maneuver" if "downside risks materialize." At the other end of the spectrum, Federal Reserve Chair Janet Yellen said on Thursday she backs gradual rate increases.

This divergence is seen in the spread between the Canadian and U.S. Treasury two-year yields, which has widened 15 basis points since the election.

"The outlook should continue to keep the (Bank of Canada) on the sidelines with a bias to cut, not hike," Toronto-Dominion Bank foreign-exchange strategist Mark McCormick said in a note about Poloz’s comments. "With the Fed set to continue normalization, this should amplify rate spreads."

Some investors are already looking to hedge against a decline in the loonie. The risk of further weakness is seen in Canadian dollar one-month 25-delta risk reversals, which are near year highs as investors buy protection.

In contrast, peso one-month 25-delta risk reversals have failed to track a rise in implied volatility since the beginning of the year, which may be a signal puts are being used to hedge long U.S. dollar positions or there is a lot of interest in selling top-side strikes.

This, along with the possibility of further intervention by Mexico’s central bank, may limit how much the peso will fall as protectionist trade policies take shape in the U.S.

Banxico doesn’t have deep pockets to fight the depreciation, but it does have choices. Mexico’s foreign-exchange commission could introduce non-deliverable forwards settled in pesos as a new tool to sell dollars, according to Barclays Plc. The central bank could also offer dollar swaps because they don’t directly impact reserves and provide hedging protection, according to Goldman Sachs Group Inc.

Mexico has $176.5 billion in foreign reserves or $260 billion in total if the IMF’s flexible credit line is factored in, according to BNP Paribas SA. That gives it a $40 billion buffer to spend on interventions.

Technicals also support a weaker loonie against the peso. The Elliot Wave study suggests the first stretch of a reversal before the pair begins to drop.

Additionally, a chart of mean reversion shows if the Canadian dollar sustains a close above 1.3280, the 12-month average closing price, it may it test toward 1.3690 standard deviation resistance.

  • Vincent Cignarella and Davison Santana are FX strategists who write for Bloomberg. The observations they make are their own and are not intended as investment advice.
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