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Mexican Peso Points to Trouble Ahead for Foreign Bond Buyers

  • Debt holdings remain high despite Nafta, election risks
  • Peso key for yield spread and investors’ Mbonos appetite

The Mexican peso has started to flash a warning to bond investors.

Foreigners hold more than 60 percent of Mexican government bonds despite the uncertainty stoked by the North American Free Trade Agreement renegotiation and an upcoming presidential election. But this may change amid growing conviction that the peso’s gains this year could soon be reversed.

Overseas investors have begun paring back their ownership of Mbonos, according to data from the Bank of Mexico, as Nafta talks have dragged into a seventh round and a left-leaning candidate is leading polls for the July vote. Foreigners hold 62 percent of the outstanding bonds as of early-March, well-above levels seen between 2015 and 2016, but shy of the more than 66 percent record reached a year ago.

It’s noteworthy that foreigners have a strong appetite for Mbonos as Treasury yields are surging and the spread between 10-year Mexican and U.S. government bonds --- the extra yield investors demand as compensation for riskier Mexican debt --- has shrunk to the lowest since October.

This could be the result of a strong peso, which has appreciated 6 percent against the dollar this year, leading emerging-market peers. Since the U.S.-Mexico yield spread is closely linked to fluctuations in peso’s exchange rate, a stronger Mexican currency, which bolsters returns on Mexican bonds in U.S. dollar terms, should lead to a tighter yield spread. On the other hand, periods of peso weakness tend to result in the gap widening.

Looking ahead, the forwards market doesn’t paint a rosy picture. Twelve-month contracts are pricing peso depreciation of more than 5 percent. In volatility markets, six-month and nine-month implied measures, which cover the period after the election, remain much higher than the rest of the curve.

In other words, the peso is pointing to more turbulence in the second half. Investors beware.

  • NOTE: George Lei is an FX strategist who writes for Bloomberg. The observations he makes are his own and not intended as investment advice
  • Some information comes from FX traders familiar with the transactions who asked not to be identified because they are not authorized to speak publicly
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