How hedging and a certain someone upended the year of the peso

This article is by Isabella Cota and Jessica Brice of Bloomberg News. It appeared first on the Bloomberg Terminal.

For the Mexican peso, 2016 wasn’t supposed to end this way.

At the beginning of the year, most currency forecasters agreed: The peso was grossly undervalued. Estimates compiled by Bloomberg at the time put it on course for the biggest gain among major currencies. Bank of America said things would get better; Citigroup and HSBC Holdings said they certainly wouldn’t get any worse.

Yet as 2016 draws to a close, the peso isn’t an emerging-market standout. Instead it’s the world’s worst performer. Battered by events far beyond its borders—such as the U.K.’s Brexit referendum—the currency tumbled 6 percent against the U.S. dollar this year through Nov. 8. And then Donald Trump was elected president of the U.S.

Overnight, the peso plunged more than 13 percent, surpassing 20 per dollar for the first time. Mexico’s peso was worth less than a nickel. It will likely end the year posting its fourth annual decline.

For much of the year, the Mexican currency’s performance tracked Trump’s up-and-down performance in the polls. In September and again just before the election, when polls suggested the Republican presidential candidate had a decent shot at the White House, the peso took big hits—and not only because of Trump’s “build a wall” rhetoric.

How FX forecasters got the call so wrong is a story that dates to the so-called Tequila Crisis in the mid-1990s, after which the Mexican government—desperate to claw its way back from near collapse—instituted a regulatory framework to bolster peso trading. In the two decades since, the peso has emerged as the hedge of all hedges.

“The peso used to only be a proxy hedge for emerging markets,” says Eduardo Suárez, a strategist at Bank of Nova Scotia in Mexico City. “Now it’s a hedge for everything.” The change was gradual, Suárez adds, until recently, when it became exponential. Over time, what started out as the Mexican financial market’s greatest strength—its liquidity—has turned into one of its biggest liabilities.

Mexico’s fundamentals don’t support the case for such currency weakness, say surprised strategists. Inflation is in check, the nation’s credit rating is still investment-grade, and economic growth estimated at 2.1 percent this year looks downright bountiful compared with recessions in Brazil and Russia, home to the two of the world’s best-performing major currencies. To many longtime Mexico watchers, the peso’s behavior makes no sense … until you look at how markets abroad have been behaving in recent years. To protect against lower commodities prices, slowing growth in China, instability in Europe, or just about anything, really, traders have been shorting the peso.

So-called short positions, or bets the peso is going to fall, have outnumbered long holdings for a record 26 months. Before now, there had been only two periods that came close (if the six-month stretch in 2009 and the eight months in 2002 can even be considered close).

Correlations between the peso and many major assets are rising, including oil, the British pound, and—most important—the S&P 500, seen as a bellwether for global growth expectations. The daily linear correlation between the peso and the index has almost doubled from a year ago, to 0.47, the most of any emerging-market currency. (A correlation of zero means the assets are independent of each other; 1 means they move in lockstep.)

As a result, the peso isn’t just a story about Mexico or the U.S. anymore, says Andrés Jaime, a Barclays strategist and former cross-asset strategist for Mexico’s central bank. “There’s a story for oil, a story for China, a story for global growth,” he says.

Driving demand for the hedge is the peso’s 24-hour, five-days-a-week trading. That’s a rarity in Latin America, where Brazil’s real and the Chilean peso trade during set business hours. The peso’s also the second-most liquid emerging-market currency (it lost the top spot this year to China’s yuan). Its average daily turnover was $112 billion in April, the latest figures available from the Bank for International Settlements. That’s about twice the ruble or the rand.

“This is the year of extreme volatility for Mexico,” says Juan Carlos Rodado, director of Latin America research at Natixis North America and the top peso soothsayer in the third quarter, according to Bloomberg rankings. He sees no reprieve in 2017. “It becomes a problem,” he says, “when the currency is trapped by that volatility and you’re forced to increase interest rates” to curb speculation.

By that measure, volatility is a problem. Mexico’s central bank, known as Banxico, startled markets with two surprise interest rate hikes in 2016 and a third that was largely expected, but only because strategists began including the extreme peso volatility in their forecasts. As recently as December 2015, Banxico Governor Agustin Carstens had signaled he’d embark on a tightening cycle when the U.S. Federal Reserve started raising rates.

It used to be that liquidity for Mexico was a virtue. In 2000 the country sold 10-year peso-denominated bonds to foreigners. The sale, unheard of at the time after a wave of developing-world defaults in previous decades, marked a major victory for a country that had itself been on the verge of financial collapse only five years earlier, says Antonio Sibaja, chief investment officer of Invercap and a former Banxico official in charge of implementing foreign exchange policy. It also set off a virtuous cycle that deepened liquidity and allowed the government to further diversify instruments.

To Mexicans, the Tequila Crisis of the ’90s was their Lehman Brothers, only the government couldn’t keep the lid on the contagion. After a sudden peso devaluation in December 1994, foreign investors fled overnight, Banxico was forced to break a managed peg to the dollar, and the currency collapsed. Inflation surged to more than 50 percent the following year. Within a month of the devaluation, the U.S. stepped in, coordinating a $50 billion bailout.

In 1995, to strengthen the new floating-exchange-rate regime, the central bank pushed additional deregulation to allow new financial instruments, specifically futures and options. In April of that year, Banxico authorized the operation of foreign exchange markets dealing in U.S. dollar derivatives involving pesos, and the Chicago Mercantile Exchange launched a peso futures contract, the first emerging-markets product of its kind to be traded on the bourse.

Those steps bolstered the peso’s liquidity, but it wasn’t until 2004, after Mexico’s finances improved and international markets stabilized following the dot-com bust, that Sibaja and other Banxico officials started to notice how the peso was beginning to trade outside Mexico and the U.S. “The peso began to have such liquidity and depth,” he says, “that suddenly it was everywhere.”

Today, Mexico’s solid finances relative to those of peers, the currency’s free float, and transparency mean the peso will remain the world’s hedge, Invercap’s Sibaja says. “Will it ever stop being a proxy hedge?” he asks. “It would either have to be a market-driven event, or we would have to suddenly become the Bolivarian Republic of Venezuela.”

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