US Dollar Strength Adds Pressure on Latin American Currencies

Recent weeks have witnessed a remarkable surge in the volatility of foreign exchange (FX) markets, particularly within emerging markets (EMs).

by Faruk Imamovic
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US Dollar Strength Adds Pressure on Latin American Currencies
© Getty Images/Ethan Miller

Recent weeks have witnessed a remarkable surge in the volatility of foreign exchange (FX) markets, particularly within emerging markets (EMs). Several interconnected factors including rising US yields, a robust US dollar, and mounting geopolitical concerns have driven this volatility spike.

Such conditions often prompt shifts in investment strategies, especially in volatile environments like those of Latin America. In particular, the USD/MXN (US Dollar/Mexican Peso) pair has experienced significant fluctuations.

Analysts and investors are keenly watching Mexico, as its central bank, Banxico, shows a strong inclination to maintain, or even increase, its already hawkish stance to counteract the FX volatility. This proactive approach by Mexico’s central bank stands in stark contrast to the political risks, which appear less severe now compared to the previous month, reflecting recent positive developments.

The broader context involves the USD/EM pair, which not only has rallied recently but has also seen implied volatilities soar due to the factors mentioned above. In the face of these challenges, there's a growing consensus among traders to strategically fade the vol rally by engaging in specific trades like selling short-dated straddles—a strategy betting on the stabilization of currency values without large movements in either direction.

Analyzing the Shifts in Global Monetary Policies

Global economic dynamics have continued to exert pressure on stock markets, which have remained jittery since the onset of April. A major factor in this unrest has been the relentless rise in global yields, spurred by higher inflation rates in the US.

Despite inflation being relatively controlled in other regions, the influence of the Federal Reserve's policies tends to dominate global financial narratives, overshadowing other central banks like the ECB, BoC, or BoE which might follow more independent paths.

For instance, while the Bank of Canada has moved towards a rate cut due to sufficient disinflation, the Fed’s recent statements have reintroduced a more cautious tone into the market. This was evident when Fed Chair Jay Powell, speaking at a panel alongside Bank of Canada Governor Tiff Macklem, adjusted his previously dovish stance to align more closely with the hawkish sentiments of other Fed officials.

This shift has had a ripple effect across various asset classes, most notably in US Treasury yields, which are expected to potentially touch the 5% mark soon—a level not seen since October 2023 when economic indicators were less favorable.

US Dollar© Getty Images

Latam Currencies Under Pressure

The repercussions of a strong USD and higher US yields have been particularly pronounced in Latin American currencies. The USD has surged against major currencies like the EUR, GBP, JPY, CAD, and CNY, which has placed additional competitive pressures on Latin American nations, many of which are heavily reliant on exports and global trade.

This impact is further compounded by the nature of their export goods, predominantly commodities, which are vulnerable to shifts in global demand and trading conditions. Yet, despite these broad challenges, the situation in Mexico presents a unique narrative.

Recent analyses suggest that the Mexican Peso (MXN) has been unduly punished in the face of these market shifts. The heightened volatility is seen by some experts as a temporary anomaly rather than a long-term trend, pointing towards opportunities to engage in volatility trading strategies like the aforementioned selling of straddles.

Moreover, the political landscape in Mexico, which could have added to the currency's woes, has begun to show signs of stability. The lead-up to the US presidential election had stoked fears of worsening bilateral relations, especially with Donald Trump's tough rhetoric on issues like migration and trade with Mexico.

However, these concerns are somewhat alleviated by the current betting odds favoring Joe Biden amidst Trump's legal troubles and the shifting political sentiments. In Mexico itself, the political scene is also stabilizing.

Presidential candidate Claudia Sheinbaum has distanced her policies from those of the current administration, particularly in areas like energy, which may encourage more US investment in Mexican energy sectors, thus fostering a more favorable economic environment for the MXN.

Strengthening Strategies: Mexico's Economic Response

Mexico's Central Bank (Banxico) is playing a crucial role in navigating through these turbulent times by likely maintaining a hawkish monetary policy. This determination has become even more pronounced following recent FX volatilities.

While other emerging markets may waver under the pressure of aligning their policies with global trends, Mexico stands firm. The resilience is partially attributed to Banxico’s proactive stance against inflation and economic disruptions, which seems to reassure investors about the stability of the Mexican economy.

Deputy Governor Jonathan Heath recently emphasized that despite proposing a minor rate cut in March, the overarching monetary policy must respond robustly to complex disinflation processes. His comments reflect a deep consideration of the current economic climate, marked by an expansive fiscal policy and resilient economic activity, factors that contribute to the 'stickiness' of services inflation.

The substantial minimum wage increase planned for 2024 further complicates the inflation outlook, solidifying the need for a steadfast monetary approach. This firm policy direction is particularly significant as Mexico prepares for upcoming presidential elections.

The current frontrunner, Claudia Sheinbaum, proposes to diverge somewhat from the incumbent President Andrés Manuel López Obrador’s nationalistic policies, especially concerning the energy sector. This shift is expected to encourage more foreign investment, particularly from the United States, in areas like energy production and clean energy initiatives.

The potential increase in US investment would not only bolster Mexico’s energy sector but also provide a stabilizing effect on the MXN by reducing the volatility often associated with uncertain political and economic policies.

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