By Michael O'Boyle
MEXICO CITY (Reuters) - Mexico's peso could slide even further if convictions mount that the massive monthly U.S. monetary stimulus is nearing an end and lead to an exodus of foreign investors who have piled into Mexican markets.
The dizzying slide in the currency, down about 7 percent in the past three weeks, came as investors worried the Federal Reserve might taper off on bond purchases in response to a better U.S. economy and job market.
Although such a move by the Fed should support Mexico and its exporters in the long term since the local economy moves in sync with its northern neighbor, the mere thought of rising market rates in the United States spooked investors who had pushed the peso to its highest in nearly two years in early May.
Assets in Mexico, with its close ties to the United States, have been among the most popular investments to leverage cheap loans in developed currencies and the prospect of a Fed exit spurred the worst sell-off in Mexican bonds since late 2010.
Early this year, bonds and stocks hit record highs as a new government pushed economic reforms aimed at lifting growth in Latin America's No. 2 economy. But in a span of just a few weeks, Mexico has flipped from a 'top pick' status among investors to some of the world's worst-performing assets.
"I can't believe it," said Alfredo Puig, a trader at Vector brokerage in Monterrey. "It is like all the fundamentals we were based on three months ago were wrong. Between the standing ovations, we get punished with a whip."
If there is a stampede for the exits by foreign investors, Mexican bonds and the peso could be facing an even more brutal sell-off. Even if bond investors hold to positions and pile on hedges to cover currency losses, the peso would be vulnerable to a bigger fall that could fan inflation fears.
Already, the peso tumble has reduced expectations for the Banco de Mexico to lower rates a second time this year.
After cutting to 4 percent in March, policymakers said they were concerned about the impact on the peso of a further wave of inflows, which have multiplied foreign holdings of peso debt over six-fold since 2009 to $1.75 trillion pesos ($136 billion).
A Banamex survey released last week showed economists forecast another 50 basis point cut by September. But markets have now priced out this prospect as the peso slumped and policymakers are seen turning to the risk of sharp outflows.
"The central bank is going to sound more neutral now. They have to get rid of this idea of a cut and address the risk of financial instability. Inflation is very sensitive now," said Salvador Orozco, a strategist at Santander in Mexico City.
The weaker peso could upset central bank forecasts for inflation to ease below its 4 percent ceiling in the second half of 2013, although policymakers argue the pass-through from exchange rate fluctuations to consumer prices is now negligible.
The Banco de Mexico is also keeping a close eye on how Mexican rates compare to other countries -- reducing the chance of policy loosening while U.S. policy is tightening.
STAMPEDE FOR THE EXITS?
Mexico has been one of the emerging markets hardest-hit by investor panic over the last week, amplified by its liquid markets and hands-off attitude by officials, although a collapse in the peso could trigger intervention to blunt the fall.
The peso blew past its 200-day moving average last week. The slump could tempt in bargain hunters, or it may bode for much deeper losses. The clear break could come soon. U.S. payrolls figures for May are due on Friday, and a significant surprise to the upside could set the stage for the Fed to start winding down its $85 billion a month bond buying program.
It is not clear how much of foreign inflows is coming from hot money which could reverse course and how much is coming from institutional investors who see Mexico as a good long-term bet, although policymakers say the investor base is more stable now.
Mexico's benchmark 10-year bond has risen about 80 basis points this month, its steepest rise since November 2010. The last time the Fed flagged a tightening, in 2006, Mexican yields shot up 200 basis points over three months. start winding down its $85 billion a month bond buying program.
Bond traders complained of thin liquidity, with selling driven mostly by local pension funds and dealer banks, and fund managers say they are stunned by the abrupt lurch higher.
"Everyone is scared and nobody knows what is happening," said Alonso Madero, a fund manager at Actinver in Mexico City, hoping that the payrolls data would bring clarity. "We will see if players come back into the market and if it's to get in or get out."
Bets on the Chicago exchange fell in the last week from near a record high of about $5.5 billion in favor of a stronger peso to about $4.8 billion, leaving a huge skew in favor of the Mexican currency that could be unwound.
A liquidation of similarly-sized net long positions in 2011 and 2012 accompanied 18 percent and 11 percent losses in the peso, respectively. A 10 percent loss would take the currency to around the 14.20 level that marked its recent multi-year lows.
Still, in the peso's favor are promises to overhaul the tax system and open up the state-run energy sector to outsiders, reforms due for presentation after Congress resumes in September.
"In a first movement, everything points to a weaker peso," Nomura analyst Benito Berber said. "But at some point there should be a stabilization in the peso as we get closer to September."
(Reporting by Michael O'Boyle; Editing by Krista Hughes and Diane Craft)
Source: http://news.yahoo.com/analysis-mexico-peso-peers-over-precipice-much-steeper-101508845.html
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