Short AUD/MXN – SocGen

Research Team at Societe Generale, suggests that the MXN has lagged the EM FX rally on Trump fears, but there is room for further unwinding of the political risk premium.

Key Quotes

“As opinion polls move against him, and given the headwinds he faces from state electoral maths, we put the odds of Donald Trump becoming the next US president at 25%. Concerns about what a Trump presidency would mean for relations with Mexico, and for global trade more generally, have resulted in the MXN dramatically underperforming EM FX peers since end-January, so much so that current pricing looks overdone.

The MXN has acted as a prominent proxy for trading US politics and as a low-cost hedging tool for Latam, with the campaign rhetoric of Republican candidate Trump suggesting that Mexico has the most to lose among all EM countries – whether that is from threats to terminate or renegotiate NAFTA, remittance flows, or tourism. Based on Trump’s recent slide in the polls, we believe there is room for a further unwinding of the political risk premium.

The MXN remains cheap given the current oil price, providing an attractive entry point. This is particularly true against other trade-sensitive currencies and even more so if oil prices are either range-bound or set to crawl higher over time. Indeed, as highlighted by our model, given the current levels of oil and the DXY, the MXN remains undervalued on a historical basis, showing a divergence of 1.5 standard deviations relative to fair value.

We maintain our constructive stance on oil for the next year, and our oil analyst forecasts Brent at $48/bbl for 3Q16 and $50/bbl for 4Q16. The rebalancing process between supply and demand is ongoing, and we expect a broadly balanced market by the next four quarters, with significant stock draws in 2H17.

Solid fundamentals in Mexico. Going forward, a gradual reduction of shorts (be it profit taking purposes, or declining risk-reward) is likely to accelerate the move lower in USD-MXN. Weakened fundamentals (economic slowdown, widening capital account deficit) might have played a part in MXN's under-performance, given Mexico’s tight linkages with the US cycle. However, we expect these factors to remain secondary in consideration, based on the diminishing significance of idiosyncratic risks elsewhere in EM. Mexico still has a reasonable economic performance, with GDP growth expected to reach 2.4% this year (IMF) and OECD leading indicator boding for an impending improvement in GDP dynamics.

The global hunt for yield has favoured the AUD, which is currently outperforming iron ore. The AUD has gained 6% against the MXN since late January on the back of the global hunt for yield. The AUD would also suffer in the event of a Trump presidency, but has far less to gain than the MXN in the event that the opinion polls are accurate. Where MXN currently looks cheap relative to the USD, when we compare that pair to oil prices, AUD/USD looks expensive relative to interest rate developments.

AUD/USD is outperforming both iron ore, one of its key drivers, and, even more massively, the short-term interest rate differential. The AUD is being supported by the low volatility environment, favouring the carry trade. The RBA cut rates as expected on 2 August, and one more cut this year remains a possibility (priced at 50% by year-end). However, the currency subsequently appreciated despite AUD rates reaching an all-time low (2y swap rate below 1.85%), making it vulnerable to the next blip in risk conditions.”