Where can Mexico go?

In the old world that ended sometime last month, the peso was a king. It was among the strongest currencies in the world and appreciated against the US dollar for the past three years. It appreciated nearly 10% against the greenback, which itself was rising against most currencies.  

Mexico is poorly placed to deal with the coming economic shock. The peso has already fallen nearly 30% in the five-week slide, and the full appreciation of the tragedy is not yet discounted.  

First, consider its pre-existing condition. The economy contracted every quarter last year. The central bank kept the overnight interest rate target was among the highest real and nominal levels in the world. This, in turn, attracted carry-trade strategies by levered accounts, and asset managers liked the yields and potential for capital gain in the bond market. Speculators in the futures market had a record large gross and net long peso position. Executives may have felt relief over the new NAFTA agreement, but Mexico's President AMLO has no won over the confidence of businesses.  

Next, think about channels that the shock will impact Mexico. Roughly 40% of Mexico's GDP is exported, 80% of which is sent to the US. The dramatic slowing of the US economy, even if not as bad as St. Louis Fed's Bullard's pessimistic scenario of a 50% contraction, means pain for Mexico's businesses. Worker remittances and tourism are also significant contributors to Mexican GDP and source hard currency. These flows have dried up.  

The collapse in oil prices also does Mexico no favors. The price of WTI for May delivery has fallen from $53.50 to $22.65 in the past four weeks. Mexico has slashed the price of is Maya benchmark as well. The government hedges oil prices but not in a comprehensive fashion. It protects the price of about 235k barrels a day or around 20% of its exports at $49, according to press reports. At $35, 80% of Pemex output is thought to be unprofitable.  

Mexico has been dealt a poor hand, but it appears President AMLO is playing it poorly. Unlike other major countries in the regions (though ironically, Brazil's president, Bolsonaro, is taking a similar stance) AMLO has not sought to curtail social life or impose travel restrictions. He warned that weakening the economy would hurt the poor. A federal court ordered the Mexican government to take "all necessary" action to protect people from the virus.  Mexico is also highly urbanized and reliant on public transportation, making social distancing difficult under any circumstance.

The response to the public health crisis is sorely lacking, and official help to mitigate the economic shock is missing-in-action. AMLO warned businesses and investors he is opposed to corporate "bailouts" (support, loans, guarantee) or tax amnesty. He also indicated no intention to draw on the standing line of credit with the IMF ($61 bln).  

The central bank announced an emergency 50 bp rate cut on March 20 to 6.50%, five days after the FOMC brought its policy rate target to the zero-bound. Banxico also some other liquidity measures, and dollar auctions can re-activated via the swap lines from the Federal Reserve. However, given the economic hit coming, rates have to be slashed. This has implications for the bond market as well as the peso. The 200-300 basis point rate cuts necessary to bring the real rate closer zero might not all be translated into the long-end of the curve, but a good part should, as inflation expectations also fall.  

The peso has plunged to record lows. Speculators in the futures market have slashed their gross long position by three-quarters, but at 55.k contracts (as of March 17), the liquidation is not over. The bears have yet to show their hands claws. The gross short position stood at 21.7k contracts, it has just begun rising from the 16.1k (March 3), which was the least since 2014.    

Volatility is the highest in the decade (three-month implied volatility is above 25.5%, and one-month is near 38%). Using the volatility to a band around spot implies around a 75% probability that it is in a range of roughly MXN22.00-MXN28.50 pin one month and MXN21.50-MXN29.50 in three months. The risks are aligned to the downside for the peso, and given multi-dimension nature of the shock, a move toward MXN30-MXN35 is possible, especially if the virus spreads and is prolonged.