- Hedge funds and asset managers are extremely net-long on the Mexican peso and the Brazilian real, in line with ultra-attractive yield differentials and solid underlying economic fundamentals.
- However, caution is necessary. Emerging market (EM) central banks have begun their cutting cycles, though this is expected to be moderate in Mexico and Brazil versus other EM economies.
- The FX volatility curve using CME options data suggests investors are no longer in “fear” mode, which is beneficial for the Mexican peso and Brazilian real.
The carry trade has proven fruitful this year, driven by strong EM FX performance. Latin America (LatAm) FX proved the main contributor, with the region accountable for 10.8 percentage points (pp) of the 13.4pp delivered by the strategy. The Mexican peso (+14.5% YTD) and the Brazilian real (+9.3% YTD) have been notable outperformers thanks to high real interest rate differentials and strong domestic growth (Charts 1 and 2).
More attractive policy rates and a solid economic backdrop have pushed investors more bullish on both the Mexican peso and Brazilian real (Charts 3 and 4). CME investor positioning data reveals that hedge funds are in the largest Mexican peso net-longs (44.4k), outpacing any other currency. Meanwhile, Brazilian real (14.9k) positioning trails closely behind in third. Hedge funds have also favoured the pound and the Australia and New Zealand dollars (Chart 5).
Meanwhile, asset managers steadily built up outsized Mexican peso net-long positions (128.7k) but have been more reluctant to engage with the Brazilian real (13.7k). Pound net-longs are the only currency positioning to have been pared more than the Brazilian real over the past month (Chart 6). Elsewhere, they have pared Japanese yen, Swiss franc, and Australian dollar net-shorts.
Aggregating investor positions, we find hedge funds and asset managers are bullish on the Mexican peso and Brazilian real, though the former is scaling back positions. Otherwise, they are both bullish on the pound and both bearish on the yen and Canadian dollar.
Macro Hive take: Being (cautiously) bullish on the Mexican peso and Brazilian real continues to make sense with large real rate differentials and the Fed “more or less” done hiking. However, heavily bullish investor positioning, now-high valuations, and EM cutting cycles place the currencies at risk. Therefore, the Mexican peso and Brazilian real could continue to outperform, but likely by less.
What are economists thinking?
To gauge the outlook for the two currencies, we turn to economist forecasts as published on Bloomberg. On average, these sell-side institutions:
- Anticipate the Mexican peso depreciating through the first half of 2024 as Banxico look to normalise the policy rate (Chart 7)
- Anticipate the Brazilian real appreciating further this year, on the back of a shrinking yield differential
- Anticipate the Mexican peso and Brazilian real will have more attractive yield differentials by the end of 2024 versus most of the major EM economies (Chart 8)
What to watch: Strong Mexican peso and Brazilian real performance depends on wide yield differentials and U.S. growth remaining (at least) steady. As EM central banks begin cutting rates from historically elevated levels, the relative speed at which Banxico (central bank of Mexico) and Banco (central bank of Brazil) cut interest rates will be key.
FX investor risk appetite
CME Group has a range of FX volatility data to help investors track the level of volatility. We can also use FX volatility data to determine investor risk appetite. We find the shape of the FX volatility curve useful in this regard. When shorter-dated FX implied volatility is higher than longer-dated volatility, this suggests investors are worried or in panic mode. In contrast, when shorter-dated FX volatility is lower than longer-dated volatility, this suggests investors expect calm markets. The latest data finds:
- The FX volatility curve is steepening, continuing to retrace from its deepest inversion in over a year (Chart 9). Investors are now less panicked than before. This is a positive for the Mexican peso and Brazilian real, which typically depreciate when investors are panicking (Chart 10).
- The move aligns with CME Group CVOL volatility indices, which have followed a similar dynamic, picking up from lows in June.
- Outside FX, equity volatility has stabilised at historically low levels, while rates volatility remains historically elevated despite being pared from 2023 extremes.
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(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)
The opinions and statements contained in the commentary on this page do not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs. This content has been produced by Macro Hive. CME Group has not had any input into the content and neither CME Group nor its affiliates shall be responsible or liable for the same.
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