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Look Homeward, Peso

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When risk appetite is strong, currencies trade less on global events than domestic factors. Here's how to play the pattern.

How do you know when investors are feeling risk averse? One approach is to keep an ear cocked for worried comments about world events. When traders point to events in Spain as a reason for the Australian dollar's weakness, you know they're feeling edgy.

That's the conclusion of Ezekiel Aguirre of Bank of America Merrill Lynch . He and Claudio Irigoyen have analyzed currency patterns over the last few months, and they found that "regional currencies become much more correlated with global factors at times of risk aversion."

That's useful for investors, since it suggests regional currencies can be successfully traded based on domestic events and indicators when investors' risk appetites are strong.

That time is now, Aguirre and Irigoyen say. Thanks to the European Central Bank's bond buying plan and the Federal Reserve's introduction of QE3, investors are less worried about low-likelihood disasters - or tail risk - in forex these days. "The reduced tail risk has lifted risk appetite and as a result global factors have less of an impact on LatAm FX right now, " Aguirre told me.

That means Latin American currencies with strong domestic fundamentals are interesting right now, Aguirre says. He and Irigoyen are especially bullish on the Mexican peso, thanks to what they call "fundamental undervaluation, competitiveness gains relative to China and prospects for market-friendly reforms by the new government." Then there is the central bank, which is highly unlikely to cut interest rates any time soon. In fact, Aguirre told me, the bank "has repeatedly said that the Mexican peso is undervalued and any strengthening will be welcomed since it will help on the inflation front."

Aguirre suggests buying the peso against the Canadian dollar or the Chilean peso. The Canadian dollar is vulnerable, he says, because investors have big long positions in the loonie, so they might rush to sell on any negative news, and "recent remarks by the central bank governor were significantly dovish." Also, he told me, "the central bank

In Chile, meanwhile, "we think that if the Chilean peso strengthens toward 460 pressure will mount for the central bank to intervene and weaken the currency, " Aguirre says.

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