Trump's fallout effect on the Mexican peso

While everyone in America was eagerly awaiting Donald Trump's speech to Congress on Tuesday, some investors were nervous about what he might say on trade. On the day of the speech, the Mexican peso fell by nearly 1 percent against the U.S. dollar, which would be a significant jump if it wasn't for the fact that the peso has fallen by 12 percent since the U.S. election. It's the second worst-performing currency other than the Turkish Lira since Nov. 8. At press time Friday morning the US dollar/Mexico peso spot rate was 19.84.

For many years the peso had been considered an emerging market proxy — it tends to move depending on what's happening in other developing nations, not just on what's occurring at home — but Trump's rhetoric on trade and immigration is now causing the currency to shift based on American politics. That's putting its proxy status at risk.

"Mexico is starting to trade more idiosyncratically," says Leah Traub, head of currencies at Lord Abbett, a New Jersey-based investment firm. "I don't necessarily think Mexico will be a proxy for all emerging markets, like it was in 2015 and early 2016."

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It's been a proxy currency in part because it's the easiest currency to trade, says Taub. It's the most liquid instrument without capital controls, and it's the most traded currency by volume.

Up until recently, investors have bought or sold its bonds, currency or even its equities, depending on their view of emerging markets. For instance, during Brazil's presidential corruption scandal, the real held up fairly well, but the peso depreciated because of wider-spread emerging market concerns, says Alfonso Esparza, a senior international market analyst with Oanda, a currency trading company.

"You can see that the real is more correlated with Brazilian fundamentals, so even as things were happening, it did not depreciate as much as the peso," he says. "The peso took a hit for the region as a whole on Trump-related factors, but also on regional economic factors."

Because of the way Mexico's currency has tended to move versus other currencies, shorting the peso has been a common hedging strategy. Investors would go long a local currency and short the peso, says Andrew Stanners, a portfolio analyst on Aberdeen Asset Management's emerging-market debt desk.

That's been an especially popular tactic over the last couple of years as commodity prices have fallen. While Mexico isn't as big of an energy powerhouse as some other nations, its currency dropped because of the impact the price decline had on many developing countries as a whole. Since July 2014, West Texas Intermediate has fallen by 47 percent, while the peso has fallen by 53 percent against the U.S. dollar.

"We saw pressure there as people associated the peso with a story of weakening currencies in the markets that have had to cope with the commodity shock," he says.

While the peso is still considered a proxy, Trump-related movements are complicating things. In January it was the worst-performing currency as the Mexico-U.S. relationship started to sour. Anti-trade rhetoric was picking up, Mexico's president canceled a visit, and tweets between the country's two leaders were flying back and forth.

In February it's been one of the strongest, rebounding by close to 4 percent, partly because people may also now be taking a more wait-and-see approach to Trump's next move, says Esparza.

Mexico's central bank has also started to more actively intervene in order to combat now rising inflation due to the low peso. It's raised interest rates from 3 percent to 6.25 percent over the last year, and it recently announced that it was going engage in a swap program, which should boost the value of the peso in the short term, adds Taub.

Other currencies may be jockeying for the proxy positon, though, including the South Korean Won, which is also fairly liquid, operates in an open economy and is exposed to global trade.
Over the last year, the U.S. dollar has fallen by 7 percent against the Won, perhaps as indication of emerging market strength. The MSCI Emerging Markets index is up 24 percent over the last 12 months, too.

Stanners points to Brazilian real as potential proxy — the Greenback has fallen by 21 percent against the currency — but with the peso still being the most liquid of the bunch, it's hard for any others to really represent emerging markets.

"I wouldn't say these currencies have overtaken it," he says.

Most retail investors won't see the impact of a volatile peso on their investments, but it could impact the way some global fund managers operate.

For instance, a manager of a global fund that invests in developed-market treasuries would normally use the peso proxy to express concerns about emerging markets. Rather than trade in and out of various countries, they may just buy or sell peso-denominated treasuries, or go long or short on the peso, based on their view, says Stanners. It's becomes harder to do that if the peso is now more correlated to what Trump is saying.

In some ways, though, the growing peso-Trump bond is making it easier for investors who have identified opportunities in Mexico, as companies are now moving based on what's happening within the country versus on a reaction to emerging market issues overall.

"The reverse of what some may be thinking is that Mexico has now started to trade more in isolation," says Stanners. "So if you looking at a company in Mexico to trade, whether it's on the equity or bond side, you're now able to do that."

The peso will likely experience more volatility over the next several months, at least until there's more clarity around trade and immigration, says Stanners. At this point, if Trump take a hard line against trade, the peso could fall further. If he takes a softer stance it may rise. With all of that uncertainty, investors must be careful about trading on headlines, adds Taub.

"The peso is still very much affected by his comments," she says. "It's going to be volatile, and investors do need to have a more of a long-term view. If you trade around every news announcement, you'll go crazy."

— By Bryan Borzykowski, special to CNBC.com