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Chandler: Battered Peso Could Weaken Further in Coming Weeks

The peso generally weakened from August last year through the middle of March. In the past month and half, the US dollar has slumped almost 17 percent against the peso. However, since the end of last week, with the outbreak of swine flu, the dollar has rallied around 9 percent.

Even before the swine flu, the peso's upside momentum had faded and the dollar found support near MXN13.0. As of last Tuesday, the CFTC commitment of traders showed the net speculative positions were the longest of pesos since last September. Given the price action, one must assume that part of the peso's sell-off was a liquidation of longs.

Three-month implied volatility of the dollar-peso peaked last October near a mind-boggling 56 percent. It has since fallen to around 17 percent in the middle of April and now is near 20 percent. Before the crisis, the dollar-peso was a low volatility pair—mostly trading between 5 and 10 percent.

In addition to the human and economic costs of the outbreak of swine flu, it has also impacted the liquidity of the peso. News reports suggest that the outbreak and, more to the point, the response to the outbreak, is dramatically reducing the turn-over in peso activity in Mexico. Some estimates suggest the $15 billion-a-day turnover in Mexico has fallen by as much as a third, though bond volumes have reportedly held in better.

The drop off in liquidity is causing not only greater volatility, but also a widening of the spreads between the bids and offers.

The MXN13.56 area, which contained the dollar's pullback on Wednesday, corresponded to a retracement objective. A break now, through MXN13.70 warns a probable move toward MXN13.42. Yet, our preferred view, is for the dollar to re-establish a foot hold back above the MXN14.00, which could see MXN14.50 in the coming weeks.

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Marc Chandler is the global head of currency strategy for Brown Brothers Harriman. He has been analyzing, writing and talking about the foreign exchange market for more than 20 years. He is a regular guest on CNBC and his essays have been published in numerous economic and business publications. He previously served as the chief currency strategist for HSBC Bank USA and Mellon Bank.