LATAM FX Talking: Crowded trades suffer in rush to the exit
The flight-to-quality that roiled financial markets has led to a reversal-of-fortunes type of scenario for LATAM FX, with the Mexican peso weakening the most after leading EM FX performance for several quarters.
Executive summary
This reflects Mexico’s more globally-integrated manufacturing supply-chain, the larger share of tourism in its GDP and the fact that Mexico’s energy industry plays a larger role in its macro outlook. Mexico is now more vulnerable to a downgrade from its investment-grade status, which could trigger material disruption in local financial markets.
Other credits that we consider in greater danger of credit-rating downgrades are Chile and Colombia, but downgrades there seem less imminent or far less disruptive as, in principle, both would remain investment grade credits. In Brazil, its CB appears well-prepared to deploy its ample intervention potential to ensure the liquidity of FX markets. Even though there’s limited scope for fiscal stimulus, the “public calamity” declaration was an effective way to ensure that temporary fiscal relief does not translate into permanent fiscal damage, as the underlying fiscal regime remains unaltered.
Ultimately, much should depend on the ability of local economies to prevent the ongoing liquidity crunch faced by households and corporates to turn into solvency issues. But not every country has the capacity to deploy resources effectively while ensuring that the necessary short-term fiscal weakening does not translate into permanent damage to its long-term fiscal outlook.
Given that much of the recent FX dynamics is being driven by risk aversion and portfolio reallocation, forecasting should remain an especially perilous exercise in the near term, with the prevalence of excessively wide trading ranges. FX intervention has been effective at limiting liquidity constraints in some markets, but it’s not enough to reverse the trend. Once risk aversion stabilizes, the aggressive rate cuts by the US Fed could also eventually translate into a weaker USD, bringing some support to EM FX at a later stage.
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