Is This the Beginning of Another Currency Attack?

I remember sitting in a trading room back in 1997, my eyes glued to the charts on my computer screens while fielding frantic calls from bankers wanting to unload their holdings of the Thai baht.

The currency was under a speculative attack. Investors were concerned about both the health of Thai banks and the government’s ability to honor its exchange-rate peg to the U.S. dollar.

Thailand’s central bank eventually floated the baht after failing to protect it. That move triggered a severe financial crunch that quickly spread throughout the region, devastating a number of emerging-market economies in the Asian financial crisis that stretched into 1998.

As I sit here at my desk in Copenhagen, in 2013, with my eyes glued to the charts on my computer screens, I can’t help but think: “Is it 1997 all over again?”

Bernanke’s Words Cause a Stir …

A number of emerging markets have been in turmoil since U.S. Federal Reserve Chairman Ben Bernanke in May 2013 made his first comments about possibly tapering the Fed’s Quantitative Easing program. Although tapering hasn’t yet occurred, investors have feared that any reduction in the Fed’s money printing would lead to higher interest rates in the U.S. and the developed world, therefore attracting investment capital previously earmarked for higher-yielding emerging markets. Investors have thus sold securities in India, Brazil, South Africa and Turkey, among others, and their currencies have tumbled as a consequence, with the Brazilian real plummeting 20% against the U.S. dollar.

While this market turmoil is troubling, I don’t believe we are seeing an epic emerging-market collapse as we did in 1997, with some currencies falling 50% or more. Don’t get me wrong, it has been a rough few months, but this time is different.

Let me explain.

First, the similarities: In the years prior to both 1997 and 2013, capital inflows to emerging markets surged, as investors were able to obtain cheap financing in international markets, which was then invested (often with leverage) in emerging-market currencies and equities. Also, the global financial system during each period was weak because of imprudent lending by banks, both in emerging and developed markets.

However, back in 1997, interest rates in emerging markets were much higher than today as confidence waned and bond prices sank. During the Asian crisis, 10-year government bonds in emerging markets spiked at 16% to 18%, some 12% to 14% above the 10-year Treasury rate. In 2013, the 10-year rate in emerging markets spiked around 6% to 7%, just 3% above the 10-year Treasury rate. Also, many emerging-market currencies fell 50% or more, and equity markets stumbled almost 60%. Today, we haven’t seen such huge movements.

Additionally, in 1997, emerging markets were looked upon as one. Not so today. Sure, developing countries like Argentina and South Africa have weak infrastructure, weak banking systems, low currency reserves and political turmoil. But the same can‘t be said about all emerging economies, especially an attractive one such as Mexico’s.

Profits Can be Found South of the Border …

Mexico enjoys a currency reserve of US$170 billion, has an improving balance of payments and a low unemployment rate (5%), along with an increasing level of consumer confidence. Also, the increase in Chinese wage rates has worked to Mexico’s advantage as more and more international manufacturers are moving production to Mexico. More specifically, U.S. automotive companies are “nearshoring” manufacturing to Mexico to obtain a shorter supply chain than found elsewhere offshore.

The Mexican government is also taking steps to improve efficiency, by introducing structural reforms in the financial and labor sectors. And the state-owned energy sector is finally facing scrutiny and could be subject to greater competition, allowing outside firms to help state-owned Penmex with fossil-fuel exploration and production.

With central banks around the world getting nervous about tepid growth prospects and high unemployment rates, the resulting accommodative policies and a slowly improving U.S. economy should provide support to Mexico. The U.S. accounts for about 25% of the Mexican economy and almost 80% of Mexico’s foreign direct investment. Also, interest rates in Mexico are higher than in the U.S., so investors can obtain a higher rate of return, along with long-term currency gains in the peso against the U.S. dollar.

Because of these developments, the Mexican peso has gained importance in the international currency markets. According to the Bank of International Settlements (BIS) triennial survey, Mexican peso turnover has reached US$135 billion a day in 2013. In 2010, that amount was US$70 billion. Also, the peso’s share of global foreign exchange trading has now increased to 2.5% and it is now one of the world’s 10 most actively traded currencies.

Right now, I recommend obtaining exposure to the Mexican peso and Mexican equities. If you want both, you can buy the iShares MSCI Mexico ETF (NYSE: EWW) or ProShares Ultra MSCI Mexico ETF (NYSE: UMX). If you just want currency exposure, the easiest solution would be a Mexican peso certificate of deposit. The USD/MXN pair is currently trading near 13.14, and I believe we could see a move below 12.00.

Regards,
Thomas Fischer
Editor, Currency Cross Trader