What's going on with the peso?

The fix rate surpassed $14 on December 2 for the first time in thirty months. On Monday, December 8, the cost of a dollar had jumped to $14.40. That same day, the Exchange Commission announced it is reviving the auction mechanism it devised in October 2008 as a “preventative measure”. If the exchange rate moves more than 1.5% in the course of a single trading day, Banco de México (Banxico) will sell up to US$200 million dollars into the exchange markets. Today, the 9^th, the fix rate retreated three centavos, the first drop in the cost of a dollar since mid-November.

A couple of hundred million dollars isn’t enough money to stop a run on the peso. In the past, though, it’s proven to be enough to prevent a panic from spreading. When trading volumes are low, a few transactions can send the exchange rate soaring. The idea behind the auctioning of options to buy dollars is simple: since a large, abrupt jump in the cost of a dollar can cause investors to sell pesos first and ask questions later, make some more dollars available to give investors time to see if the problem is more than one of thin markets.

The fundamental question is why the peso has been steadily weakening since May. The strength of the dollar is an explanation that highlights the fact that developments outside of Mexico are behind the weakening of the peso and that the peso isn’t alone: the currencies of other emerging markets have weakened along with the Euro. That’s not the only story, though.

Portfolio investment flows are another face of the same coin. Those depend on the attractiveness of peso-denominated investments compared to investments in other currencies and the fluctuations in investors’ appetite for risk and search for returns.  The magnitude of portfolio investment flows can swing wildly from quarter to quarter. This year provides a good example. In the first nine months of 2014, portfolio investment totaled US$19.9 billion. Of that, US$4.9 billion entered in Q1 and US$13.4 billion, in Q2. Inflows in Q3 plunged to US$1.7 billion, their lowest level since the financial crisis with the exception of the “taper tantrum” in Q2 2013 sparked by the announcement that, at some point, the Fed would begin to dial down asset purchases.

Will the peso strengthen or will it continue to depreciate? In 2011 and 2012 – not so very long ago – we saw steeper jumps in the cost of a dollar, ones followed by a recovery of the peso. In July 2011, the cost of a dollar averaged $11.67. Five months later, a dollar cost, on average, $13.76. Two months after that, in February 2012, the cost of a dollar averaged $12.78, only to bounce back to $13.92 in September. Over the course of fourteen months, the fix exchange rate traded in a $2.25 range (monthly averages), ending the period $1.27 higher than it began. By those standards, the peso’s variations over the last fourteen months have been relatively mild. In October 2013, the fix rate averaged $13.26. Assuming, for a moment, that the rates we’ve seen in the first six trading days of December hold for the rest of the month, the range will be less than a peso.

Don’t expect the peso to appreciate much before Christmas: between holiday travel plans and normal quarter and year-end business transactions, there’s typically a seasonal increase in the demand for dollars. We don’t expect investors to redeploy money to emerging markets towards the end of the year, as they often do once they’ve locked in their annual bonuses.

The peso could well appreciate at the very end of the year. Then again, it might not. Relative returns, confidence, oil prices, and perceptions of the strength of the world economy will all play a role in determining capital flows. But, foreign investment flows don’t depend on just exogenous events. The reforms approved during this Administration piqued interest in Mexico’s future. While investors in money market obligations may focus most on how returns today compare to returns in other countries, equity investors will be very interested in how the reforms passed during this Administration are implemented.