Mexican Peso Surges 4% on USMCA, Arbitrage Boost

Over the past three months, the Mexican peso has appreciated by 4% against the US dollar, transforming from an early victim of the trade war into a beneficiary. This shift is largely due to Mexico's successful navigation of trade negotiations with the US, particularly through the USMCA agreement, which granted Mexico tariff-free treatment for most of its goods. Additionally, the current environment for arbitrage trading has provided a strong boost to high-yield currencies like the Mexican peso.

Analysts attribute the overall strength of the Mexican peso and Mexican assets to a weak US dollar environment and high arbitrage yields. The resurgence of global carry trades, driven by expectations of a Federal Reserve rate cut and a weakening dollar, has made the Mexican peso a significant beneficiary. This has positioned Mexico as an unexpected winner of Trump's trade policies.

In February, the peso plummeted to a low of 21 pesos per dollar following the US announcement of a 25% tariff on Mexican goods. However, it has since rebounded to around 18.5 pesos per dollar, erasing all losses since Trump's election and becoming a key beneficiary of the resurgence in arbitrage trading.

Mexico's success in trade negotiations has been a significant factor in this turnaround. Unlike other countries, Mexico secured tariff-free treatment for most of its goods through the USMCA agreement and received a 90-day extension of Trump's "reciprocal tariff" policy on July 31. This has been seen as a relatively successful handling of trade relations with the US.

The current environment for arbitrage trading has also provided a strong boost to high-yield currencies like the Mexican peso. The cumulative carry trade index, which tracks the performance of eight emerging market currencies, has risen by more than 10% this year. Global funds investing in developing country bonds have seen weekly inflows for the past four months.

Three key factors have driven the resurgence of arbitrage trading. Firstly, weak US employment data has increased market expectations of a Federal Reserve rate cut in September, reducing the cost of borrowing in dollars and clearing obstacles for carry trades. Secondly, the interest rate differential between emerging markets and developed countries is significant. Mexico's central bank policy rate remains at a high 7.75%, while US Treasury yields are relatively low, providing investors with a substantial carry trade opportunity. Currently, the yield on 10-year Mexican bonds is 9%, compared to 4.3% for 10-year US Treasuries.

The third driving factor is the significant reduction in market volatility. The CME Group's dollar-peso exchange rate volatility index has fallen sharply from its peak in November last year, reaching its lowest level since May 2018. This stability has made carry trades more attractive. Global asset management companies are reallocating to high-yield markets like Mexico. According to data from the US Commodity Futures Trading Commission, leveraged funds' bullish bets on the Mexican peso reached their highest level in nearly a year as of August 6, following the Mexican central bank's decision to slow the pace of monetary easing. This indicates investor confidence in the currency's high-interest-rate environment.

In this round of carry trade resurgence, Latin American currencies have performed exceptionally well. Data shows that the carry trade yield for Latin American currencies reached 3.7%, far exceeding the 1.1% for Europe and Africa, and significantly outperforming the average carry trade yield of -1.1% for Asian currencies. The overall strength of the Mexican peso and Mexican assets is primarily driven by a weak US dollar environment and high carry trade yields. However, the US trade policy remains a risk factor, although Trump's frequent changes in the most destructive policies have somewhat alleviated concerns.