FX Dashboard: High Volatility Relative to Carry Weighing on LatAm Currencies

With risk assets recovering this morning, the dollar index (DXY) was flat. EM currencies were similarly flat on average with no notable outliers. Overall, Latin American currencies performed better than other regions, though the difference was minor with an average appreciation of 0.1% versus -0.1% for CEEMEA and 0.0% for Asia.

Even if modest, today’s outperformance of LatAm currencies was welcome given their recent underperformance (see here). Indeed, as the first chart below shows, the volatility of LatAm currencies has picked up and is above its 10-year average. While EM currencies overall had turned more volatile a month ago, their volatility on aggregate has once again dropped below the long-term average.

Complicating the situation for the five LatAm currencies is that they offer low carry currently. As the second chart below shows, all the LatAm currencies have low carry relative to their volatilities – they are all below the best-fit regression line.

Currently, the average carry for these five LatAm currencies is 2%, which is only marginally higher than the average carry for Asian currencies. Historically, the carry difference between LatAm and Asian currencies has been high, which is reasonable to expect as LatAm currencies are typically more volatile than Asian currencies. The unprecedented level of monetary easing provided by central banks in the aftermath of the pandemic resulted in the low carry offered by most currencies, particularly LatAm currencies.

Looking ahead, of the five Latin American currencies, the Mexican peso (MXN), the Brazilian real (BRL), and the Chilean peso (CLP) are less vulnerable from this perspective. The carry for MXN is close to fair and the curve has further rate hikes priced in. In the case of BRL, the curve is pricing in almost 350 bp of additional rate hikes by the end of the year, including a hike of 75 bp likely to be delivered at the MPC meeting later today. Expectations of a strong growth rebound due to high copper prices and the rapid pace of vaccination are likely to support CLP despite its low carry.

This leaves the Peruvian sol (PEN) and the Colombian peso (COP) as the most vulnerable of the group. Continued volatility in these currencies – due to the upcoming second-round presidential election in the former and protests related to a tax reform proposal by the government in the latter – places the accommodative monetary policies in the two countries at risk. Colombia’s Banco de la República said as much in their statement last week.

This is particularly notable for Colombia as we have held the view that there was room to ease (see here). The recent spate of volatility has changed our view and even though there was a split vote at the MPC meeting last week with 1 vote for a rate cut, we now don’t think a rate cut is likely. At best, the central bank may delay rate hikes. Given the rise in risk to the short end of the curve on the back of recent events, we recommend closing the 5s10s curve steepener recommendation we had in Colombia with a small profit.

Data Source: Refinitiv; Note: EM and LatAm refer to equally weighted spot returns for 22 EM and 5 LatAm currencies, respectively

Best Longs / Best Shorts

• To the list of underperformers based on our models in the attached FX Dashboard, we added the Colombian peso (COP) as its average z-score based on 3m changes exceeded 1.
• The Peruvian sol (PEN), the Thai baht (THB), and the Romanian leu against the euro (EURRON) were on the list already.
• The list of outperformers stayed unchanged with the Chilean peso (CLP) on it.

Best Crosses

• Our list of preferred relative-value trades remain unchanged with Long COP vs Short CLP or ZAR and Long PEN vs Short CLP on it.
• The 3m expected returns for these pairs are high in the range of 10-12% (not annualized), assuming mean reversion.