FX Dashboard: Peru’s Currency and Rates Already Reflecting Election Risk

The dollar index (DXY) edged 0.1% lower to 92 as it has retreated to its erstwhile range of 89.5 to 92.5 that persisted from mid-December to mid-March. With the dollar range-bound, EM currencies were flat on the day. There was a fair bit of differentiation within EM though with the Chilean peso (CLP) and the Brazilian real (BRL) appreciating around 0.5% each and the Hungarian forint against the euro (EURHUF) and the Polish zloty against the euro (EURPLN) depreciating around 0.5% each.

Despite the differentiation within EM, few currencies stood out. One of the currencies that need to be watched over the coming weeks is the Peruvian sol (PEN). The first round of the presidential election in Peru produced a surprise outcome with the leftist Pedro Castillo, who was in sixth place in polls a week ago, leading the pack with 19% of the votes. He will be facing Keiko Fujimori in the second round in June.

The extreme-left views of Castillo combined with a rejection rate of above 60% for Fujimori may lead one to conclude that there is significant more downside for the currency and rates. However, we would caution against reaching a hasty conclusion for a few reasons:

• Historically, Peru’s assets have experienced high volatility ahead of elections, only for this volatility to moderate quickly post-elections. The most pertinent presidential elections to mention in this regard are from 2006 and 2011. The leftist Ollanta Humala was viewed very negatively by the market. He ended up losing in the second round in 2006 and won in the second round in 2011, which he followed by nominating an orthodox cabinet and voicing moderate policies. Markets rallied post elections in both cases. This time around, while Castillo is likely to persist with his anti-establishment and populist rhetoric in the campaign as they have worked, it is not a given that his policies will necessarily end up being extreme. Also, in the two months until the second round, he could commit gaffes and lose.
• As the chart below shows and as we discussed in a note a month ago, PEN is already pricing in a high risk premium as the currency has lagged its peers considerably, despite the partial catch-up ahead of the elections. The same is true for Peru’s local rates. Indeed, we showed in a recent note that adjusted for beta, PEN has been the worst performer among EM currencies over the past few weeks.
• Finally, the central bank has sufficient firepower to manage the currency’s volatility. Supported by the rise in metal prices, the country’s terms of trade have improved considerably. Additionally, with global demand rising, export volumes have also increased this year leading to a trade balance of USD 8.8bn in February 2021, the highest since May 2012. Overall, international reserves have jumped by USD 6bn this year to a record USD 80bn.

As such, while on first blush the outcome of the first round appears quite negative, all else equal, we would be inclined to look for an apt entry point to go long the currency before the second round.

Data Source: Refinitiv; Note: EM refers to an index created from equally weighted spot returns for 22 liquid EM currencies

Best Longs / Best Shorts

• On our list of underperformers in the attached FX Dashboard, we replaced the Malaysia ringgit (MYR) with the Israeli shekel (ILS).
• The list already had the Thai baht (THB), the Romanian leu against the euro (EURRON), and the Taiwanese dollar (TWD) on it.
• From our list of outperformers, we removed the Czech koruna against the euro (EURCZK) to leave only the South African rand (ZAR) on it.

Best Crosses

• Our list of preferred relative-value trades still has all pairs with ZAR on the short leg, but the long legs have changed.
• Specifically, we like Short ZAR vs Long THB or ILS or the Indian rupee (INR) or the Indonesian rupiah (IDR).
• The 3m expected returns for these pairs are high as they are in the range of 10.5-12.0% (not annualized), assuming mean reversion.