FX Dashboard: Peruvian Sol Cheapens Further Ahead of the Elections

The dollar index (DXY) continues to move away from the peak of last week as it edged 0.1% lower to 91.7. Ahead of the FOMC tomorrow, the dollar is likely to stay in a narrow range. Even the short dollar speculative positions based on CFTC data have dropped by a third from the recent extreme of USD 35bn at the end of January to 23 bn currently (see our note on the topic).

EM currencies were on the flip side of the dollar as they appreciated 0.1% on average, with the only standout being the Turkish lira (TRY), which appreciated almost 1%. Among EM currencies, the Peruvian sol (PEN) continues to underperform. Indeed, as the chart below shows, the gap of PEN with EM is the largest in almost 10 years. Even in REER terms, the currency is at its cheapest in almost a decade, according to BIS data.

The currency continues to be weighed down by the political noise in the country. After the impeachment and removal of President Martín Vizcarra last November, the currency’s lag with its EM peers accelerated. A presidential election is scheduled for April 11. Historically, the volatility of Peruvian assets picks up ahead of presidential elections, and this one is turning out to be no exception. The release of a poll earlier this week added to PEN’s woes because with no candidate currently polling anywhere close to 50%, a run-off election in June is almost guaranteed.

The central bank (BCRP) for its part has been intervening in the currency market with the stated goal of reducing the currency’s volatility. As we discussed in a note last week, BCRP has indeed managed to lower the currency’s volatility relative to where it should be when compared with the volatility of local bonds.

BCRP uses 3 mechanisms to intervene in the currency market:

1. Currency swaps, which are non-deliverable forwards settled in local currency
2. Certificates of deposits, CDRs, indexed to the currency
3. Spot interventions

As of March 10, BCRP showed a net selling position of USD 2.85bn from all these operations combined. As of the end of last year, this position was a net buying position of USD 0.28bn. In other words, the total net interventions year-to-date have amounted to around USD 3bn.

In contrast, the net international reserves have jumped by USD 6bn since the start of the year. A major factor behind the rise has been the sharp rise in terms of trade from a year ago mainly due to the jump in metal prices, which the country exports. Indeed, the trade balance rose significantly in January with the 12m balance rising to USD 8.5bn, the highest in several years.

Given the increase in international reserves, the main question is why does the central bank not intervene more aggressively? One reason could be they don’t see much value in the effort ahead of the elections. Also, they may prefer a weaker currency at this point to help recover more quickly from the deep economic shock of 2020 due to the pandemic. With the policy rate close to zero, there is little room on the monetary policy front. Moreover, the risk of inflation passthrough from a weaker currency is low with inflation expectations well anchored.

In terms of strategy, even as the Peruvian sol continues to be close to its cheapest level in a decade, we may find a better entry point closer to the election. As such, we recommend closing the Long PEN vs Short Chilean peso trade from earlier in the year at a loss.

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

Best Longs / Best Shorts

• While our list of underperformers in the attached FX Dashboard pdf stayed unchanged, the most notable point to make is that, in line with our observations above, PEN is now flashing as the cheapest on our metric with an average z-score based on 3m changes of almost 2. The other currencies on the list are the Hungarian forint against the euro (EURHUF), the Polish zloty against the euro (EURPLN), and the Korean won (KRW).
• Meanwhile, the list of outperformers continued to be empty.

Best Crosses

• Our list of preferred relative-value trades has changed. It now consists of Long Polish zloty (PLN) or Hungarian forint (HUF) vs Short British pound (GBP), and Long HUF vs Short Australian dollar (AUD).
• The 3m expected returns for these pairs are in the range of 8-9% (not annualized), assuming mean reversion.