The Wall Street Journal's coverage of our "trade of the year" provides an timely opportunity to update our recommendation published in mid-December 2012 calling for a dramatic realignment of the Australian dollar against the Mexican peso.
Rationale: We argued both legs of the trade had much to recommend. We recognized that the positive terms of trade shock was going into reverse. This is true for many commodity producers more generally, including Brazil and South Africa, for example.
Even though there is a positive carry associated with the trade, we conceived of it as a mean reverting strategy. OECD's metrics had the Aussie as the most over-valued currency in its universe and the Mexican peso the most under-valued.
The trade also expressed a contrarian theme; namely the enhanced competitiveness of the Americas' side of the Pacific. The Asian Pacific region captured the imagination and investment flows. The story was over-bought and the Australian dollar was often seen by many investors as a liquid and accessible proxy for Asia.
But that oft told story is old. We have been anticipating an important shift in competitiveness that is in fact taking place. It is crystallized in the two themes. The first is the cheap U.S. energy and is and will continue to encourage bringing manufacturing closer. Second, based on estimates of unit labor costs, it is cheaper to manufacture in Mexico than China. A combination of rising wages and inflation in China is changing the competitive landscape in ways we did not think enough investors appreciate.
The new reform minded government in Mexico adds an additional dimension to the attractiveness of Mexico. Mexico also benefits for the depth and breadth of its credit markets and the international quest for yield. Price Action: In mid-December the Australian dollar was trading near MXN13.50. We anticipated a 10% move. In late March, we updated the view suggesting to sell the Aussie into an upside correction, which fizzled just shy of the MXN13.00 level, in anticipation of a MXN11.90.
Now What? The Australian dollar, which proved so sticky for so long has cracked. Our year end target was $0.9700 and we will be revising it down in the next quarterly forecasts by a few cents. Our year end target for the U.S. dollar was MXN12.00 and we will be revising that down as well.
Fundamentally, there is scope for additional rate cuts by the RBA. We think one rate cut before the September election and one after it is a reasonable and modest assumption. We do see scope for a Mexican rate cut in H2, but price pressures need to ease first and more importantly, a rate cut may be seen as generally a favorable development.
This was the case with the surprise 50 bp rate cut in March. Investors will also likely reward Mexico for as the government's reform agenda makes its way into legislation. The relative strength of the U.S. economy also lends support to Mexico.
Beyond our MXN11.90 target from March, we now see scope for MXN11.20. More difficult than managing a winning trade is where to get in or add-on. Immediate resistance is seen near MXN12.15. Bounces in the Australian dollar against the peso have been limited to about 1.5% Given that last Friday and yesterday's low was about MXN12.035, a bounce toward MXN12.20 area may offer a new low(er) risk entry level.
In terms of legging into the trade, note that the Australian dollar is more volatile and as the currency has weakened recently it has become more volatile. Peso volatility was goosed at the end last week, but has come back off and in any event remains at the lower end of what it has traded since Lehman.