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Liquid Insight
Trump’s effect on MXN
22 September 2016
Unauthorized redistribution of this report is prohibited. This report is intended for amanda.ens@baml.com
Key takeaways
• We provide an empirical analysis of Donald Trump's potential effects on the Mexican
peso
• Our analysis suggests the exchange rate is perhaps as much as 15% undervalued
• We remain neutral for now given US election risks are likely to remain high in the near
term
By Claudio Irigoyen and Ezequiel Aguirre
Chart of the day: MXN may be as much as 15% undervalued
Source: BofA Merrill Lynch Global Research, Bloomberg
Trump’s effect on MXN
We provide an empirical analysis of Donald Trump’s effects on the Mexican peso. Our
analysis suggests the exchange rate is perhaps as much as 15% undervalued. In our
view, buying the Mexican peso likely would prove a profitable strategy if Hillary Clinton
wins. However, we remain neutral for now given US election risks are likely to remain
high in the near term.
A model of MXN weekly returns including Trump
We estimate a model of MXN returns with standard financial fundamentals that also
includes Donald Trump’s RealClearPolitics polling average in the US presidential
election. It is generally accepted now that Trump’s chances in the US election have been
a major driver of the Mexican peso (Chart 1).
Trading ideas and investment strategies discussed herein may give rise to significant risk and are not
suitable for all investors. Investors should have experience in FX markets and the financial resources to
absorb any losses arising from applying these ideas or strategies.
BofA Merrill Lynch does and seeks to do business with issuers covered in its research reports. As a
result, investors should be aware that the firm may have a conflict of interest that could affect the
objectivity of this report. Investors should consider this report as only a single factor in making
their investment decision.
Refer to important disclosures on page 6 to 7. Analyst Certification on page 5. 11668923
Timestamp: 22 September 2016 12:30AM EDT
Rates and Currencies Research
Global
Global Rates & Currencies Research
MLI (UK)
Claudio Irigoyen
LatAm FI/FX Strategy/Economist
MLPF&S
+1 646 855 1734
claudio.irigoyen@baml.com
Ezequiel Aguirre
LatAm FI/FX Strategist
MLPF&S
+1 646 855 9689
ezequiel.aguirre@baml.com
Adarsh Sinha
FX Strategist
Merrill Lynch (Hong Kong)
+852 3508 7155
adarsh.sinha@baml.com
Yang Chen
Rates Strategist
Merrill Lynch (Hong Kong)
+852 3508 8695
ychen8@baml.com
See Team Page for Full List of Contributors
Recent Liquid Insight Publications
21 Sep 2016 Eur FRA-OIS and 3s6s basis:
tighter, despite wider credit spreads
20 Sep 2016 BoJ preview: BoJ to try, try again
19 Sep 2016 A cautiously hawkish Fed
16 Sep 2016 UK inflation-linked – when the
“pass-through” has passed through
15 Sep 2016 Getting unreal
14 Sep 2016 The real rate guide to FX
13 Sep 2016 Consumption Gumption
12 Sep 2016 UK: Better but not good
9 Sep 2016 The Fed's cacophony of sound
8 Sep 2016 EEMEA: The ECB buys EM too
We estimate a regression of weekly returns on the MXN spot exchange rate on five
variables: a basket of commodity currencies, US equities, the 10-year US bond yield, the
two-year interest rate differential between MXN and USD swaps, and RealClearPolitics
polling average for Donald Trump in the 2016 US presidential election. The estimated
equation is
R MXN = b0 + b1*R basket + b2*R SP500 + b3*dy 10 + b4*(r MXN – r USD ) + b5*RCP + e
where R MXN is the MXN spot return, R basket is the commodity currency basket spot return,
R SP500 is the SP500 index return, dy 10 is the 10-year US bond yield change, r MXN – r USD is
the two-year swap rate differential (lagged one period), RCP is RealClearPolitics polling
average for Donald Trump, and e is an error term. The commodity currency basket
consists of BRL, CLP, COP, CAD, NOK and AUD with equal weights. The full data sample
has weekly frequency and runs from 6/20/2012 to 9/21/2016.
The model without Trump yields an R-squared coefficient of 0.50. Including Trump’s
variable increases the coefficient to 0.63, a significant improvement (Chart 2). We use
data only up to 1/27/2016 for parameter estimation of the financial variables. We use
the full sample to estimate the parameter on Trump’s variable due to its shorter history.
Chart 1: The Trump factor on the Mexican peso
Chart 2: Forecasting MXN returns with and without Trump
20
19.5
19
18.5
18
17.5
17
16.5
16
15.5
15
Aug15 Nov15 Feb16 May16 Aug16
48
46
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42
40
38
36
34
32
30
20
19
18
17
16
15
14
13
12
2014 2015 2016
20
19
18
17
16
15
14
13
12
MXN
Trump's polling average
Model (without Trump) Model (with Trump) MXN
Source: BofA Merrill Lynch Global Research, Bloomberg
Source: BofA Merrill Lynch Global Research, Bloomberg
A possible 15% negative shock on MXN
According to the model that does not include Trump’s polling average, we estimate that
MXN should be trading at around 16.50, more than 15% stronger than current levels
(spot 19.72). Chart 2 shows the possible magnitude of the Trump effect on the Mexican
peso.
The model including Trump’s polling average appears to do a much better job at
explaining the recent behavior of the Mexican peso. However, it still suggests that the
currency has depreciated more than justified by Trump’s increase in recent polls. Based
on Trump’s increase to 43.9% (RealClearPolitics polling average on 21 September) from
39% (RealClearPolitics polling average on 29 June), our model suggests the Mexican
peso should be trading at around 18.50, still almost 7% stronger than current levels.
This, however, does not necessarily mean that MXN has oversold. The almost 5% gain in
Trump’s polling average since June could have had an outsized effect on MXN if those
gains took place in swing states, potentially leading to crucial Electoral College votes.
Strategy: neutral MXN for now
From a strategy standpoint, we recommend staying neutral the Mexican peso for now.
We believe the Mexican peso would likely strengthen significantly if Hillary Clinton wins
the US election. But there is still significant uncertainty. Net speculative long USD/MXN
positions are somewhat stretched, but could increase much more (Chart 3).
2 Liquid Insight | 22 September 2016
The Bank of Mexico will meet on 29 September, and a 50bp rate hike is already priced in
(Chart 4). A stronger hike, perhaps of 75bp, or a 50bp rate hike accompanied by a
hawkish statement could lead to MXN strengthening in the very short run.
Chart 3: Net speculative USD/MXN position in CFTC
Chart 4: Bank of Mexico expected to hike
8
6
4
2
0
-2
-4
-6
-8
2013 2014 2015 2016
20
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300
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0
2012 2013 2014 2015 2016
6
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1
0
Net Dollar position
Source: BofA Merrill Lynch Global Research, Bloomberg
MXN
Source: BofA Merrill Lynch Global Research, Bloomberg
spread 1y TIIE ONR
Notable Rates and FX Research
* Global Rates & Currencies 2016 Year Ahead, 23 November 2015
* USD/MXN builds momentum, FX Quant Trader, 19 Sep 2016
* Central banks still the only game in town, Global Rates and FX Weekly, 15 Sep 2016
* Land of the rising bond yield, US Rates Weekly, 16 Sep 2016
* Policy uncertainty, Liquid Cross Border Flows, 19 Sep 2016
Key trade ideas
Top Rates and FX trades for 2016
For rationale and details, refer to Global Rates & Currencies 2016 Year Ahead: The
“Great Divorce”, 23 November, 2015
Rates:
Buy US 30y TIPS, entry: 1.2%, target: 70bp, stop loss: 1.55%
Closed at 101bp (3 Mar 2016): Short USD 5y5y vs EUR 5y5y, entry: 115 bp, target: 160
bp, stop-loss: 90 bp (3 Sep 2015)
Long $100mn 6m5y ATMF UK vs $100.75mn US rates straddles, net take-in: $126K,
target: +450K, stop: -$225K
Sell 3y Fannie Mae debt vs Treasuries, entry: 6bp, stop: 2bp, target: 20bp
Closed at 11bp - Long 12m Treasury bills vs OIS, entry: 1bp, target: -10bp, stop: 7bp
FX:
Closed at 6.5630 (26 May 2016): Buy USD/CNH 6m forward outright, entry: 6.5260,
stop: 6.40
Long a 12m USD/CNH forward outright, entry: 6.7485, target 7.00, stop: 6.67, current:
6.7420 (26 May 2016)
Closed at 0% - Buy EUR/USD 3m 1.10 call with a 16 Dec 1.1050 window KO, cost:
0.55% EUR (spot: 1.0690)
Buy 1y EUR/USD<1.00, USD/JPY<120 dual digital, cost: 7.0% USD (spot: 1.0690, 122.80)
Liquid Insight | 22 September 2016 3
Closed at 902 (10 Mar 2016): Buy AUD/KRW, entry: 832, target: 920, stop: 859 (revised
from 790)
Closed at 38.25 (18 Apr 2016): Sell TRY/JPY, entry: 43.40, target: 36.15, stop: 45.25
Closed at 8.27: Sell USD/NOK spot 8.685, target: 8.27, stop-loss: 8.60 (revised from 9.00)
New trades
Rates:
Mar17 FRA-OIS widener, entry: 6.25bp, target: 10bp, stop loss: 4bp (21 Sep 2016)
* Despite recent tightening, richness of bonds vs OIS, upcoming TLTRO & corporate
issuance point to renewed widening
Existing open trades
For a complete list of our open trade recommendations, as well as our trade
recommendations closed over the last 12 months, please see: Global Rates and FX
Weekly: Central banks still the only game in town 15 September 2016
Rates:
Pay 5y5y forward 3s6s basis, entry: 11.3bp, target: 13.3bp, stop: 10.3bp (10 Aug 2016)
* Bank hedging flows on the back of sharp pickup in corp issuance suggests the
widening of 3s6s basis is structural. It also hedges any aggressive ECB easing in Sep
Buy 6m30y ATMF+25bp/+50bp/+75 bp payer ladders for a net premium of €950k on
€100m notional (or 3.3 bp) (20 Jul 2016)
*30y rates are at risk from the ECB tomorrow, especially if tweaks to the capital key are
flagged already
Buy 3-year 3.5% ZC RPI inflation caps, entry: 26.0c; current 37.5c (21 Oct 2015)
*Sterling vulnerability due to the UK's large current account deficit makes being long
inflation volatility attractive. Pairing this trade with a long-standing recommendation to
be short 30-year UK breakevens is an attractive way to finance it.
Closed at 0 (22 Jul 2016): Buy 167 Aug RXU6 call and buy 162 put, cost 118 cents (16
Jun 2016)
Closed at 55bp (12 Jul 2016): OATei 2018/2027 flattener; entry: 78.5bp, target: 40bp;
stop-loss: 100bp (11 Mar 2016)
FX:
Short EURUSD 6m 1.0740/1.1500 risk reversal, cost: 0 (off 1.1077 spot)(6 Jul 2016)
*EUR downside risks are underpriced. We think the post-referendum risk rally is
overdone and could be at risk. Potential shocks include Brexit uncertainty, turbulence in
Italy's banking sector, and political paralysis in Spain.
Closed 1.0840 (1 Jul 2016): Buy 3m EURCHF 1.08/1.03 put spread for 0.76% Eur
(7.75/8.05 ag 10.45 vols off 1.0930 spot)(1 Apr 2016)
4 Liquid Insight | 22 September 2016
* EUR is underpricing Brexit and that shorting Euro was a cheaper way to express such a
view via options. CHF tends to perform strongly when risks become more localized.
Closed on 28 Aug 2016: Buy EUR/USD 6m 1.00/1.20 strangle for 155 usd pips (off
1.1020 spot, DF two-way vols 12.1/12.3) (29 Feb 2016)
*Owning low delta EURUSD strangles may be an effective and cheap double hedge in the
scenario that either the US enters a recession or the European debt crisis resurfaces.
Options Risk Statement
Potential Risk at Expiry & Options Limited Duration Risk
Unlike owning or shorting a stock, employing any listed options strategy is by definition
governed by a finite duration. The most severe risks associated with general options
trading are total loss of capital invested and delivery/assignment risk, all of which can
occur in a short period.
Investor suitability
The use of standardized options and other related derivatives instruments are
considered unsuitable for many investors. Investors considering such strategies are
encouraged to become familiar with the "Characteristics and Risks of Standardized
Options" (an OCC authored white paper on options risks). U.S. investors should consult
with a FINRA Registered Options Principal.
For detailed information regarding the risks involved with investing in listed options:
http://www.theocc.com/about/publications/character-risks.jsp.
Analyst Certification
I, Adarsh Sinha, hereby certify that the views expressed in this research report about
securities and issuers accurately reflect the research model applied in such analysis. I
also certify that no part of my compensation was, is, or will be, directly or indirectly,
related to the specific recommendations or view expressed in this research report.
Liquid Insight | 22 September 2016 5
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6 Liquid Insight | 22 September 2016
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this report or its contents.
Liquid Insight | 22 September 2016 7
Research Analysts
US
Ralph Axel
Rates Strategist
MLPF&S
+1 646 855 6226
ralph.axel@baml.com
Shyam S.Rajan
Rates Strategist
MLPF&S
+1 646 855 9808
shyam.rajan@baml.com
John Shin
FX Strategist
MLPF&S
+1 646 855 9342
joong.s.shin@baml.com
Ian Gordon
FX Strategist
MLPF&S
+1 646 855 8749
ian.gordon@baml.com
Vadim Iaralov
FX Strategist
MLPF&S
+1 646 855 8732
vadim.iaralov@baml.com
Europe
Ralf Preusser, CFA
Rates Strategist
MLI (UK)
+44 20 7995 7331
ralf.preusser@baml.com
Ruben Segura-Cayuela
Europe Economist
MLI (UK)
+44 20 7995 2102
ruben.segura-cayuela@baml.com
Mark Capleton
Rates Strategist
MLI (UK)
+44 20 7995 6118
mark.capleton@baml.com
Athanasios Vamvakidis
FX Strategist
MLI (UK)
+44 20 7995 0790
athanasios.vamvakidis@baml.com
Kamal Sharma
FX Strategist
MLI (UK)
+44 20 7996 4855
ksharma32@baml.com
Myria Kyriacou
FX Strategist
MLI (UK)
+44 20 7996 1728
myria.kyriacou@baml.com
Ruairi Hourihane
Rates Strategist
MLI (UK)
+44 20 7995 9531
ruairi.hourihane@baml.com
Sebastien Cross
Rates Strategist
MLI (UK)
+44 20 7996 7561
sebastien.cross@baml.com
Pac Rim
Tony Morriss
Rates Strategist
Merrill Lynch (Australia)
+61 2 9226 5023
tony.morriss@baml.com
Adarsh Sinha
FX Strategist
Merrill Lynch (Hong Kong)
+852 3508 7155
adarsh.sinha@baml.com
Shuichi Ohsaki
Rates Strategist
Merrill Lynch (Japan)
+81 3 6225 7747
shuichi.ohsaki@baml.com
Yang Chen
Rates Strategist
Merrill Lynch (Hong Kong)
+852 3508 8695
ychen8@baml.com
Shusuke Yamada, CFA
FX Strategist
Merrill Lynch (Japan)
+81 3 6225 8515
shusuke.yamada@baml.com
Global Emerging Markets
Claudio Irigoyen
LatAm FI/FX Strategy/Economist
MLPF&S
+1 646 855 1734
claudio.irigoyen@baml.com
David Hauner, CFA
EEMEA Cross Asset Strategist
MLI (UK)
+44 20 7996 1241
david.hauner@baml.com
Claudio Piron
Emerging Asia FI/FX Strategist
Merrill Lynch (Singapore)
+65 6591 0401
claudio.piron@baml.com
Trading ideas and investment strategies discussed
herein may give rise to significant risk and are not
suitable for all investors. Investors should have
experience in FX markets and the financial resources
to absorb any losses arising from applying these ideas
or strategies.
8 Liquid Insight | 22 September 2016