FxWirePro: LATAM FX hedging intricacies with pinch of salt

Fundamentals currently seem uber-supportive for EMFX space. However, as this opinion has become the consensus, it raises red flags. A simple, and perhaps naive, parallel to previous cycles suggests that 2018 may resemble 2006 (implying that there may be more room for risk assets to run). But we worry that the parallels for 2018 are closer to 2007. As asset markets enter their late-cycle phase, the delta on “surprises” is more likely to hurt rather than benefit EM FX.

The fundamental case for EM currencies is clear but is very consensus – valuations, flows, slow place of DM policy normalization, global growth, commodities, real yields and external positions.

Valuations close to neutral: In aggregate, EM real effective exchange rates (REER) are just slightly below their long-term average. There are pockets of value in LATAM and EMEA, while Asia remains the most expensive region.

Neither Fed hikes nor the near-passing of US tax reform has seemed to daunt LatAm FX basket, for now, domestic stories have remained the main driver of price action.

As we maintain a more bullish stance on the high-carry currencies (ARS and BRL) given each idiosyncratic story, we are mindful that these have become consensus trades for 2018, and that year-end may accentuate position unwinding.

Thus, we maintain a larger MXN hedge (despite the large negative carry) and have upgraded CLP to Neutral ahead of Chile's presidential elections.

The peso has eased further against the dollar since the last central bank meeting on 14th December. This is likely to fuel concerns on the part of the Mexican central bank (Banxico) regarding future inflation developments.

Although neutral LatAm FX sentiments are lingering, shift in UW MXN and OW ARS, in addition to our OW BRL, Neutral CLP, PEN and COP. Long BRL/NOK positions and 6m ATMF/21.0 MXN put spreads have been recommended.

6m USDMXN digital put: A 6m 17.0 strike costs approximately 10% of notional (maximum loss limited to the premium paid).

While USDBRL has turned into corrective modes for more than two years, ever since shooting star has occurred at peaks of uptrend at 4.0093 levels it has tumbled retrace more than 38.2% Fibonacci levels. Currently, the cross is stuck in a tight range between 3.2140 and 3.0415 levels since last February, trading near the lower end of the range.

Stay OW BRL and initiate long BRL/NOK targeting 2.80 to partially hedge beta risk (though assuming some short EUR exposure).

Elsewhere, -1M/+3M vega-neutral calendars in USDBRL to fade the mid-week vol uptick driven by local and NAFTA political noise.

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