The Mexican central bank will decide on its key rate tonight. The majority of market participants expect unchanged key rates. After all, the central bank has already hiked its key rate by a total of 350bp over the past quarters, and the peso has recovered notably since January.

However, in our view, the strong rise in consumer price inflation suggests that the central bank will adjust interest rates once again. That means we take a minority view and expect a 25bp rate hike for today. That would be positive for the peso as it would prove once more the central bank’s credibility when it comes to fighting inflation.

Fears of economic downturn appear overdone. Early in the year, the Mexican economy was buffeted by a host of shocks, ranging from surging inflation to US policy driven uncertainty. However, hard data have rolled in on the strong side, suggesting the economy remained quite resilient to these shocks.

A tight labor market is helping shoulder the hit to disposable income from higher inflation while external demand is firming, providing an important boost to the all-important manufacturing sector. 1Q GDP preliminary data showed a healthy 2.4% ar expansion, reinforcing our out-of-consensus call for 2% growth this year.

Higher policy rates should prove a tailwind for MXN as ex-ante real rates look quite attractive. The short-term inflation outlook has continued to deteriorate. We now expect inflation to peak at 6.3% this year before converging to a slightly lower 5.9% rate by year-end.

As such, we now think Banxico will deliver two additional 25bp hikes this year, bringing the policy rate to 7% by mid-year. However, given our forecast for inflation to rapidly converge near target (3%) by June of next year, ex-ante real rates stand around 4%, which we deem to be quite attractive when comparing MXN to EM peers

Hedging Strategy:

After last month’s correction in USDMXN upto lows of 18.4540 levels, the pair takes support at 7EMAs on monthly terms and showing strength to resume its previous bullish rallies, for now, the major uptrend appears to be robust and likely to resume bull trend. But for now, it has been testing a stiff resistance at 19.1907 levels.

While ATM IVs of this pair is substantially spiking higher above 16% and 15.23% for 1w and 1m tenors respectively which is conducive for holders of the call options, but using the minor dips in this underlying pair writing narrowed tenor OTM calls would reduce the cost of hedging.

Thus, using any abrupt dips, initiate a diagonal debit/bull call spread (DDCS) at net debit.

The execution: Initiate shorts in 1W (1%) out the money calls with positive theta, simultaneously, buy 1M (1%) in the money 0.51 delta call option. Establish this option strategy if USDMXN spot FX is either foreseen to be in sideways or spike up considerably over the next month but certainly not beyond your upper strikes in short run.