FxWirePro: USD/MXN risk reversals in tandem with ATM vols, economical delta-hedging regardless of swings

We at FxWirePro could foresee USDMXN at 20 over 2H’17 on a putative disorderly renegotiation of NAFTA, de-anchoring inflation expectations leading to bond outflows and local politics volatility.

In adverse case scenario, the pair can head towards 17.5 in 2H’17 on strong momentum for the MXN, a weaker USD and inflation peaking and subsequently declining from the highs, in which case Banxico would end the tightening cycle and portfolio inflows would likely be strong.

The peso has come a long way from its Trump lows and screens overbought and overvalued at current levels, leading our LatAm team to turn underweight recently.

The standout feature of the USDMXN vol surface to us is the cheapness of risk-reversals, both vis-à-vis ATM vols and particularly relative to the amount of carry in forwards (refer above chart) that allows for carry efficient expressions of bearish directional views or tail risk hedges.

The telling statistic from the graphic is that that the static carry of delta hedged vega-neutral 3M 25D skews is a very substantial 2.5 vol pt., near the upper-end of its 2-yr range.

For investors already MXN, collaring the existing cash exposure via an overlay of purchased risk-reversals is a compelling proposition, as an increase in core G7 rates has the potential to trigger a correction in the consensus long EM trade predicated on low-for-long monetary policy and contained volatility.