The Mexican peso (MXN) is one of the most traded currencies in the world and is third in the Western Hemisphere, behind only the U.S. dollar (USD) and the Canadian dollar (CAD). Although the peso crosses with USD attract fewer investors than major pairs, including the euro (EUR/USD) and yen (USD/JPY), the peso still offers highly liquid access to Latin America and emerging market growth opportunities.
The Mexican peso has transformed from just a national currency into a formidable international financial instrument in recent decades. While forex trading has also boomed worldwide, three specific catalysts have helped drive the currency’s popularity and liquidity.
Key Takeaways
- The Mexican peso is a formidable international financial instrument due to three specific catalysts that have helped drive the currency's liquidity.
- Typically Mexico has higher interest rates than the United States, which can attract investment funds into higher-yielding Mexican government bonds.
- Mexico and the United States share a border, which has led to broad trade agreements, increasing commercial interactions between the two countries.
- Mexico is one of the largest petroleum producers globally and is the fourth-largest oil producer in the Americas after the United States,Canada, andBrazil.
Mexican Peso and Global Economic Conditions
Before delving into the liquidity of the Mexican peso, it's important to discuss how the currencies of emerging market economies, such as the Mexican peso, are impacted during global economic downturns and geo-financial crises. Developed nations tend to attract investment flows during times of uncertainty and global recessions. On the other hand, emerging market economies tend to attract investment capital during times of economic expansions and global stability. As a result, currencies like the peso can see wild fluctuations—called volatility—in their exchange rates during times of instability.
The Dollar As a Reserve Currency
The U.S. dollar is a reserve currency, meaning it's held by central banks and used to facilitate many financial transactions, particularly in the commodity market. For example, gold, silver, and crude oil are usually priced in U.S. dollars. As a result,t the U.S. dollar is often used as a safe haven, which is essentially an investment that limits an investor's exposure to losses during market downturns.
As a result, the dollar tends to appreciate or rise in value versus other currencies during recessions or when investors are risk-averse. For example, global investors might sell their peso-denominatedinvestments and mutual fundsfor U.S. dollar-denominated investments and Treasuries. In doing so, the peso weakens against the dollar.
The Mexican Peso and Recessions
We saw this risk aversion play out during the financial crisis of 2007-2008. On July 30, 2008, the peso traded at 10.0345 versus the dollar, meaning you would receive 10.0345 pesos for one dollar. Once the financial crisis struck, leading to the Great Recession, investors opted to send their money to safe-havens like U.S. Treasuries, leading, in part, to the peso weakening by more than 53% to 15.4060 by March 2, 2009.
The Mexican peso also lost value versus the dollar due to the COVID-19 pandemic and the resulting recession in 2020. The peso stood at 18.86 on Dec. 31, 2019, a few months before the pandemic began in March 2020. Once the pandemic struck the global community, many investors sought safety sending their money to safe-haven assets, such as U.S. Treasuries.
As a result, U.S. Treasury bond prices soared, and the Mexican peso weakened versus the dollar as capital flows fled Mexico, causing the peso to weaken by more than 33% to 25.13 pesos-per-dollar by March 24, 2020. The peso eventually rebounded somewhat to 20.51 by Dec. 30, 2021. However, the U.S. dollar has essentially doubled in value versus the peso since July 2008.
1. Higher Interest Rates and the Carry Trade
Typically Mexico has higher interest rates than the United States. In other words, Mexican bonds pay a higher yield or return than U.S. government-backed U.S. Treasuries.
Interest Rate Differential
Typically, Mexico produces higher interest rate returns (or yield) than the U.S. because of the central bank maintaining higher interest rates. For example, Mexican government bonds were paying about 8% in interest per year in 2019, compared to around 2% for the U.S. dollar. However, as of December 2021, the fed funds rate stood at .08% as a result of monetary policy by the Fed, designed to stimulate the U.S. economy during the 2020 recession. The policy included lowering interest rates (via the fed funds rate) to encourage borrowing and stimulate the purchase of goods, such as automobiles and homes.
The result of lower rates in developed nations can lead to speculators and investors borrowing money in zero-to-low interest rate policy countries and putting it in markets with higher interest rates—a strategy known as the carry trade.
Carry Trade
The carry trade can be far more profitable due to the use of leverage by currency traders. Foreign exchange (forex) traders can use 10:1 or even 100:1 leverage to multiply gains from the carry trade. Shorting (or selling) the U.S. dollar and going long (or buying) the Mexican peso with enough leverage can produce returns of 60% or even 600% in one year. When interest rates are six percentage points higher in Mexico, such leveraged gains are possible even when there is no movement in the exchange rate.
However, just as leverage can magnify gains, it can also magnify losses. The peso carry trade can collapse suddenly when the U.S. dollar rises rapidly against the Mexican peso, as happened during the 2020 bear market.
Before the 2020 recession, Mexican interest rates for government bonds offered 5-6% more in interest than its U.S. counterparts, which encouraged borrowing funds from U.S. banks and investing in Mexican bonds. The trade can work well in times of stability since the USD/MXN exchange rate would likely be stable, but during the 2020 recession, instability rose due to the pandemic.
As a result, capital flows fled Mexico and into safe-haven investments, such as Treasuries, despite them offering much lower yields than Mexican government bonds. This led to the peso weakening by 33% from the end of 2019 to late March of 2020.
Using leverage in the carry trade can be very dangerous, as well as highly profitable.
2. Proximity to the United States
Mexico and the United States share a border and a relationship that extends to broad trade agreements and immigration disputes. Physical proximity has an additional effect on the peso’s value. Highly prosperous border regions engaging in commercial interactions significantly increase Mexican peso liquidity.
The USD/MXN forex pair offers a natural currency play, and it is also the most liquid MXN pair. Regarding trade, the United States exported more than $252 billion in goods to Mexico in 2021 while importing $351 billion worth of goods, adding significant liquidity. This balance of trade (BOT) showed some fluctuation in the last decade, and the shifting ratio had an impact on relative value.
However, the trade agreements with Mexico can be revised, which can lead to volatility in the USD/MXN exchange rate and capital flows between the two countries. For example, following the election of President Donald Trump in 2016, uncertainty surfaced regarding theNorth American Free Trade Agreement (NAFTA), which, in part, led to the peso depreciating by nearly 18% against the dollar from October 2016 to January 2017. However, a new trade agreement—called the U.S. Mexico Canada Trade Agreement (USMCA)—was eventually reached in early 2020.
3. Crude Oil
Mexico is one of the largest petroleum producers globally and is the fourth-largest oil producer in the Americas after the United States,Canada, andBrazil. As of January 2020, Mexico had 5.8 billion barrels of crude oil reserves, making Mexico in the top 25 reserves holders in the world.
The Mexican peso often moves with energy prices because Mexico's oil reserves provide collateral for financing. The money from borrowing allows the Mexican government to obtain funds for domestic spending programs. International lenders are more willing to invest and assume risk in petroleum-dominated countries when crude oil prices are high. The connections between the Mexican peso and oil have also led to investors speculating on oil prices and the USD/MXN exchange rate.
However, many risks exist to investors due to volatility and uncertainty surrounding crude oil prices and Mexican oil production. A dramatic collapse in oil prices in early 2020 added to the depreciation in the value of the peso. Also, Mexico's oil production has declined significantly over the years due to the maturation of the country's oil fields—decreasing by 50% from their 2004 peak.
The Bottom Line
The Mexican peso shows high liquidity for three reasons. First, it can offer relatively high-interest rates that support the carry trade. Secondly, the country's physical proximity to the United States encourages billions of dollars in commercial activity. Finally, it has crude oil reserves that contribute to international trade.
