Mexican Peso Could Have More Room to Run Against the Yen

At the moment, the currency market is presenting numerous unusual dynamics, one of which is a pair that does not always get the attention of mainstream financial news, the Mexican peso and the Japanese yen. Currency analysts and traders are paying close attention to the Mexican peso vs. the Japanese yen, citing a possible confluence of conditions to see the peso continue to appreciate in value with regard to the yen. In order to understand why this confluence of conditions exists, it is important to look at the very different economic conditions of the two countries as well as how their central banks manage the currencies of those countries.

Despite earlier predictions of weakness due to political risk, nearshoring dynamics, and Mexico's relationship with the US economy, the Mexican peso has been remarkably resilient over the last several years. The Mexican peso has benefited from considerably higher interest rates being maintained by Banco de Mexico than Japan. While this remains true, the inflated Mexican peso is substantially of more interest to traders who initiate 'carry trades' (borrowing funds at a lower interest rate and buying assets that yield higher returns) than what may happen after those trades occur.

The Japanese yen has often acted as a preferred funding currency due to the extended period of loose monetary policy sustained by The Bank of Japan. Although recent comments have suggested that The Bank of Japan is slowly moving toward a more normalized stance, the pace of change has been very cautious and therefore the yen has not fully recovered as many analysts had anticipated.

The combination of a continued relatively higher yielding peso and a very low yielding yen creates carry trade dynamics that should support peso appreciation versus the yen as long as the broader risk tone remains intact and that no central bank experiences an unexpected shift in monetary policy.

The greatest risks to this outlook will continue to be geopolitical risk and volatility within global capital markets. If risk appetite deteriorates sharply, carry trades unwind quickly and the funding currencies, such as the dollar or yen, tend to appreciate dramatically when positions are liquidated.

For traders and investors closely watching this cross-rate, the current environment looks appealing, but keep in mind as with any carry trade, returns come with significant tail risk that should be carefully analyzed before deploying capital.