Peso Hopes For Fomc 'Light' Taper As Usdmxn Sees Bearish Reversal

In our last FX Update on USDMXN, we had detailed several reasons as to why the Mexican peso is one of our favourite emerging market currencies on the long-run time horizon. Since our last update, the Mexican central bank has, in a somewhat unexpected move cut benchmark interest rates by 25bp to 3.75 percent, on an account of a slowdown in the second quarter of 2013 and poorer growth outlook. This cut in rates has bolstered expectations of a further trimming to occur in the policy rates in the remainder of 2013.

While growth in Mexico is yet to show any stellar signs of acceleration, the rate cut has actually brightened the growth prospects and with it expectation of the potential capital inflows, thus allowing local currency denominated bonds to rally and somewhat perversely also causing the Mexican peso to appreciate in the aftermath of the rate cut. The Mexican peso has also been positively affected by the Mexican government's ongoing reform efforts as well as from the somewhat diluted expectations of the US Federal Reserve September tapering action.

As will be the case with all other emerging market currencies, this week's Federal Reserve rate setting meeting on Wednesday is a pivotal event for the peso. Given Mexico's extremely close US trading and financial relations, this event is all the more critical. With a "light tapering" scenario seemingly now priced in by the markets, any announcement of a larger-than-expected tapering amount by the Federal Reserve is likely to prove very negative on the peso, while a less-than-expected amount or a complete absence of tapering will very likely be a strong peso-positive.

While we would refrain from taking on any large bets on the outcome before the actual announcement, we take a good note that on the technical side, USDMXN is now displaying increased signs of a double top formation, potentially showing the way for further Mexican-peso gains in the remainder of the year.

Aside from seeing the confirmation of this formation in the spot market by a break of the neckline support level, one other potential way to capture a downside acceleration in USDMXN is by purchasing a medium-term put option in USDMXN. With the risk reversal volatility skew favouring the buying of puts, a year-end put option with a strike set around the double top neckline confirmation level of 12.43 (see for the chart at the bottom) now costs around 90 USD-pips.

Below, we provide a detailed technical outlook for USDMXN, with a focus on the downside dynamics and key levels.

USDMXN daily chart hinting at double top formation
In September, USDMXN managed to break the highs from May, coming in at 13.4609. A lack of follow through and the subsequent weekly closing below 13.2660, a 38 percent retracement in the 14.5963-11.9358 wave, have however reinforced the longer term bearish technical outlook.

Daily support is now found at the prior top from July 31 at 12.8935, but for a more sustained downside correction, a break below the daily cloud and trendline support from the June lows, presently in the 12.7500 zone, is needed. This would give scope for a test of the double top neckline support at 12.4306 before year-end.