The Mexican peso (MXN) ranks as one of the top 15 most traded currencies in the world. It is third in the Western Hemisphere, behind only the U.S. dollar (USD) and the Canadian dollar (CAD). MXN crosses with USD attract fewer participants than major pairs, including the euro (EUR/USD) and yen (USD/JPY). However, the peso still offers highly liquid access to Latin America and emerging market growth opportunities.
MXN has transformed from just a national currency into a formidable international financial instrument in recent decades. While forex trading has also boomed worldwide during this period, three specific catalysts have driven the currency’s rapid growth.
1. Higher Interest Rates and the Carry Trade
The Mexican peso is not so weak, despite what many Americans think because Mexico usually has much higher interest rates. According to the Federal Reserve, the U.S. dollar roughly doubled in value against the peso between 1999 and 2019. However, that makes for an average annual gain of little more than 3.5%. On the other hand, the Mexican peso was paying about 8% in interest per year in 2019, compared to around 2% for the U.S. dollar. In many years, the Mexican peso produces higher returns than the U.S. dollar because of higher interest rates. But how did interest rates get so low in the United States?
After the 2008 financial crisis, central banks lowered interest rates in the U.S. and many other developed countries to near zero. Although these policies were supposed to encourage borrowing and investment within these nations, something different happened. Speculators and investors borrowed money in zero interest rate policy (ZIRP) countries and then put it in markets with higher interest rates. This strategy is commonly known as the carry trade.
The carry trade can be far more profitable than most people realize because of the heavy 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 the U.S. dollar and going long 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, this carry trade can collapse suddenly when the U.S. dollar moves up rapidly against the Mexican peso, as happened during the 2020 bear market.
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 add significantly to 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 $256 billion in goods to Mexico in 2019 while importing $358 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.
3. Crude Oil
The Mexican peso often moves with energy prices because Mexico's vast 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 also make it an excellent way to speculate on oil prices.
As a nonmember oil producer, Mexico has been hard hit by an OPEC supply buildup, adding to the pressure created by the decline in oil prices after 2013. A dramatic collapse in oil prices in early 2020 also caused a noticeable decrease in the value of the peso.
The Bottom Line
The Mexican peso shows high liquidity for three reasons. First, it offers 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 vast crude oil reserves that contribute to international trade.