The collapse of emerging markets severely impacts the Mexican peso and the Brazilian real.

Emerging market stocks experienced a significant plunge on Monday, reflecting growing concerns over a potential economic slowdown in the United States. This decline was exacerbated by a massive sell-off of carry trade positions, primarily funded by Japanese yen, which negatively impacted Latin American currencies, with the Mexican peso being the most affected. The emerging market stock index fell by 4.2%, marking a sharp deterioration that began last Friday, representing the worst two-day decline since March 2020, when the COVID-19 pandemic broke out. Technology stocks in Taiwan and South Korea led this drop, signaling a shift in risk perception in these markets. Although the MSCI index of emerging market currencies closed positively thanks to Asian currencies, the strengthening of the yen, which has become the preferred currency for carry trade, caused a sharp depreciation of the Mexican peso. At its lowest point, the Mexican currency weakened by up to 5.4%, although it managed to recover some of those losses throughout the day. Gabriela Siller, head of economic research at Grupo Financiero Base in Mexico, explained that the reversal of the carry trade was driven by a change in Japan's monetary policy, which resulted in a domino effect of uncertainty and panic in the markets. "The rest is the domino effect due to panic," Siller stated, suggesting that investors are reacting to an imminent risk situation. The Brazilian real, another Latin American currency, also suffered severe consequences, falling to its lowest level since March 2021, although it later managed to reverse some of its losses. Over the past month, both the real and the Mexican peso have been the hardest-hit emerging market currencies, with accumulated declines of nearly 7% and 5%, respectively. The increase in implied volatility of the Mexican peso, which reached levels not seen in over three years, has discouraged carry trade investors, further exacerbating the situation. Christian Lawrence, cross-asset strategist at Cooperatieve Rabobank, suggested that corporations managing pesos were selling dollars at these levels, which helped moderate some of Monday's losses. However, the impact of the plunge on the Mexican peso cannot solely be attributed to external factors. A surprising rise in the unemployment rate in the United States, reported last Friday, has fueled fears of an economic slowdown in the country, posing a considerable risk to the Mexican economy, which heavily relies on trade with its northern neighbor. Francisco Campos, an economist at Deutsche Bank, added that the effect on the peso has been disproportionate, reflecting the combination of international uncertainty and internal challenges facing Mexico. The recent intervention by the Bank of Japan in the foreign exchange market, along with its unexpected decision to raise interest rates for the first time since 2007, has intensified the liquidation of long positions in the peso. Political concerns also play a crucial role in the peso's weakness. Chris Turner, head of currency strategy at ING, warned that Mexican politics could come into play as the new parliament convenes in September, potentially hindering the peso's recovery below the 19.00 per dollar level. Uncertainty regarding potential constitutional reforms by the elected president, Claudia Sheinbaum, could negatively influence risk perception. Despite a solid performance of the peso in previous years, where it appreciated by 5% in 2022 and 13% in 2021, the current context presents significant challenges. President Andrés Manuel López Obrador has defended the peso's strength during his tenure, but the current situation requires attention, as record-high international reserves have not been able to contain the depreciation. Although analysts suggest that the room for further losses of the peso might be limited, the volatility and context of carry trade position liquidation create a sense of uncertainty that could persist in the coming days. "It's always difficult to say in these large sell-offs, but I think we are closer to the target," concluded Brad Bechtel, global head of currencies at Jefferies, suggesting that the market might be approaching a stabilization point.