Returns on assets: The equity-oil connection

But as noted at the outset, currencies are more than a simple interest-rate arbitrage. One of the reasons for the MXN’s stability in recent years has been the strength of its stock market, the Bolsa.

If we measure the relative performance of the Bolsa to the U.S. market (represented by the Russell 3000 index) since the March 2000 bull market peak, we find Mexican stocks have left their American counterparts in the dust — irrespective of whether we measure the Mexican market in USD or MXN terms. This high return on assets has kept international capital in Mexico and put a bid under the MXN.

Of course, a currency linked to a stock market carries its own peculiar set of risks, not the least of which is the stock market sinking under its own weight in a bear market. And here we have to add another special risk factor: The strong relative performance of the Bolsa in USD terms is linked inextricably with the price of crude oil, in it measured by Mexico’s export price of its benchmark “Maya Blend” to the U.S.

As the bull market in crude oil accelerated, so did the relative performance of Mexican equities. And as noted above, it was this strong relative return on assets that allowed the MXN to remain stable in the face of a declining rate gap.

To put it simply, the MXN’s course is linked, dangerously, to the price of a single and famously volatile commodity. That should give its holders some pause.