Despite whipsaw changes on trade policy in recent weeks, investors remain somewhat sanguine about the prospect of tariffs when it comes to Mexico and India.
A Black-Scholes model of one-month at-the-money implied volatility options against the Mexican peso and Indian rupee suggests that investors are expecting a last-minute deal that would lower the impact of the tariffs.
To a certain extent, this outlook may reflect investor exhaustion around the almost daily back and forth on tariffs in recent months.
In addition, investors are concerned about the direction of the U.S. economy, and that concern may be dampening enthusiasm for holding dollars or dollar-denominated assets until the new rules of the road on trade are established.
But those ideas do not fully explain why forward-looking investors are not pricing in a period of dollar strength over the next month, when large U.S. tariffs are set to be imposed.
A look at Mexico’s and India’s trade linkages and outright dependence on the United States, as well as its currency, imply a greater possibility of near-term deals in contrast with Canada, the European Union, Japan and other economies.
With respect to Mexico, the recent executive order on applying a 25% tariff on select auto imports has two gaps that may explain why one might anticipate a near-term deal. The overwhelming majority of auto part imports, worth $81.2 billion, that are used in the final production of autos in the U.S. come from Mexico.
While the executive order imposes a large tax on auto imports, it does not apply to auto parts covered under the United States-Mexico-Canada Agreement on trade until Commerce Secretary Howard Lutnick establishes a process for establishing what is covered and what is not. The tax on auto parts is set to begin on May 3.
From our point of view, that delay is clearly a signal to purchase more time on the part of Washington to cut a deal with Mexico.
So that partially explains why one-month at-the-money options remain well behaved with respect to the Mexican peso.
Read more of RSM’s insights on the economy and the middle market.
Perhaps more interesting is the case of the Indian rupee.
India has a weighted average tariff of 12% on U.S. imports and is focused on retaining $83.7 billion in exports ($126.5 billion in total trade through 2023) to the U.S. These exports include apparel and pharmaceuticals, which are a focus of the U.S. in the coming round of tariffs.
More critically, India estimates that should the U.S. apply reciprocal tariffs on its exports, roughly $66 billion in trade is at risk.
While India is not completely dependent upon trade with the U.S., the numbers are large enough for that economy to create the conditions to cut a deal.
A decelerating Indian economy and depreciating currency against the dollar are more than sufficient conditions for the government to cut a deal with Washington sooner rather than later.
And that underlying reality of large numbers and economic dependence is sufficient enough to shape market positioning and near-term currency valuations amid a difficult time of change in U.S. trade policy.
