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China’s Mundell-Fleming Trilemma

China’s Mundell-Fleming Trilemma

The following is an excerpt from our weekly Market Brief. If you’re interested in learning more about Market Briefs and the Macro Ops Hub, click here.

You’re probably familiar with the story of how Soros and Druckenmiller “broke the Bank of England” in 92’.

The two bet against the pound believing that it couldn’t maintain its peg to the Deutsche Mark in the European Exchange Rate Mechanism (ERM). They were right. The Bank of England was forced to stop defending the peg and the pound plummeted. The Quantum Fund (Soros and Druckenmiller) netted over a billion dollars over the course of a few days. The rest is history.

It was an amazing trade. It had all the markings of a “perfect setup”; the kind that only come around once every decade or so. It was extremely asymmetric in that the risk was clearly defined by the upper-band of the ERM peg. And if the lower bound broke, like they expected, they knew the pound would collapse due to all the investors on the wrong side forced to liquidate.

It was also a fundamentally compelling trade. The thesis was based on an economic law derived from the Mundell-Fleming model. It states that in a world of high capital mobility, a central bank can target the exchange rate or the interest rate but not both. This economic reality is also known as the policy trilemma. Here’s the following explanation from The Economist:

The policy trilemma, also known as the impossible or inconsistent trinity, says a country must choose between free capital mobility, exchange-rate management and monetary autonomy. Only two of the three are possible. A country that wants to fix the value of its currency and have an interest-rate policy that is free from outside influence cannot allow capital to flow freely across its borders. If the exchange rate is fixed but the country is open to cross-border capital flows, it cannot have an independent monetary policy. And if a country chooses free capital mobility and wants monetary autonomy, it has to allow its currency to float.

To understand the trilemma, imagine a country that fixes its exchange rate against the US dollar and is also open to foreign capital. If its central bank sets interest rates above those set by the Federal Reserve, foreign capital in search of higher returns would flood in. These inflows would raise demand for the local currency; eventually the peg with the dollar would break. If interest rates are kept below those in America, capital would leave the country and the currency would fall.  

Where barriers to capital flow are undesirable or futile, the trilemma boils down to a choice: between a floating exchange rate and control of monetary policy; or a fixed exchange rate and monetary bondage.

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Trump And The Dollar

Trump And The Dollar

The following is an excerpt from our weekly Market Brief. If you’re interested in learning more about Market Briefs and the Macro Ops Hub, click here. Read more

Understanding Why Currencies Move

Understanding Why Currencies Move: Vicious and Benign Circles

Let’s talk about currencies. The different types of currencies and the various roles they play in the global financial system.

Because this topic is complex and I don’t want to get lost in the weeds, I’ll be making broad sweeping generalizations while focusing on the key points that matter. My plan is to do this while trying not to bore you to death. Read more

Chinese Yuan

The Chinese Yuan and a Global Tipping Point

Every market cycle has 1 to 2 macro drivers at the heart of its regime. We call these the fulcrum points. Keep an eye on the fulcrum and you’ll know when a major cyclic turn is underfoot. Read more

Fed and BOJ

What the FED and BOJ Decisions Mean for Markets

No surprises here…

Both the Fed and BOJ did exactly what everyone expected them to. Read more

USD Currency

Liquidity Crisis? What The New SEC Money Market Fund Regulations Mean For The Financial System

Things could get real interesting in the next few months.

On Oct. 17th a new SEC rule finally comes into play that will affect money market funds and liquidity across the financial sphere. There’s potential for some really big moves here. Read more

Bitcoin

A Sober Look At The Cryptocurrencies Bitcoin and Ethereum

One of our more profitable trades this year was in the cryptocurrency Bitcoin. Read more

Federal Reserve Meeting

Some Thoughts Before The Fed Meeting

The Fed is back at it again on Wednesday of this week. And as with every Fed meeting, we get to play the “will they” or “won’t they” game.   Read more

USD Macro Trend

The Dollar Deke

Webster defines a linchpin as “a person or thing that holds something together: the most important part of a complex situation or system”. In global economics, there’s always a critical factor or “linchpin” on which everything rests.

Right now, that linchpin is the US dollar. Its movements will determine the fate of global markets. The USD trend is the biggest macro trend in the world. It affects everything from equities to commodities and bonds. Read more

Why the Bank Of Japan’s Move to Negative Rates Signaled the Beginning of the End

If you want to be successful in the markets, you need to pay close attention to inflection points. Correctly evaluating an inflection point is the key to understanding market sentiment. And once you understand market sentiment, you’ll be able to determine which way an asset will trend.  

An inflection point is a critical juncture in an asset’s price. It’s a sort of crossroads, where after a big fundamental piece of news is released, the price takes off in either direction.

For example, say a high-growth tech company that’s been one of the best performers over the past few years is now reporting earnings. The company ends up releasing great earnings, but its stock price plummets the next day. This negative price reaction can be taken as a signal that investors were disappointed. Their expectations were not met, and the company’s share price suffered as a result. Read more