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A Corn Soybean Spread Trade

A Corn/Soybean Spread Trade

The following is straight from Operator Jose, a member of the Macro Ops Hub.

The Corn to Soybeans Ratio is very important to American farmers. In normal conditions, it’s a key factor that helps them decide how much Soybeans or Corn they’ll put into the ground. Both crops compete for the same acreage area. I like to think of it like this:

Farmers have a portfolio, but instead of money, they have acreages. There are two assets they can choose to invest in. Either Corn or Soybeans. This key decision is ASSET ALLOCATION. Whether they want more exposure to Corn prices, or prefer holding more Soybean bushels, depends on many factors, but price is a big one.  

Farmers can check, even months prior to the harvest, how much money they’ll receive for every bushel they pull from the ground. This is done by evaluating the relationship between the Corn and Soybean futures that’ll be trading by harvest time.

Here´s the long-term relationship for the front month futures:

Soybean Corn Ratio

The ratio is Soybeans over Corn. Whenever the ratio is over 3, farmers get 3 times more money for every Soybean bushel than Corn. Sometimes the ratio goes crazy due to weather risk and supply imbalances, but in normal conditions it shouldn’t be over 3.

Whenever the ratio is over 3, farmers plant a heck of alot more Soybeans than Corn. And by the laws of supply and demand, this will eventually cause the ratio to go down as Corn becomes scarcer relative to Soybeans.

The best way to play this relationship is through a spread trade. You can use one contract of Soybeans per two contracts of Corn. This means you’ll have 5,000 bushels of soybeans and 10,000 bushels of corn on a notional basis.

If we’re bearish on the Soybean/Corn spread, meaning we think corn prices will rise relative to soybean prices, we’ll need to short one contract of Soybeans, and go long two contracts of Corn. If bullish, meaning we think soybean prices will rise relative to corn prices, we do the opposite — buy one contract of Soybeans and short two contracts of Corn.

Soybean Corn Chart

You’ll notice that this chart is very similar to the previous spreads chart, but the Y-axis is now quoted in points instead of in a ratio. Every point on the Y-axis is worth $50 per the spread trade.

The reason we use a spread instead of playing the commodity straight up is to hedge weather risk. Weather is THE principal risk factor in grain commodities. Weather produces a largely asymmetric effect: while bad weather alone could completely destroy a crop yield, good weather by itself won’t produce a bumper harvest. Good weather is just one factor involved in a successful growing process. By taking the spread we’re strictly betting that Corn futures will do better than Soy futures no matter the other general conditions. Weather risk is partially hedged.

I´m bearish on the Spread. Here are the fundamentals that support my theory:

The chart below shows how the Soybean/Corn ratio went over 3 last year when farmers planted too much Corn relative to Soybeans (Soybeans became scarce and therefore fetched a higher price). Since December the ratio has been falling.

Soybean Corn December Ratio

The ratio didn’t do much in February and March other than consolidate. But at the end of March the USDA released the Prospective Plantings report. This report shows how many acreages farmers intend to commit between Corn and Soybeans. The keyword in this report is “Intention”. Following our portfolio analogy, the farmers are telling you the percentage of their portfolio they’re willing to invest in Corn or Soybeans.

But keep in mind that the grains aren’t in the ground yet. These farmers can change their planting intentions. There’s currently a small portion of Corn being planted right now, but there’s still time to switch acreages in later stages. Farmers aren’t forced to stick to what they reported in the prospective planting report.

On March 31st the report was released showing a decline in Corn acreages of 4% and an increase in Soybean acreages of 7%. Less Corn supply means each kernel is worth more. And more Soybeans means each is worth less. This confirmed my bearish bias on the spread. All that was left was price action to follow.

What do you think the big funds did on the day of the report? They shorted 11,000 contracts of Soybeans… and went long 20,000 contracts of Corn… a big 10,000 spread trade.

Amazing! It was almost like forecasting the future….

Here´s a chart with the Net Contracts position of Managed Money in the Soybean market. Notice the downtrend. They are finally net short!

Net Positions of Managed Money On Soybeans

The spread went from around 230 per bushel to 168 — a 27% move in 7 days. Report day was the biggest red candle of almost 30 points.

November Bean December Corn Spread

I believe there’s still downside potential to this trade. Price has retraced almost completely since the day of the report, and as I said, I don’t think the market has fully discounted a big soybean crop this year. And if you check the long-term historic spread, there’s still downside potential.

I am short the New Crop Spread ZSX17- 2*ZCZ17 (Short 1 November Soybean Future and Long 2 December Corn Futures.) These are the futures at harvest time when the market should be overflowing with Soybeans relative to Corn.

To learn more about how we trade at Macro Ops, click here.

 

 

Is The Dollar About To Break

Is The Dollar About To Break?

A couple of my favorite quotes from legendary trader Bruce Kovner are:

What I am really looking for is a consensus the market is not confirming. I like to know that there are a lot of people who are going to be wrong.

As an alternative approach, one of the traders I know does very well in the stock index markets by trying to figure out how the stock market can hurt the most traders. It seems to work for him.

If you can figure out how the majority of the market is positioned and where the most consensus trades are, you can do very well by opportunistically fading the herd. This is playing the player and trading at the second level… a skill that’s vital to long term market survival.

Fading crowded trades is a great strategy, especially recently.

For example, our oil short went against near record long speculative positioning as noted in the COT report. Our long bonds trade went against speculative positioning as well and has been very profitable.

Since markets have lacked volatility and benchmark indices have gone vertical over the last few months, money managers have been desperately chasing and recklessly crowding into trades. This has resulted in a lot of one sided positioning that traders like us can continue to take advantage of.

Looking around global markets there’s one obvious trade that would make a lot of people wrong and hurt the most traders. That trade is the ole’ greenback.

Let’s look at the evidence.

The chart below shows speculators are max long the dollar against broker dealers. This is an extreme reading. When you see COT positioning at this level of divergence, it’s almost always the dealers who win out. The market doesn’t pay a bunch of speculators so easily.

BofA’s monthly Global Fund Manager Survey was released this week. The chart below shows that a large net % of respondents are saying the dollar is overvalued. This survey has a pretty good track record of noting short-term reversal points in the dollar.

It’s been a long time since there was a large and violent forced selloff in the dollar. That means dollar longs have grown complacent and many of them are probably leveraged. When there’s been mostly one way moves in an asset for a few years, it creates a situation where positioning, leverage, and complacent beliefs are like piles of dried, kerosene-soaked kindling. They’re just waiting for a spark.

Take away talk of the border adjusted tax and combine it with other global central banks like the BOE and ECB looking to end their easing cycles, and you have the potential for a ripe and violent reversal… or a dollar bonfire if you will.

Is The Dollar About To Break

USD price action is setting up in what looks like a textbook head and shoulders pattern. We could see a break below the neckline this week.

Now we don’t think this is a major reversal in the dollar here, it’s only short-term. But it’s still very playable.

There are a number of ways to get short the dollar since it directly and indirectly affects the pricing of many other assets (ie, emerging markets, oil, gold etc).

But in order to find the optimal dollar short trade, let’s again look at market positioning — using COT data and the BofA Fund Manager Survey —  to see how other players are long dollars directly or synthetically.

The chart below via www.freecotdata.com shows the 5-year percentiles for Net Speculator positioning. The instruments in red on the right are those that speculators are net short and vice versa for those in green on the left.

ZB, the bond futures contract we’re currently long, is essentially a synthetic dollar short position.

The 10-year yield and USD have moved in lockstep fashion over the last two years. This means that the potential for a dollar selloff looks good for our long bond positioning.  

The next instrument — 6B —  is the British Pound futures contract. Looking at the graph below from the Fund Manager Survey, you can see that respondents are historically net short the euro, pound, and bonds.

Like the dollar, both the euro and the pound have been forming inverse head and shoulders and are close to closing above their necklines.

We took a crack at going long the pound (FXB is the ETF alternative for the pound and FXE is the euro ETF alternative) a few months ago but closed our position for scratch as it failed to carry through. I’m willing to take another stab at it and perhaps the euro as well should we see price break those necklines.

If you’re interested in seeing exactly how we play these coming currency moves, take a trial of the Macro Ops Hub. Hub members get alerts to our exact entries, exits, and position sizes of both our model portfolios. Membership comes with a 60-day money-back guarantee. Check it out for 2 months, and if you don’t get your money’s worth, we’ll return it right away. Click here to learn more.

 

 

Optimism and Complacency

A Dovish Hike and a Third Step Before a Stumble?

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.

The Fed hiked on Wednesday as expected, bringing the Fed Funds rate to a whopping 1%. The market, with its rose colored glasses in full effect, interpreted the hike as dovish.

In reality the meeting was neither overly dovish or hawkish. The Fed stuck to its playbook of hiking rates and muting expectations going forward. Their infamous dots still project two more planned hikes this year and three more the year following.

Nautilus Research published the following chart noting market action following the third rate hike in a tightening cycle.

The “3 steps and a stumble” theory was put forth by late trader and market guru Marty Zweig (he wrote a book worth reading titled Winning on Wall Street). Zweig noticed that the market has a tendency to considerably underperform following the third rate hike in a hiking cycle. Here’s the following from Nautilus.

The SP500 has endured significantly below average results from 1 to 12 months after  3rd rate hikes in 11 events back to 1955.  Note that 6 (more than half) of those hikes occurred within a year of a major cyclical top for stocks (1955, 1965, 1968, 1973, 1980, 1999).  However, the market defied that relationship on the last occurrence in 2004 by rallying for 3 more years… When looking at all hikes – note that hikes are generally bad for stocks, somewhat bad for the US Dollar, and bullish for 10yr yields and commodities.

Yale economics professor Robert Shiller, of CAPE ratio and “Irrational Exuberance” fame, noted the similarities in sentiment between the current market and that of the late tech bubble (an analog we’ve discussed quite a bit).

In a recent Bloomberg article Shiller said, “They’re both revolutionary eras, in the tech boom it was a new era of prosperity brought on by the internet now it’s a ‘Great Leader’ has appeared. The idea is, everything is different.” But no matter how you cut it, Shiller says “The market is way over-priced… It’s not as intellectual as people would think, or as economists would have you believe.”

Going off of the chart below, it’s safe to say we’re transitioning from the greed to euphoria stage. Take a look at magazine covers and article headlines and it’s easy to see that the market is entering a new level of optimism and complacency.

Optimism and Complacency

As we progress further into the latter innings of this cycle, and as expectations become more and more dependent on a narrowly defined and exceedingly optimistic future, it pays to remember the following from the book Ubiquity: Why Catastrophes Happen (bolding is mine):

In this simplified setting of the sandpile, the power law also points to something else: the surprising conclusion that even the greatest of events have no special or exceptional causes. After all, every avalanche large or small starts out the same way, when a single grain falls and makes the pile just slightly too steep at one point. What makes one avalanche much larger than another has nothing to do with its original cause, and nothing to do with some special situation in the pile just before it starts. Rather, it has to do with the perpetually unstable organization of the critical state, which makes it always possible for the next grain to trigger an avalanche of any size.

(Note: There will be eleven(!!) Fed members speaking this week. Who knows what kind of tone they’ll take, but it should make for an interesting week).

The above 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.

 

 

George Soros The Way Ahead Lecture
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A Review Of George Soros’ “The Way Ahead” Lecture

The following review is straight from Operator James, a member of the Macro Ops Hub.

With my TV broken for the last several months, and a useless repairman backed by a company going out of business, I’ve had a lot of time to devote to learning and thinking. Recently I realized I need to dig into fundamentals and decided George Soros was the best place to start. Thankfully there’s plenty of his speeches and lectures online (along with a lot of ‘Soros is the devil’ articles and something about him being a Nazi).

Soros’ “The Way Ahead” lecture series from 2010 is very interesting. It covers his theory of reflexivity and how it applies to financial markets. The lecture contains some interesting ideas that have yet to happen, but seem to apply to the near future. You can watch the lecture below. To follow are my quick notes and thoughts on the material presented.

7:00 to 8:00 – Back in 2010 Soros felt the financial crisis was not the end. He expected another crisis within a year or two. Obviously that didn’t happen. But he explains that he didn’t see the recovery from 2009. I’m not saying a crisis is around the corner, but we should never lose sight that one could be.

9:00 to 9:30 – Eventually the US won’t dominate the world as it has in the past. If Soros is right, a new paradigm will emerge. There will likely be many potential opportunities to profit during the shift. As a 13th generation American, I’m saddened by the short-sightedness of our leaders, but a new world order is not the end, but rather an opportunity.

12:00 to 17:50 – Soros discusses the concept of central and periphery currency flows.

20:30 to 21:00 – After talking about global financial regulations needing a force with teeth, Soros mentions how the system is currently constructed to give rise to ‘financial protectionism’ that could disrupt the global markets.

40:40 to End – Soros discusses many points in the last few minutes of the lecture. The overriding theme is: what happens after the dollar rises and puts developing countries in a bind? The world does not seem to trust American leadership anymore and that could spell trouble for US debt and dollar dominance. My intention is not to say that the following will absolutely happen, but rather to game scenarios to see where things may land. Ultimately, how do we profit from these events should they happen? I will try to encapsulate as many points as possible:

  • If the USD continues to advance higher, will the other powers (including China) want to operate under the Bretton Woods arrangement? Soros’ suggests the world should move to an SDR basket as a reserve currency. But could this realistically happen? I doubt the current US administration would be willing to sit down with the Chinese and allow a new world order where the dollar ceases to be the reserve currency. After all, USD reserve currency status provides certain advantages to the US government (e.g. greater debt spending because foreign governments are willing to buy in).
  • Would it be in China’s best interest to join an SDR-like arrangement? With all the poverty still racking their country, I doubt they’d want to give up their manufacturing advantage by becoming the reserve currency. Maybe they think they can do better than the Americans and prevent the hollowing of their rust belt. But of course I should mention that America can still produce a lot. I see it everyday. However, I also happen to know by dealing directly with the Chinese that they’re skeptical of automation (plant automation is my profession).
  • Around 46:50 to 47:00 Soros concedes that if Obama fails to prevent a double-dip, the population could become susceptible to populism. We didn’t have another dip in asset prices, but the folks in the places that voted for Trump didn’t see it that way. Shortly before the election I interviewed an engineer who worked for the steel industry in western PA. He told me he was looking for a job because a lot of plants had shut down and he knew he was next. This is a common story that illustrates that the people that voted for Trump did not care about stock prices.
  • At 48:50 Soros mentions that China will need a more open society if it wants to be considered a developed country. This point makes me wonder whether a crisis will serve to open China up, or makes it more isolated. This is something we’ll have to wait to see.

These are just my own thoughts on the lecture. I would love to hear yours as well. Please feel free to respond in the comment section below. Thanks!  

To learn more about our investment strategy at Macro Ops, that includes wisdom learned from Soros, click here.

 

 

SPDR Bloomberg Barclays High Yield Bond ETF

Hawkier Fed, Drowning Oil, and Insiders Jumping Ship

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.

The Fed is going to hike this Wednesday. They’ve made that clear. But why the complete reversal in tone since their last meeting?

The answer is obviously because of the Fed’s unspoken third mandate — putting caps on bubbles. This is something it’s historically been poor at. But Yellen and team have commented in recent weeks on the market’s seemingly lack of concern over economic and political “uncertainty”.

Charts like the one below are evidence of this:

So the Fed’s gonna hike. But the real question is, do they talk dovish following this week’s hike as has been their modus operandi? Or do they increase their hawkish rhetoric out of fear that the market and expectations are running away from them?

I don’t know, but we’ll find out shortly.

We nailed the breakdown in oil. Our option play in Vol Ops should pay out nicely.

Now we just need to see if oil experiences another v-bottom reversal at its 200-day like it did the last two times, or if the third time’s the charm and she trips off the cliff here.

What happens to oil will have big implications because it’s wagging the tail of credit (see nearly identical chart below). If oil turns lower, then credit will continue lower and we’ll see spreads begin to widen and defaults increase.

SPDR Bloomberg Barclays High Yield Bond ETF

Not to mention what a lower oil price will do to S&P earnings over the coming year. The rebound in oil prices have been a big boon to earnings and revenue growth over the last year. The chart below shows expected forward earnings for the SPX, Energy and SPX ex-energy.

If oil prices roll over from here then expect that blue line to come crashing back down. And the green line showing S&P companies ex-energy doesn’t look a whole lot exciting either.

Indicators are pointing South for the credit cycle. The chart below is a prime example of an end of cycle liquidity suck. Falling liquidity = falling demand = falling growth = asset prices adjusting lower.

The 12-month, 3-month and 1- month change in bank lending (an aggregate of business, consumer, and real estate loans) growth is rolling over and looks like might actually start contracting later in the year.

This liquidity tightening is happening all while sentiment and retail participation is markedly picking up. The chart below shows soft data (dark blue) which is various business and consumer sentiment survey data compared to the hard numbers (light blue) which report actual data on the economic state of our country.

Large divergences between exuberantly optimistic soft data and the actual hard numbers as shown in the chart above don’t have a history of working out well for those giddy individuals.

My call last week for a coming market retrace still stands. The divergence between breadth and credit is still there (has actually widened more). I suspect the market levitates for the next few days and starts selling off into the end of the week.

I’m not calling a top here, just a retrace. The highs haven’t been made on this market yet. It has some more room to run. But expect things to start getting a lot more bumpy…

The above 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.

 

 

Uncertainty Is Good For The Stock Market

Uncertainty Is Good For The Stock Market

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.

Here’s an interesting question: Is the Trump administration’s erratic policy and governing style bullish or bearish for stocks?

Lately, I’ve read a number of analyst notes talking about how the current political uncertainty spells trouble for the stock market. They all include the line “…if there’s one thing markets don’t like, it’s uncertainty about the future.” I think that’s lame thinking.

I would argue that this “uncertainty” is bullish for equities, at least over the short-term.

I say this because this “uncertainty” is feeding into the Fed’s rake hiking decisions. Remember the hawkish tone coming from Fed members back in December? That seems to have been reversed since Trump took office and started significantly shaking things up. Fed members have cited the uncertainty over future fiscal policy as a key reason to err on the side of caution in raising rates.

FOMC member, Neel Kashkari, wrote a post this week explaining his reasoning for voting to keep rates steady at last month’s meeting. The whole post is worth reading (link here). but here’s Kashkari’s concluding remarks:

We are still coming up somewhat short on our inflation mandate, and we may not have yet reached maximum employment. Inflation expectations remain well-anchored. Monetary policy is currently somewhat accommodative. There don’t appear to be urgent financial stability risks at the moment. There is great uncertainty about the fiscal outlook. The global environment seems to have a fairly typical level of risk (though that can change quickly). From a risk management perspective, we have stronger tools to deal with high inflation than low inflation. Looking at all this together led me to vote to keep rates steady.

Fed President James Bullard, also cited fiscal uncertainty in a speech he gave this week saying “It is unlikely that fiscal uncertainty will be meaningfully resolved by the March meeting… We don’t have to move. We have a lot of fiscal uncertainty. Why not wait until that is more clearly resolved?”

So Trump’s unconventional governing style is creating uncertainty over the future which is making the Fed step back from its rate hiking path. This is supportive of equity prices over the short-term. The breakouts this past week in many of the indexes seem to confirm this.

This creates the unusual situation where a more steady governance and a clearer picture of future fiscal policy would likely lead to faster rate hikes and thus be a net-negative for markets.  

The Fed conducts a Senior Loan Officer (SLO) Report every quarter. In this report they survey roughly 60 large commercial banks and up to 24 large foreign banks with branches in the US. The survey is intended to provide a quarterly update on credit availability and demand as well as developments in lending standards. It’s a good barometer of the overall credit market and provides us useful insight into how the credit cycle is developing. Read more

SKEW Index Has Trended Straight Upward

Low Volatility Begets Low Volatility. Here’s Why…

The following is an excerpt from our monthly Macro Intelligence Report (MIR). If you’re interested in learning more about the MIR, click here.

The trading community has been yapping away about the VIX trading sub-11 and the extreme number of speculative shorts involved. They’re saying it’s gotta burst higher.

Their proclamations are presented with a chart like the one below which measures net nominal non-commercial positioning.

VIX Future Positioning

But these positioning charts are misleading. They fail to account for the growth in open interest. The VIX futures in particular become heavily distorted because open interest and volumes have increased 10x since they first started trading in 2004.

VIX Future Open Interest

Net nominal numbers therefore mean nothing. Yes, the total amount of net shorts is higher than it’s ever been, but that’s because more people are trading VIX futures than ever before.

It’s easier to see why this is true with a simplified example.

Say they’re 100 open contracts and specs are short 99 contracts. Well obviously that’s a crowded trade. If the specs race to cover, price will squeeze hard. Specs are short 99% of the open interest.

Now let’s say activity grows and there’s 1,000 open contracts. Of these, specs are short 600, or 60% of the open interest. Compared to the prior reading, net short 600 looks a lot bigger than net short 99. But in reality the first situation has a more concentrated spec position. Participants previously were short 99% of open interest instead of 60% of open interest now.

That’s why you need to make sure you’re accounting for open interest.

We know a number of you visit freeCOTdata.com to look at positioning. We emailed the site owner Adam to ask if he was accounting for changes in open interest or not. As of now he is not accounting for them. But he’s rolling out an update soon to reflect the changes. After that update, the charts should give us a better idea of whether or not we’re at a true speculative extreme.

It’s worth noting that even without the update the 5-year percentile in VIX futures is not at an extreme. All the fuss on twitter was for nothing…

Futures Is Not At An Extreme

Given that positioning isn’t at an extreme (money managers are way too afraid to short vol in the Trump era), we’re in agreement with Goldman on what these low VIX readings mean. The data shows that low vol begets low vol, not high vol. Goldman conducted a study going back to 1990 to find out what happens to VIX and the market after VIX crosses below 11. The specifics of the study are shown below: Read more

Why Equities Are NOT Overvalued

Why Equities Are NOT Overvalued: The Relative Risk-Premium Spread

The following is an excerpt from our monthly Macro Intelligence Report (MIR). If you’re interested in learning more about the MIR, click here.

Some investors, desperate for better yield, have been reaching not for a new Wall Street product but for a very old one–common stocks. Finding the yield on cash unacceptably low, people who have invested conservatively for years are beginning to throw money into stocks, despite the obvious high valuation of the market, its historically low dividend yield and the serious economic downturn currently under way.

How many times have we heard in recent months that stocks have always outperformed bonds in the long run? Funny, but we never hear that argument at market bottoms. In my view, it is only a matter of time before today’s yield pigs are led to the slaughter house. The shares of good companies and bad companies alike are vulnerable to sharp declines. Moreover, many junk bonds that have rallied will tumble again, and a number of today’s investment-grade issues will be downgraded to junk status if the economy doesn’t begin to recover soon.

What if you depend on a higher return on your money and can’t live on the income from 4% interest rates? In that case, I would advise people to ignore conventional wisdom and consume some principal for a while, if necessary, rather than to reach for yield and incur the risk of major capital loss. Stick to short-term U.S. government securities, federally insured bank CDs, or money market funds that hold only U.S. government securities. Better to end the year with 98% of your principal intact than to risk your capital roofing around for incremental yield that is simply not attainable.

I would also counsel conservative income-oriented investors to get out of most stocks and bonds now, while the gettin is good. Caution has not been a profitable investment tactic for a long time now. I strongly believe it is about to make a comeback.  

The above is from a Forbes article written by legendary value investor and hedge fund manager Seth Klarman.

In the article, Klarman excoriates common investors for being “yield pigs” blindly piling into common stock. Low yields having driven them into a frenzy for return… as they hoof their way to the slaughterhouse to be ground into some expensive breakfast sausage. Read more

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.

Read more

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