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"Impossible Trinity" Global Monetary Exchange Policy Reviewed By Ross Aldridge Consultants In Las Vegas Nevada

|Includes: ProShares UltraShort Financials ETF (SKF)

Ross Aldridge Consultants Review The "Impossible Trinity". Las Vegas Nevada Casino Monetary Conversion Policies Could Be Modeled For A Global Remake?

 

What is the Impossible Trinity?

It's a theory that says a country cannot have all three of the following at once: an open capital account, a pegged exchange rate, and an independent monetary policy. That's all there is to it.

You can have one or two of those three conditions, but not all three at once. If you try, you'll fail. It's those impending failures that make the Impossible Trinity so useful for predictive analytics.

The Impossible Trinity is simple to break down.

An open capital account means it's easy for investors to get their money in and out of a foreign country. If the investor country is the United States and the target country is, say, Thailand, it's fairly easy for investors to put their dollars into Thailand. The question is, "Can you get them out again?"

That's up to the central bank. If they are willing to use their dollar reserves to let investors cash out, that's fine. But if they decide to lock investors in (or, worse yet, they run out of reserves), then you are stuck with a local currency asset and no way to sell it for dollars.

A pegged exchange rate means that a foreign central bank is willing to use dollars to buy and sell its own currency to fix its exchange rate to the dollar. Most countries use floating exchange rates (where the market decides what the local currency is worth in dollars), but many still use pegs.

An independent monetary policy means that a central bank in one country will set its interest rates independently from what the Federal Reserve is doing. The European Central Bank (ECB) is a good example. Right now, the ECB is cutting rates (even into negative territory), while the Fed is raising rates. Each central bank acts independently.

Why is the Impossible Trinity impossible?

The reason is that if you set your interest rates higher or lower than another central bank, investors will borrow in the low-rate currency and invest in the high-rate currency. (That's called the carry trade because the low-rate debt "carries" your investment in the high-rate security, often on a leveraged basis.)

Once the carry trade gets momentum, investor capital flows from one country to another. This puts upward pressure on the currency of the target country receiving the inflows. If the target country's central bank is committed to maintaining a fixed exchange rate, it has to print more money to absorb the inflows.

This money printing causes inflation and asset bubbles. Eventually, the bubbles burst and investors run for the exits (which they can do with an open capital account). Now, the reserves disappear with a vengeance, and eventually the target country will have to close the capital account, lose its reserves, or raise interest rates against its will (or all three).

This exact scenario played out in Thailand in 1997-98. And almost caused the collapse of global capital markets. The Thai contagion spread to Russia and my old firm, Long-Term Capital Management.

Similar scenarios are playing out around the world today. Using the Impossible Trinity, we can see the next crack-ups coming.

Why? Because the policies being pursued are impossible without one of the policies breaking.

We focus on which policy will break first. Will the fixed exchange rate be broken? Will the capital account be closed? Will interest rates be hiked? All three? These are the questions that need to be asked and that central banks ask themselves.

Often, it's possible to eliminate one or two of the choices based on external or political considerations. A central bank might want to stick with an open capital account to appease the U.S. or the International Monetary Fund (NYSE:IMF). Once you narrow down the choices, it's easy to make the call.

Taking all of this into account, where is the next crack-up?

Signs point to Mexico. The foreign exchange situation in Mexico is a textbook case of the operation and limitations imposed by the Impossible Trinity.

Right now, Mexico has an open capital account. The central bank of Mexico (Banco de Mexico) accommodates investor demand for dollars by using its foreign exchange (mostly dollars from tourism, remittances, oil sales, and other exports) to buy pesos.

Mexico also has an independent monetary policy. The short-term interest rate set by the Banco de Mexico is 3.25%, significantly higher than the Fed's target short-term rate of 0.25%.

Mexico is trying to peg the peso to the dollar at around 17-to-1. It's not a hard peg, but it is a policy target. Banco de Mexico conducts up to $400 million per day in currency auctions, if needed, in order to keep the peso from falling more than 1.5% per day from the previous day's fixed rate.

The chart below shows that while the peso has devalued 23.5% against the dollar in the past 18 months, the Banco de Mexico has recently attempted to keep the peso from breaking through the 17-to-1 barrier.

The Mexican peso has devalued from 13 pesos to the dollar to 17 pesos to the dollar over the past 18 months. However, the peso traded in a narrow band between 16.5 and 17.5 pesos to the dollar for the past four months. That effort at a stable exchange rate by the Banco de Mexico is now coming to an end due to limitations imposed by the Impossible Trinity.

Mexico is attempting to pursue an open capital account, an independent monetary policy, and a currency peg at the same time. The Impossible Trinity tells us this policy will fail.

The only issue is to identify how and when it will fail. Once we do that, we're in a position to profit from the inevitable break in the system.

The effects of trying to pursue the Impossible Trinity are already showing up. Mexico lost over $21 billion in reserves in 2015. Mexico is not in an imminent reserve crisis, but the trend is worrying. There are limits on how much hard currency Mexico is prepared to lose in order to defend the peso.

Spotting the limits on a central bank's ability to defend its currency is the same method George Soros used to make over $1 billion in a single day when he broke the Bank of England on September 16, 1992 (a day still known as "Black Wednesday" in British banking circles).

What can Mexico do to escape the Impossible Trinity?

It has three choices: close the capital account, give up its monetary independence, or devalue the peso. There are no other ways out for Mexico.

It is almost inconceivable that Mexico will close its capital account. Mexico is dependent on U.S. trade and an IMF backstop lending facility. Both the U.S. and the IMF would strongly oppose closing the capital account. Mexico is highly unlikely to move in opposition to its two largest sources of financial support.

As a short-run expedient, Mexico has abandoned its independent monetary policy. The chart below shows how Mexico raised interest rates 0.25% two weeks ago, exactly one day after the Fed raised rates by 0.25%.

If Mexico had not raised its interest rate, capital would have flowed from Mexico to the U.S. in search of higher yields. These capital outflows would have drained Mexican reserves. This rate hike illustrates the constraints imposed by the Impossible Trinity.

Outsourcing its monetary policy to the Fed bought a little time for Mexico, but it's not a long-term solution. The Fed will likely raise rates next March, and again in June. The Mexican economy is already slowing down because of declining growth in its major trading partners, China and the U.S. Raising interest rates only make the Mexican slowdown worse.

If Mexico will not close its capital account, and cannot raise interest rates to follow the Fed, there's only one thing left for Mexico to do - devalue the peso. Not only can we see this coming with our IMPACT system, but we have a good sense of the timing.

The Mexican Currency Commission (the official body that sets the Mexican exchange rate to the dollar) will meet later this month to decide on whether to extend the peso support program. The Fed is unlikely to back off its rate hike rhetoric before then, so that's an opportune time to devalue the peso.

All of this analysis is probabilistic, but none of it is certain. Still, our analytic tools, including the Impossible Trinity and my IMPACT trading system, give us fairly good visibility on a coming peso devaluation. U.S. dollar investors in Mexican stocks will suffer when the peso value of those stocks declines.

The ideal way for investors to play this is to short a major Mexican company with dollar-based securities and weak fundamentals. That way, an investor can be positioned to win on a declining stock and a declining currency.

Follow Ross Aldridge Consultants:@exoticfinance

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.