The Mundellian Trilemma, China’s Box, and Dollar Risk Bid

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“Anyone who spends too much time thinking about international money goes mad.”

 --Charles Kindleberger

 Commentary & Analysis

The Mundellian Trilemma, China’s Box, and Dollar Risk Bid

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The Mundellian trilemma says policy makers can control only two of the three main variables in global finance, but not all three at the same time.

“…it is not feasible to have at the same time a fixed exchange rate, full capital mobility and monetary policy independence. Only two of the three may co-exist (according to the Mundel-Fleming logic),” writes Helene Ray, of the London School of Business, International Channels of Transmission of Monetary Policy and the Mundellian Trilemma

That’s the theory.  Now take a look at China’s situation for application of the theory.  Chinese policy makers seem to be stuck in a tight policy box—the alternatives available aren’t very appealing.

The dynamics of the trilemma for China can be seen in the chart below...

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The chart above compares the benchmark 2-year Chinese interest rate (red); to the 2-year United States interest rate (black); to the Chinese currency priced in US dollars (green). 


1.    The 2-year yield spread between China and the United States is narrowing as the Fed continues to hike the Fed Funds rate, while the Chinese 2-year yield is falling as China attempts to stimulate growth (so far it isn’t working).  

2.    As the 2-year yield spread narrows between the China and the US, it pushes the value of the Chinese yuan lower; i.e. CNY/USD is moving lower as the spread (red line minus the black line) narrows.  Hot money is moving out of China and into the US.

China is facing slowing growth, rising unemployment, and the possibility of a major acceleration in capital flight (as we saw back in 2016). 

So, China’s policy choices seem to be these:

1.    Raise interest rates and protect the currency (including capital controls) in an effort to avert a capital run. This means China loses control over sovereign monetary policy which calls for lower rates to stimulate growth (add more debt). Unemployment rises under this policy choice and that means China’s efforts to rebalance its economy and shift more resources to the household sector is stymied once again.  

2.    Let the currency run and lower interest rates in an effort to stimulate local demand. This leads to more household indebtedness.  And with China’s current account surplus now at just one percent of GDP, the measure of safety here if capital runs offshore is thin and a plunging currency would be seen by the United States a currency war on top of a pending trade war.

If China chooses #1, we can expect a continued deceleration of Chinese growth; the country’s manufacturing index is approaching stall speed (see the chart below). But, rising rates would help slow the dangerously rising debt formation and be best for global stability, though internally rising unemployment is never popular. 

China’s manufacturing index grinding lower - China’s NBS manufacturing PMI fell to 50.8 in September, from 51.3 in August and below the Bloomberg consensus of 51.2. While this was the first September drop since the NBS manufacturing PMI series was released, it was also the 26th consecutive month of prints above the 50-point mark that separates growth from contraction.

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If China chooses #2 above and let’s the currency run it risks trigger a major flow of capital not only out of China but emerging markets in general—a contagion trigger if there was one. 

But there is a third choice I haven’t shared, but there is a third alternative according to Andrew Polk at Trivium.  From the Financial Times:

Makes sense, but the difference is this is 2018, not 2016.  The spread has tightened a great deal since then’ it is potentially a more powerful drain on China’s capital given the rising risks of a trade war.

Keep in mind, the sentiment toward emerging market economies is driven in large part by the health of China.  EM policy choices are tremendously hampered as they have a lot less control over their sovereign monetary policy than China.  EM ex-China lack capital market depth (in addition to other intangibles such as proven fiscal and central banking track records—China has some depth though Hong Kong and lots of reserves). 

EM’s still rely primarily on US dollar denominated funding (US dollar denominated debt is estimated from $3+ trillion; likely more); i.e. emerging markets are the periphery; the US and other developed markets are the center.  The periphery capital funding flows from the center outward.  This simple fact hasn’t changed much since either the emerging markets crisis back in 1997 (after which the IMF urged Asia to develop capital market depth in order to avoid this funding risk; they didn’t) or the credit crunch in 2007.

Effectively, EM ex-China countries have extremely limited sovereign monetary policy; however, they do have floating rate currencies driven by the ebb and flow of global capital. In other words, they are subjected to the whims of free global capital flow across borders seeking the best home. Already their currencies have been under lots of pressure—and said pressure will likely build with each ratchet higher in Federal Reserve rates.  Where oh where might that Bancor be?   

Take a look at the chart below which compares Emerging Market Stocks (symbol EEM) to Emerging Market Bonds (EMB) to the China-United States 2-yr yield spread. Who leads, who follows? Our guess: EM stocks and bonds follow the 2-year China-US spread. And if true, and this spread keeps widening, there is plenty of room for EM stocks and bonds to fall considering from where they came back in 2009.

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The US Fed’s rising interest rate campaign is a wrecking ball to the pretense of a sovereign monetary policy in China at this stage in the cycle; this is especially true for the emerging markets.  We don’t see the Fed stopping anytime soon.  The question is: What will China do?  If this 2-year spread continues to tumble, it likely means the damage we have seen to EM stocks and bonds will look tame compared to the future.

As you know, a run out of EM and China would be extremely dollar bullish as the money runs to US Treasuries and to buy US Treasuries you first have to buy the US dollar.  That is part our rationale as to why the buck sees 100 (measured by the US dollar index) before it starts down once again into a long-term bear market sometime in early to mid-2019.

Jack Crooks, President, Black Swan Capital

772-349-6883/ Twitter: bswancap


Will the Dollar – Oil correlation get back into gear?

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“Formula for success: rise early, work hard, strike oil.”

 --J. Paul Getty

 Commentary & Analysis

Will the Dollar – Oil correlation get back into gear?

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Chart Analysis/Comments/Guesses:


  1. During the hay days of the US-China symbiotic commodities for shrinking dollar boom there was an extremely tight negative correlation between the US dollar and oil prices, i.e. as the US dollar pushed lower and lower into its final cycle low in 2008, crude oil went higher and higher peaking near $147.  

  2. Then an event called the Credit Crunch reared its ugly head and changed all that.  Oil, as you know, tumbled and bankrupted many who believed the trend was their friend and got caught up in the Peak Oil story—a nice piece of fiction.

  3. Then global central banks got busy reflating the global economy unleashing massive amounts of money and credit, plus zero-bound interest rates, onto the market.  That reflation worked until 2011 as oil peaked and the dollar put in a test of its lows. But despite all the debt dumped into the global economy, real growth, which would have driven oil prices higher, didn’t materialize.  Instead, all the money rushed into financial assets and avoided real assets like the plague.

  4. Reflation fails.  Oil tanks and the dollar soars

  5. Five years after reflation failed to stimulate the real economy (though the financial economy is flying) oil makes a low in 2016; then nirvana.  The US economy starts to respond to sensible policies: tax cuts, regulation cuts, and fiscal stimulus (not quite as sensible) ushered in by President Trump’s administration (despite the ongoing protestations from the most over-rated economist who ever lived—Larry “I am somebody” Summers.  Real growth again.  Surprise, surprise, surprise. to paraphrase the late great Gomer Pile.   Party time for oil as it rockets off its lows in 2016.

  6. Now we come to today. Though we don’t expect some kind of sea change event similar to the credit crunch (one never knows when a correction is going to morph into a rout), we do expect the trade conflict between the US and China to intensify.  I suggest an excellent piece in today’s WSJ story--An Economic Cold War Looms Between the U.S. and China; this game is strategic, not tactical, and it will most-likely become more serious and dangerous in time.  This is not the raw material of vibrant global growth and soaring demand for oil

So, what do we expect?  We expect the negative correlation between oil and the US dollar to kick back into gear.  And because we are dollar bulls, we are naturally oil bears.

President Trump is already pressuring OPEC (read Saudi’s) to pump more oil and try to push prices lower.  He has leverage.  US support for the Saudi three-year Yemini war is waning as civilian casualties and reports of human rights abuses by the Saudi’s accumulate.  Quid pro quo?  Pump more oil or we pull US support for your Yemini quagmire? 

WTI Nov. Crude Futures 240-min Chart:  Expanding flat setup anyone? 

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Jack Crooks

President, Black Swan Capital



The three-body problem and debt in the year 2018

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"We cannot therefore avoid the question that Hyman Minsky posed —whether a monetary economy with debt contracts and capitalist financial institutions will ever be stable, and in particular whether stability is possible as long as there are fractional reserve banks.”

 --Adair Turner

 Commentary & Analysis

The three-body problem and debt in the year 2018

 Different year, same problem—debt overhang!

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Despite the best efforts of governments and central banks we remain to a large degree mired in the same trap thanks to global supply exceeding demand in manufactured goods and commodities.  Though we see it in all economies where legacy assets are protected by crony capitalism, the poster child is China whereby much of their debt build has been funneled into unproductive assets in the absence of real demand, all in an effort to keep nominal economic growth numbers on track….READ MORE

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Fundamentals are still smiling at the dollar

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“I don't think..." then you shouldn't talk, said the Hatter.”

― Lewis Carroll, Alice in Wonderland

Commentary & Analysis

Fundamentals are still smiling at the dollar

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There is a simple framework we can use to help evaluate the likely intermediate-term trend of the US dollar, measured in months and quarters.  It is referred to as the dollar smile. I first saw this concept in a research note written by Stephen Jen, when he was with Morgan Stanley many years ago.   I do my best to keep it in mind as I trade Mr. Greenback, as at times it helps keep me out of the weeds. At the moment the dollar smile is indeed happy with the buck.

 Three scenarios gleaned from the dollar smile:

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 1)        Left side of the smile reflects an appreciating dollar as global risk comes back into the financial system.  From our current perspective, we are thinking about a major “risk off” safe haven bid into the dollar resulting from a big drop in the stock market.  Though such a risk bid can be short-lived, it can be a powerful initial driver sustained by relative fundamental factors over the intermediate term.

2)         The middle of the smile reflects dollar depreciation against the major currencies as the US economy decelerates or muddles through soft spots, while relative economic growth and yield (central bank policy catchup) begin to improve among in both the developed and developing world economies; i.e. some global inflation.    

3)         The right side of the smile reflects an appreciation in the dollar on the back of strong US growth and rising yield differentials.  This backdrop pulls in hot money and a greater share of foreign direct investments as the US economy grows faster than key country competitors and the Fed is expected to hike rates faster than other major central banks (CBs).  This process naturally tends to be self-reinforcing. 

Below is a chart showing the path of 2-year relative yield spread favoring the US dollar compared to the euro, pound, Australian dollar, and Canadian dollar.  Yield spread keeps grinding in favor of the dollar.

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Looking at this another way, in the chart below we have compared the US dollar Index to the 2-year yield spread for the United States – Eurozone (the euro represents about 57% weight of the US dollar index).  A rising spread (red line) means the US yield is increasing relative to the Eurozone.  And as you can see, this spread has blasted off in favor of the United starting back in October 2016.  Yet, the US dollar index is now nine points lower.  With Eurozone growth concerns back in play, it doesn’t seem we will see this yield gap narrow anytime soon.  And if interest rates still matter, and we think they do, this spread reality seems dollar supportive to say the least.

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There is legitimate background expectation of CB interest rate policy catchup with the US Fed.  Granted, the Bank of Canada and Bank of England have signaled rates will be headed higher soon.  Additionally, the recent Reserve Bank of Australia minutes from their last meeting suggest the bank will be hiking sooner than was expected.  Two points here: 1) We do not expect any major CB to be as aggressive as the Fed over the next 12-18 months, and 2) if there is a major risk event, i.e. a major stock market correction and/or a markdown in global growth as a result of the ongoing US-China trade tensions, the relative impact will likely moderate expectations more quickly for BOC, BOE, and RBA than the Fed.

Keep in mind currencies at the core are considered free-floating instruments in the developed world, and most of the key emerging markets.  Free-floating means the price driver for a currency is based on supply and demand.  In a world where global capital flows freely across borders (China’s effectively closed capital account being the major exception) these fund flows into currencies can further be broken into two broad baskets: 1) hot money; and 2) *foreign direct investment (FDI). 

*Foreign Direct Investment definition should also consider US corporate repatriation triggered in large part by the recent tax cuts in the United States. 

So, if you consider these two baskets of flows, you can then better understand why higher relative interest rate yield and economic growth for a country are powerful determinants for its local currency.  Hot money moves to the highest real yield, and FDI heads to the country with the best longer-term capital gains opportunity which is an economic growth decision. 

Presently, the US dollar is the winner on both yield and growth; and that lead may acceleration, at least on a relative basis.   

Fundamentals influence currency values and currency values in turn influence fundamentals in a continuous feedback loop; this is what often drives powerful self-reinforcing trends.  

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And we suspect the next powerful trend in the dollar is up—and we are targeting to 100 once what we suspect is a minor correction is over.

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  Jack Crooks, President,

Black Swan Capital