Impossible Trinity

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.

Jim Rickards, Editor, Currency Wars Alert, says Mexico is experiencing the Impossible Trinity now and predicts a coming devaluation of the Peso.

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.