Betting on the Czech Koruna & the Mundell-Fleming Trilemma
Foreign exchange rates are notoriously difficult to predict over the short term, because there's a great deal of volume traded across the world by many various players (governments, corporations, individuals, etc) for all sorts of reasons. However, they are easier to see over a longer term period as they are the reflection of the interactions of many entities and their actions across the world based on fundamentals.
As mentioned by the 'Currency Specialist' in Steven Drobny's " Inside the House of Money ":
"...foreign exchange is the tail of the distribution... Central banks control the price of money and drive everything with their central bank rate. They use monetary policy to get supply and demand moving in the economy by encouraging people to move out along the risk curve. The risk curve, in essence, is the credit curve... from there, you move out along the risk curve to government bonds, corporate bonds, and then equities. At the tail end, you have foreign exchange (FX) fanning out... Foreign exchange is like the fan at the end of the credit curve. It's a function of how people are looking at those credits along the curve. For example, if the market decides that Brazil is a great credit, then other things being equal I'd expect the Brazilian real to rally because people have to go in and buy it if they want exposure to Brazil.
They are beta on interest rate and credit sentiment, or beta on beta. Foreign exchange is sentiment driven because it's a relative price between two countries. It reflects the relative sentiment of investors, reality and the perception of a bunch of different factors between two economies."
One great way to understand the fundamentals of the currency market is via Robert Mundell's and J. Marcus Fleming's work, known as the Mundell-Fleming Model . As written by Callum Henderson in his primer "Currency Strategy" :
"In an economy with high capital mobility, suppose that a central bank decides to loosen monetary policy by cutting interest rates. One must assume that it does this because of weak growth conditions and benign inflation. As we saw before when looking at money demand, lowering interest rates reduces the incentive to hold interest-bearing securities, thus on a relative basis increasing the incentive to hold money or cash. This increase in money demand can be put to work buying goods and should reflect a future rise in national income and growth. The standard monetary model thinks of this in terms of rising demand causing price increases, which in turn causes the exchange rate to depreciate via the concept of PPP. Looking at it another way, rising domestic demand will cause rising import demand, which should mean deterioration in the trade balance. This in turn should eventually lead to depreciation in the exchange rate to allow the trade balance to revert back towards an equilibrium level. Another way of expressing the same thing is that lower interest rates cause capital outflows, which in turn cause depreciation in the exchange rate. Conversely, the basic assumption is that tighter monetary policy through higher interest rates should lead either to weaker domestic demand and a positive swing in the trade balance, or capital inflows, both of which should cause exchange rate appreciation.
On the fiscal side, much depends on whether trade or capital flows dominate. On the one hand, looser fiscal policy, either through tax cuts or spending increases, should cause rising domestic demand, which in turn should cause deterioration in the trade balance. On the other hand, looser fiscal policy causes higher domestic interest rates, which in turn attract capital inflows. If trade flows dominate, then the exchange rate should depreciate. However, if capital flows dominate, then the exchange rate should appreciate.
Conversely, tighter fiscal policy should, according to Mundell–Fleming, lead to weaker domestic demand. On the trade flow side, this should result in reduced import demand, causing a positive swing in the trade balance. On the capital flow side, tighter fiscal policy should lead to lower interest rates, which in turn lead to capital outflows. Here, if trade flows dominate, the exchange rate should appreciate, whereas if capital flows dominate, the exchange rate should depreciate. In a world of perfect or at least high capital mobility, it is assumed that capital flows dominate over trade flows..."
To put it simply as described by The Economist : a country must choose between free capital mobility, exchange-rate management and monetary autonomy. Only 2 of the 3 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. 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.
This understanding above is illustrated by The Economist in the following diagram...
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https://keanchan.com/2017/02/15/betting-on-the-czech-koruna-the-mundell-fleming-trilemma/
