It’s a big world after all: Foreign capital flows and the US markets

In the summer of 2002, we were alarmed by how much the dollar had fallen.

In just five months, from March to July 2002, the US dollar had declined in value by 12.5% versus the euro, 11.3% against the yen and 9.9% on a trade-weighted basis versus six major world currencies. We were so alarmed by the decline that we stopped to consider the global macro levers that had set the swoon in motion, and how its continued collapse could affect the financial markets (see “The Dollar Riddle,” August 7, 2002). Our conclusion at the time: “[E]xpect more dollar weakness, and expect to see its ramifications-deflationary pressures leading to inflationary ones, weakness in financial assets, continued downward pressure on short-term rates and upward pressure on long-term rates.”

We were, we believe, right on all counts but early on some. Indeed, the dollar has weakened. Since July 2002, it has fallen yet another 23% versus the euro, 12% versus the yen and 20% versus the basket of six currencies. Overall, since the dollar last hit a cyclical peak of 0.86 versus the euro in March 2002, the dollar has lost almost 45% of its value against that currency. Deflationary pressures persist-the CPI is still growing at less than 2%-but we have yet to see any signs of price pressure except in one small corner of the production chain, raw materials. US financial assets have not only not been weak; they have been on a tear. Since the summer of 2002, the Nasdaq Composite has gained 69% and the ten year, which yielded 4.39% then is yielding 4.06% now (up from an intraday low of 3.07% on June 13, 2003). Short rates have come down since then, as the Fed made the 12th and 13th cut to Fed Funds.

We revisit the topic today because our sense of concern over the state of the dollar apparently has not been shared by the US Treasury, and it has only lost more ground. Besides obligatory statements from Treasury Secretary Snow about a strong dollar policy being in the best interests of America, the US Treasury still has not found it necessary to take action. Rather than “strong dollar”, a more apt description of our policy is “expedient neglect.” And so we again must consider what it all means because, to us, the continuing weakness of the dollar will matter-eventually. The weakening dollar, which may be helping the US economy right now, could end up hurting it if the textbook chain of events takes place. A weaker dollar, by definition, means that it buys less, which puts upward pressure on prices, and the inflationary pressure changes expectations for credit market participants, driving long-term interest rates up. A declining dollar makes our exports more attractive to foreign consumers, but it hurts the value of dollar-based assets, which ultimately repels foreign investors and makes it more expensive to finance the federal budget deficit and the current account deficit.

In short, our conclusion today is essentially the same as it was a year-and-a-half ago. The mitigating circumstance, or what we may have failed to fully appreciate back then, is the pervasive globalization of the capital markets. These are new financial markets with new rules. The textbook chain of events that one would expect to happen with a weak dollar has not happened. To us, the reason the textbook writers are wrong is because they never contemplated such an outsized US current account deficit, the hegemony of the US dollar as a global reserve currency, and the substantial global ownership of dollar-based financial assets and hard assets. This condition has elicited new influence by and motivations of foreign investors.

The ownership position of foreign investors of US assets is substantial and growing. Non- US investors own approximately 40% of outstanding public debt, up from 20% a decade ago. Over $1.5 trillion in Treasurys, Agencies, corporate debt and equities are owned by foreign investors. The US current account deficit for the September quarter was $135 billion, and $542 billion over the last four quarters. In other words, in the United States we consume more than we produce, and to meet the demand, we import more than we export. We pay for these imported products by borrowing money from the people who make them in other countries. James Grant, editor of GrantŐs Interest Rate Observer, has called it "the biggest vendor-financing scheme in the history of lending and borrowing." To finance this deficit, we receive investment dollars (i.e. we borrow) from foreigners approximately $1.5 billion a day-in the form of financial assets like Treasurys, Agencies, corporate bonds and stocks.

Theoretically, this pace of foreign investment could continue indefinitely. But here is the critical point: While anything short of that amount and the deficit would shrink, it would also mean that the assets that have been bought by foreign buyers to fill that hole-primarily financial assets-will shrink in value. Moreover, the foreign countries that have gotten accustomed to selling their products to be consumed in the US and financing our purchase of those products will have to find a replacement for that demand. Both sides of the current account deficit, then, are currently motivated to keep the status quo.

Looking at such a situation, one would have to conclude that it is in need of structural reform. During the last five years or so, the current account deficit has widened considerably, on an absolute basis and as a percentage of GDP. There are, according to Asha Bangalore, economist at Northern Trust, two primary reasons for the growth in the deficit. First, Americans donŐt save enough to provide the demand for domestic financial assets. Second, foreign central banks, particularly Asian ones, are not only taking up that slack but extending the deficit as they try to support the dollar. The problem with a current account deficit of these proportions is that once it is out there, reversing it becomes risky. “Asian central banks could stop supporting the dollar if they perceive these actions as a threat to the health of their economies,” she writes. “In other words, when and by how much will both the private sector and foreign central banks wish to liquidate their holdings of dollars and dollar assets is the question.” To Bangalore’s two primary reasons, we would add a third reason for why the current account deficit has grown: Americans are the worldŐs best at consuming, and the rest of the world likes to sell its products to us. In size. Not only do they not want that to change, but they also perceive a weaker dollar as a threat.

For the Federal Reserve, this new-or more precisely, no longer ignorable-dynamic is easily explained and even welcomed. “Globalization,” said Alan Greenspan in a speech on January 13, 2004, “has altered the economic frameworks of both developed and developing nations in ways that are difficult to fully comprehend. Nonetheless, the largely unregulated global markets do clear and, with rare exceptions, appear to move effortlessly from one state of equilibrium to another. It is as though an international version of Adam Smith’s ‘invisible hand” is at work.”

Chairman Greenspan observed that the rise to record levels of the US ratio of current account deficit to GDP has been uneventful so far, primarily because America has been “rare in its ability” to finance its debt in the world’s reserve currency. Indeed, we would say that this ability is virtually unprecedented in human civilization. But Chairman Greenspan did raise a note of caution about the sustainability of foreign investor’s desire to finance our current account deficit: “In the end, the restraint on the size of tolerable US imbalances in the global arena will likely be the reluctance of foreign country residents to accumulate additional debt and equity claims against US residents.”

To date, only the opposite has been happening. The imbalances have only been getting greater, not smaller. The following series of charts, derived from data provided by the Department of Treasury International Capital System, illustrates the growing appetite for US financial assets, and who has been hungriest. The following graph shows the monthly net purchases by foreign investors of US securities, broken down into Treasurys and Agencies, stocks, and the total. Note in the graph the overall increases in demand for US securities since 1990, and in particular the demand for stocks by foreign investors during the bubbly years of 1999 and 2000 and the rotation into bonds afterwards. Note also the huge inflows into the bond market in the summer of 2003.

The next graph provides detail on this time series for 2002 and 2003. US fixed income securities have been snapped up by foreign investors at an extremely strong pace since March 2003. According to the Federal Reserve, over the six quarters ending with the second quarter of 2003, the total outstanding US government debt rose by about $345 billion, while foreign holdings of such debt rose by about $304 billion-90% of that amount.

The graph below details the monthly net purchases of US securities since 1990 by country or region. Europe and Canada together are the biggest investor in US securities (with the UK making up the lion’s share of that demand). Note the sizable increase in demand by China ($55.5 billion in 2003 through November versus $68.8 billion in all of the 1990s) as well as the volatile and sizable buying by Japan.

The next graph, rather than showing flows, shows total cumulative holdings of US securities by China and Japan. At November 2003, China owned $144 billion and Japan $525 billion. Since May 2000, China has increased its holdings by 98%, and Japan has increased its holdings by 64%.

At November 2003, Japan and China held 44% of the $1.5 trillion of US financial assets held by foreigners. Interesting to note that since 2000 the UK and China have switched their positions as 2 and 3, and Japan has increased its share from 30% to 34%.

This is clearly an issue that increasingly concerns the Federal Reserve. William Poole, President of the Federal Reserve Bank of St. Louis, devoted a speech to international capital flows. Like Chairman Greenspan, he marveled at the fluidity of the global financial marketplace and suggested that all that is happening is that “aggregate patterns of international trade flows may simply be a by-product of a process through which financial resources are seeking their most efficient allocations in a worldwide capital marketÉdriven by investors seeking the best combination of risk and return in the international capital market.”

That sounds very nice, but we would suggest that the 10-year Treasury at 4% does not offer the best combination of risk and return available in the marketplace today. There is some other reason for the seemingly endless demand for US securities, particularly the demand from Japan and, increasingly, China. To us, the weakness of the dollar is the culprit. “A rising babble of complaint has come from the European and Japanese sides of the table about the pressure the rapidly falling dollar has put on their economies,” the Financial Times reported on January 20, 2004. The dollar’s decline versus the yen, the main event in the currency markets right now, is threatening Japan’s recovery, and that country has been assiduously spending on foreign currency intervention to stave it off. As we can see, that effort to prop up the dollar has not been very successful. Bloomberg reports that Japan’s central bank has been selling record amounts of its currency to sustain its export-led recovery, 8 trillion yen ($75 billion) this month alone. A bystander in this race to have the weakest currency is the euro-it has nowhere near the trade imbalance with the US of Japan or China-but as a major world currency with a strong central bank, it has also been rising. The latest chatter in the market is that the ECB will cut its benchmark rate shortly in order to weaken its currency.

The wild card in the currency wars is China, which has had its currency, the renminbi, pegged at about 8.27 to the US dollar since 1995. To put this in perspective, in 1996, the US economy (measured in GDP) was almost 10 times as large as China’s. In 2003, that ratio will likely shrink to less than 8. The Chinese demand for resources and seemingly limitless supply of cheap labor is turning its economy into the engine for global growth. Electricity blackouts and SARS can’t stop China-it was the fastest growing economy of the world’s 10 biggest last year, creating 8.5 million jobs and consuming 55% and 36% of the world’s cement and steel production. Chinese exports grew 51% and industrial production grew 18% in December.

With this type of performance, China is no longer an appropriate candidate for a currency peg-rather than being the small international player it once was, it is now becoming a strong competitor in the global marketplace. Some have suggested that by 2050, the Chinese economy will be as large as the United States. Left to float freely, the renminbi would likely strengthen versus the dollar. But in order to keep the peg where it is, the Chinese need to do exactly what the Japanese are doing: They buy dollars. Those dollars then have to be invested somewhere-typically they are invested right back here in the US, primarily in Treasurys and Agencies. The solution for China could be for the country to let its currency float freely (one market participant we spoke with suggested that a freely-floating renminbi would be somewhere around 5 or 6 to the dollar), float in a range against the US dollar or get pegged against a basket of currencies. In any of these solutions, the result could be negative for the dollar and interest rates.

What have all these flows into US financial assets meant in the US financial markets? We think that the connection between the current account deficit and the financial markets, besides the weak dollar, has been prices for financial assets. To illustrate that, we have compared the flows into the bond market by foreign investors to the change in the 10-year Treasury yield (approximately 25% of the flows into Treasurys are bills, the balance in notes and bonds). Note how the extremes in flows into the Treasury market resulted in significant market moves in rates. We can’t say directly that the heavy flows in a particular month moved rates down, but we can draw significant inferences. In the heaviest month of buying of Treasurys and Agencies, May 2003, during which $73 billion flowed into the market, the 10-year yield fell from 3.838% to 3.372%, a decline of 12.1% in yield. However, during June and July and August of 2003, foreign buyers poured $140 billion (an average of $47 billion per month) into the bond market, and yields rose from 3.372% to 4.466%. We would argue that in these months there was also significant activity from mortgage hedgers that swamped the market, overcoming the flows from the foreign buyers, but they were in there trying. Similarly, September was an interesting month because foreign buying declined precipitously to a little over $2 billion and rates declined during the month. The timing of the measurement of these flows versus the movement of rates may be the issue, but our belief is that the foreign buyers of US public debt securities are exerting a significant pressure on interest rates as they struggle to maintain currency values that keep them competitive on the world markets.

Clearly, there are many forces driving interest rates-growth expectations, inflation expectations, Fed action on the short end, Treasury issuance along the curve, the perception of safety in a risk-filled world, as well as demand from other quarters, most particularly the mortgage hedgers. There are also many other aspects of the current account and trade deficit that will have an effect on their longevity, including trade policy and any official response to job exporting. Nevertheless, the point we hope survives this 3,200 word article is that a side- effect of the growth of the current account deficit has been the increased market presence of foreign investors, and that presence has resulted in a new and powerful source of demand and volatility.

In conclusion, our views today are essentially the same as they were in August 2002. The weaker dollar will put upward pressure on rates and prices. The only change we will add to this is that this will only occur when financial institutions around the world pull back their purchases of US financial assets, or issuance of US Treasurys tips the supply-demand balance. When will this happen? Eventually. The evidence suggests that the point of restraint has so far not arrived. Global financial managers have not yet looked at their asset allocations and decided that they have reached their limit on US financial assets and cut back on their buying, stopped buying entirely, or even started outright net selling. That global asset rebalancing hasn’t started yet, but we think that it’s closer now than it was in the summer of 2002.

Signs that the rest of the world is starting to re-think the whole arrangement can be seen in the discussions of the G-7 regarding currency values. There is also the sentiment expressed in a Jan. 22, 2004, Wall Street Journal story, “A Growing Global Unease: Can a Recovery Built on Ballooning US Deficits Be Sustained.” We are first in line to admit that we don’t know the answer to that question. But we’ll give the last word on the subject to Fed Governor Donald L. Kohn, who delivered an address, “The United States in the World Economy,” just a week before Chairman Greenspan delivered the one mentioned above. “In the second half of the 1990s, we had both foreign and government savings to finance investment; a few years from now we may have less of the former and none of the latter….If the fiscal path does not change, unless private savings rise considerably to compensate, interest rates will be higher than they otherwise would be…”

January 27, 2004
By Jeremy Diamond, Executive Vice President
Annaly Mortgage Management/FIDAC

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