Guest Post: A Plunge in Foreign Net Capital Inflows Preceded the Break in US Financial Markets

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Served by Jesse of Le Café Américain

The peak of foreign capital inflows into the US was clearly seen in the second quarter of 2007, just before the crisis in the US that has rocked its banking system and driven it deeply into recession.

Are the two events connected? Had the US become a Ponzi scheme that began to collapse when new investment began to wane, and the growth of returns could not be maintained?

Watch the dollar and the Treasury and Agency Debt auctions for any further signs of capital flight, which is when those net inflows of foreign capital turn negative. And if for some reason the unlikely happens and it gains momentum, the dollar and bonds and stocks can all go lower in unison, and there is no place to hide except perhaps in some foreign currencies and precious metals.

The sad truth is that US collateralized debt packages and their derivatives have become toxic in the minds of the rest of the world, and there is little being done to change that, except an orderly winding down of the bubble, with the remaining assets being divided largely by insiders, and not price discovery and capital allocation mechanisms driven by ‘the invisible hand’ of the markets.

Unfortunately the Net Inflow Data is quarterly, and subject to revisions. But we have to note that the spectacularly rally off the bottom in the SP 500, not fully depicted above, is not being matched by a return of foreign capital inflows.

If that inflow does not return, if the median wage of Americans does not increase, if the financial system is not reformed, if the economy is not brought back into balance between the service and manufacturing sectors, exports and imports, then there can be no sustained recovery in the real, productive economy.

The rally in the US markets is based on an extreme series of New Deal for Wall Street programs from the Fed and the Treasury, monetization, and the devaluation of the dollar.

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  1. "DoctoRx"

    Informative, concise and thought-provoking post.

    Good line–"New Deal for Wall Street": welfare queens!

  2. donna

    The impulsive gambler is always good for the money until he isn't…. Uncle Sam started losing at the table…

  3. DownSouth

    Brad Setser has done some work on this subject too.

    This post was from January, and his data he used was from the Treasury International Capital System (TIC), for which he gives a link:

    If one follows Setser's link to the TIC, it appears their data is current through June 2009.

    What I like about Setser's graphs is he breaks the capital flows down into stocks, equities, short-term Treasury bonds, long-term Treasury bonds, short-term agency (Fannie and Freddie) bonds, long-term agency bonds, and private (US corporate) bonds.

    None of this detracts from what you have to say, Jesse, but some people might like to see in more detail what the foreigners are buying and what they're not. At the time Setser did his post, private corporate bonds and agency bonds were cold, long-term treasury bonds were cooling off and short-term treasury bonds were heating up.

    The fact that foreign investors were opting for short-term instead of long-term Treasury bills may be of some import.

  4. Ina Pickle

    What amazes me is that no matter how many times you rationally, clearly state what must be done to fix the real economy, no one appears to want to do it. It is almost like the oligarchy feel like they can still make it to the lifeboats and have time for just one more dance. . . while those of us down in steerage stand around waiting for the dance floor to clear so that we can get to the deck. Meanwhile, the waterline is up around our ankles.

  5. Mr. S

    I would echo DownSouth's comment.

    I seem to recall that the "flight to safety" during the depths of the crisis caused T-bill yields to crater spectacularly and the dollar to jump.

  6. gruntled

    And I echo Ina Pickle's comment.
    I think it's clear that "fix" will break's oligarchy's hegemony; thus, it will never be done.

  7. Jesse

    Thanks DownSouth,

    I was very familiar with Brad's work, and had been looking at TIC and doing my own analysis from it for many years.

    I will miss Brad's work now that he has left the CFR to go work at Treasury.

    One word of caution, and as Brad has often said, the TIC data is far from complete or even pristine, and there is a truing up with other sources of data so that the most correct figures lag.

    Still, as you say, it takes away nothing from the premise of capital inflows.

    Shortening duration is a great concern. Yes, it is part and parcel of the 'flight to quality' but that flight would have been more impressive if it had been accompanied by net inflows.

    Shortening duration is what investors do ahead of Capital Flight.

    The best thing the US has going for it is that it has the reserve currency, and no clear alternative exists.

    If it did not, there is little question in my mind at least that the US would be on the ropes in a big way, like Argentina or Russia were when they had their financial crises.


  8. Jesse

    "Conversely, the surge in short-term inflows to the US coincided with the dollar’s recent rally. That in some sense is the puzzle. In the past, record demand for US financial assets was strangely enough tied to dollar weakness. And now a deterioration in the quality of the inflows is tied to dollar strength. Go figure."

    This is the money quote. It is an anomaly indicating some gap in the data.

    I would actually worry about it a lot, because the only buying I have been able to find is 'official' as part of currency manipulation.

    The 'underpinnings' of the US financial system are strong for now but narrowing. Narrowing to the point of a collapse should those underpinnings, which are very artificial, continue to weaken.

    Until the productive economy of the US is restored to balance, until the financial system is reformed, the dollar and the bond are living on "borrowed" time.

  9. jlivesey

    "Is Sterling about to tank?"

    Written when Sterling was $1.39. Today it's $1.63. There is something about Sterling that turns peoples' brains to mush.

  10. Hugh

    I agree too with Ina Pickle. We could all add items to Jesse's list but the main point remains the same: the fundamental problems which underlie our economic problems are not being fixed or addressed. I think the reason that capital flows are not returning is because of wealth destruction and because in the absence of an imminent crisis there is not a lot here that is that attractive.

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