A chart heavy piece this week in which we dig into the underlying shifts in the capital flows into the United States.
We had aimed to issue this piece last week but it took more work and longer to draw out coherent conclusions than we had anticipated.
The key takeaways we draw out from the analysis in this week’s piece are (1) the structural shifts in capital flows into the US since the Global Financial Crisis and (2) a flows based framework for charting the path of the US dollar.
“Total return has three elements: the interest rate differential, the exchange rate differential, and the capital appreciation in local currency. Since the third element varies from case to case we can propose the following general rule: speculative capital is attracted by rising exchange rates and rising interest rates.
Of the two, exchange rates are by far the more important. It does not take much of a decline in the currency to render the total return negative. By the same token, when an appreciating currency also offers an interest rate advantage, the total return exceeds anything that a holder of financial assets could expect in the normal course of events.
That is not to say that interest rate differentials are unimportant; but much of their importance lies in their effect on exchange rates and that depends on the participants’ perceptions. There are times when relative interest rates seem to be a major influence; at other times they are totally disregarded. For instance, from 1982 to 1986 capital was attracted to the currency with the highest interest rate, namely, the dollar, but in the late 1970s Switzerland could not arrest the influx of capital even by imposing negative interest rates. Moreover, perceptions about the importance of interest rates are often wrong.”
― The Alchemy of Finance, George Soros (emphasis added)
For those of you not wanting to run through the lengthy discussion, jump to the ‘Putting It Altogether’ section at the end of the piece.
One Quick Detour
Before going on to this week’s piece, a brief comment on bitcoin (or cryptocurrencies, in general).
We do not discuss cryptocurrencies or blockchain often and write about them even less. Even so, in our occasional discussions about cryptocurrencies we regularly come across statements along the lines of: “I am bullish on blockchain, not bitcoin,” or “The use case for blockchain technology far exceeds that of cryptocurrencies.” You too might have heard similar such statements from investors, venture capitalists, or other “authoritative sources” in discussions or interviews.
This line of thinking, we suspect, has driven capital and resources into developing private blockchains or proprietary databases that are based on blockchain technology. For example, banking behemoths of the likes of JP Morgan and UBS are spearheading efforts to use blockchain technology for settling cross-border trades worldwide with their own “Bitcoin-like” tokens.
The arguments in favour of private blockchains over public cryptocurrencies may yet prove prescient and the development of private database-like structures turns out to be the optimal use case for blockchain technology. The below passage from The Hard Thing About Hard Things written by Ben Horowitz, of Andreesen Horowitz fame, about the Internet and competing proprietary networks, is a reminder, however, that the public versus private implementation debate is not new. And a technology that appears to be inferior, insecure or volatile can evolve and supersede a seemingly superior competing solution.
“In retrospect, it’s easy to think both the Web browser and the Internet were inevitable, but without Marc’s work, it is likely that we would be living in a very different world. At the time most people believed only scientists and researchers would use the Internet. The Internet was thought to be too arcane, insecure, and slow to meet real business needs. Even after the introduction of Mosaic, the world’s first browser, almost nobody thought the Internet would be significant beyond the scientific community-least of all the most important technology industry leaders, who were busy building proprietary alternatives. The overwhelming favorites to dominate the race to become the so-called Information Superhighway were competing proprietary technologies from industry powerhouses such as Oracle and Microsoft. Their stories captures the imagination of the business press. This was not illogical, since most companies didn’t even run TCP/IP (the software foundation for the Internet)―they ran proprietary networking protocols such as AppleTalk, NetBIOS, and SNA. As late as November 1995, Bill Gates write a book titled The Road Ahead, in which he predicted that the Information Superhighway―a network connecting all businesses and consumers in a world of frictionless commerce―would be the logical successor to the Internet and would rule the future. Gates later went back and changed references from the Information Superhighway to the Internet, but that was not his original vision.
The implications of this proprietary vision were not good for business or for consumers. In the minds of visionaries like Bill Gates and Larry Ellison, the corporations that owned the Information Superhighway would tax every transaction by charging a “vigorish”, as Microsoft’s then―chief technology officer, Nathan Myhrvold, referred to it.
It’s difficult to overstate the momentum that the proprietary Information Superhighway carried. After Mosaic, even Marc and his cofounder, Jim Clark, originally planned a business for video distribution to run on top of the proprietary Information Superhighway, not the Internet. It wasn’t until deep into the planning process that they decided that by improving the browser to make it secure, more functional, and easier to use, they could make the Internet the network of the future. And that became the mission of Netscape―a mission that they would gloriously accomplish.”
A parting thought, consider the oft-cited explanation for the superiority of open-source solutions: “Given enough eyeballs, all bugs are shallow.”
US Trade Balance and Foreign Portfolio Investment
The below chart consists of the de-trended US trade balance (magenta bars), presented in reverse order and defined as the quarterly trade balance minus the three-year moving average of the trade balance, and the quarterly foreign portfolio investments into the US on a net basis (orange line).
US Trade Balance De-Trended vs Net Foreign Portfolio InvestmentSources: US Census Bureau, US Department of the Treasury
The US, over the last twenty-five years, has, more often than not, run a trade deficit with the rest of the world. That is, Americans have consumed more than they have produced. During the 1990’s and the first five years of the current millennium, a growing trade deficit coincided with increasing foreign portfolio flows into the US.
Ahead of the financial crisis, the US trade deficit shrank and was duly followed by a sharp drop in foreign portfolio inflows. During and a few quarters following the Global Financial Crisis, the trade balance and foreign portfolio flows relation was flipped on its head. The US started to run a trade surplus, more on that anon, yet foreign portfolio flows increased rather than retrenching. The safe-haven bid for US assets, specifically US Treasury securities, was sufficiently large to overrun the impulse for foreign capital to retreat as the US went from running a trade deficit to running a trade surplus.
In the chart below, international flows into US Treasury securities are plotted against the US trade balance. The international bid for Treasury securities was strong during the Global Financial Crisis and, following a brief pause, remained strong all the way through 2011.
US Trade Balance De-Trended vs US Treasury International Capital FlowsSources: US Census Bureau, US Department of the Treasury
Following the Global Financial Crisis and up until the election of President Trump, the US no longer ran consistent trade deficits and even when it did, they were not as large as they were prior to the crisis. As a corollary, foreign portfolio investments, too, waxed and waned between positive and negative during the time period.
The Diminished Role of Oil in Dictating Foreign Flows
Prior to the crisis, US oil imports were on a steady uptrend, going from below 5 million barrels per day at the end of 1990 to a peak of more than 10 million barrels in 2006/07. Imports dropped sharply to below 8.5 million barrels per day during the crisis, spiked in 2010, then continued declining through 2015, picked up in 2016 and 2017, and once again started falling from the second quarter of 2018. In February 2019, US oil imports averaged less than 7 million barrels per day for an entire month for the first time since February 1996.
US Trade Balance De-Trended vs Price of Brent Crude Oil De-TrendedSources: US Census Bureau, Bloomberg
The rise of shale and the sharp drop in oil prices in the second half of 2014 has shifted the source and structure of net foreign portfolio investments into the US. The US trade balance, particularly during the commodity super-cycle witnessed during the first decade of the new millennium, was strongly correlated with the fluctuations in the price of oil. Since 2012, however, the correlation has broken down.
US Net Foreign Portfolio Investment vs Price of Brent Crude Oil De-TrendedSources: US Census Bureau, Bloomberg
The US trade balance being less correlated with the fluctuations in the price of oil also coincided with the correlation between foreign portfolio flows and the price of oil declining.
The breakdown in the correlation can be understood through the shifting structure of foreign portfolio flows. From the 1990’s through 2006, the growth in portfolio flows was predominantly driven by increasing international flows into US Treasury securities. Oil exporting nations, particularly those operating US dollar pegged currency regimes, and China, were recycling their US dollar windfalls back into Treasury securities.
The rise of shale and subsequent drop in the price of oil has meant oil exporting nations no longer have the kind of excess capital to re-direct into Treasury securities as they once used to. China’s dollar-shortage challenges are, of course, well documented. Consequently, foreign flows into US government bonds have become more sporadic and the relative share of foreign flows into other securities has increased. The relative share of US foreign portfolio flows from other pools of capital, specifically pension funds and insurance companies in Europe and Japan, has also increased.
Structure of US Net Foreign Portfolio InvestmentSource: US Department of the Treasury
The shift, however, in the correlation between the fluctuations in the price of oil and foreign flows into US Treasury securities has not been as dramatic. Suggesting that oil exporters continue to prefer parking excess capital into US government bonds and are not going out on the risk curve.
US Net Foreign Portfolio Investment vs Price of Brent Crude Oil De-TrendedSources: US Department of the Treasury, Bloomberg
Putting It Altogether
We have gone through some of the high level dynamics of the US trade balance and foreign portfolio flows. To round off the discussion, we outline a framework that can be helpful in thinking about the US dollar and demand for US dollar assets in general.
US Trade Balance + Net Foreign Portfolio Investment De-Trended vs YoY Change in US Dollar IndexSources: US Census Bureau, US Department of the Treasury, Bloomberg
The magenta line in the above is the sum of the de-trended trade balance and the de-trended net foreign portfolio investment. The line being above zero implies foreign demand for US dollars exceeding the supply of US dollars. For example, the demand for US dollars emanating from portfolio flows exceeds the supply of US dollars being created by the US running a trade deficit.
Demand outstripping supply, to state the obvious, places upward pressure on the US dollar.
Outside of periods of insatiable demand for safe-haven assets, this flows based framework works well as a tool to chart out a path for the US dollar.
Based on this framework, let us consider the scenario of the US undertaking a large fiscal spending programme following the presidential election. If such a fiscal spending programme greatly increases the US trade deficit, supply of US dollars should also increase substantially. This increase in the supply of US dollars will place tremendous downward pressure on the greenback unless accompanied by a commensurate increase in foreign portfolio flows into American financial assets.
An increase in foreign demand for American financial assets, in all likelihood, requires higher long-term interest rates. The optimal way for investors to position for it in the current environment, in our opinion, is to be long yield curve steepeners.
This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.