US Taper and Foreign Investors - Part 2, Wary and Tactical

Last month, I wrote about how net foreign investment in long-term US instruments recorded an unprecedented US$133bn capital out flow during 2013 – something that has only happened once before in post-Cold War financial history. Since changes in fundamental financial behaviour are rare, it raised the question of whether this was merely a trading response by international investors to the prospective end of the Fed's taper, or whether it represented a fundamental re-assessment of the role of US dollar markets in the global financial system. The stakes could hardly be higher.

We now have data from January, which extended the trend: in January, net long-term foreign capital inflows came to just $7.3bn, which is $20bn less than in January 2013, and which takes the 12m net outflow to $157bn.

But closer inspection of the composition of this shortfall reveals that the origin and targets of the outflow are not as simple as merely a reaction to Fed's tapering. And as a result, the strain put on the dollar, and and dollar asset markets, is probably less than it appears. Finally, there is also evidence that insofar as the exodus from US bond markets is motivated by the announcement of Fed tapering, the exit has been tactical rather than strategic.  Overall, the detail belies the impression that the world is quietly removing itself from the dollar-standard.

The first surprise is that despite the headline deficit, there has been no foreign net selling of domestic US securities. Rather, in the 12m to January, foreign investments cut their buying of US domestic securities by $567bn yoy to just $15.4bn – a massive drop in buying, but not actually net selling.  The collapse in net buying was shared by both private investors (down $311bn yoy to just $16bn net buying in the 12m to Jan), and official investors (down $255bn yoy to a net $0.6bn sold in the 12m to Jan).  What pushed the entire balance into deficit was a net selling not of US securities, but rather of securities of foreign companies and institutions floated and traded in the US – there was net selling of $173bn of these securities!

So foreign net buying of US domestic long-term securities fell by $567bn to just $15.4bn: what were the major portfolio changes? As expected, the main driver was a reluctance to buy new treasuries: on a 12m basis, net buying fell $350mn yoy to just $10.5bn in the 12m to Jan.   But the biggest actual net selling was in equities: foreign investors sold a net $52.1bn in the 12m to Jan,  compared with net buying of $110.5bn in the same period the previous year. This is consistent not just with caution in bond markets, but also modest profit-taking in equities.  Foreign investors bought $53.6bn of agency bonds (down $72.7bn yoy), and $3.4bn of corporate bonds (up $18.6bn).

The combination of bond caution and profit-taking in equity markets looks much more like a tactical trading strategy than a wholesale decision to exit US asset markets.  And this suspicion is bolstered by a further detail: at the same time as foreign investors were cutting their holdings of US securities, they were building up unprecedented levels of deposits in  the US banking system.  (To be precise these are banks' liabilities to foreign investors – since they cannot be either bonds or equities,  I am assuming they are deposits.) To put some numbers on it: in the 12m to Jan, foreign investors sold a net $157bn, but raised their deposits in US banks by $541bn.  The change in behaviour from the previous year is stark: in the year to Jan 2012, foreign investors had bought a net $528bn in securities, but raised their deposits in US banks by just $79bn.

Now take a look at the chart below, which tracks 12m changes in foreigners' net purchases of US securities, and net deposits in US banks. The first thing to notice is the offsetting relationship between changes in holdings of securities and bank deposits which seems to have been fairly consistent since 2011.   Since then, when purchases of securities have dried up, bank deposits have risen, and conversely when securities buying is booming, bank deposits run down.  The most obvious explanation for this is simply that foreign investors are tactically trading in and out of securities markets without at the same time trading in and out of the US financial system, or the US dollar.  Which perhaps explains why the lack of impact on the dollar from the net sales of US securities.

But notice also that this pattern is new: prior to the crisis, there was no obvious offsetting relationship between securities purchases and bank deposits – both tended to move in the same direction both in and out of the dollar financial system.  This suggests an underlying change in the overall pattern of foreign investor behaviour in dollar markets, with a far greater sensitivity to market conditions and a far greater willingness to trade. The pre-crisis willingness simply to pile rather indiscriminately into dollar assets has been modified.

And, finally, this is reflected in overall investment patterns (of securities and bank deposits). Whilst the 12m to Feb 2014 still showed an overall inflow of $383.2bn, the total has been in steady and unspectacular decline since 2011.  In 2011 the net inflow was $754bn; in 2012 it fell to $563bn, and in 2013 it fell again to $394bn.  This is clearly a different pattern of behaviour from the steady pre-crisis build-up, or the rout  experienced during the crisis. A willingness to hold dollars remains, but that willingness is less enthusiastic than before, and evidently more qualified by tactical trading opportunities than before the crisis.  The world's investors have not abandoned the dollar, but the relationship has changed.