Summary: International capital flow analysis has suddenly become quite popular again. There are rare instances where this seems to be done well. But for the most part, the standard take is superficial, lagging, circular, or even backwards.
In my view, the proper way to do this basically ignores the direct effect of flows on domestic asset prices. For example, don’t think of flows into mid-term Treasury bonds being a major source of downward pressure on mid-term yields. Instead, we should focus on the impact of capital flows on exchange rates, how they feed back into domestic economic variables, and how they in turn influence asset prices. Forex rates can also be a useful signal of relative domestic demand conditions in the countries involved in the flows, which influence trade sector performance even more than exchange rates.
My perspective on this is not new or unique. It is just an application of the standard bastard Keynesian framework plus a conviction that portfolio balance effects are not dominant, particularly in US fixed income. The purpose of this post is mostly to remind you of that perspective, which is admittedly incomplete and imperfect, but seems to dominate the trivial approach taken by much of the media and Wall Street.
Many of you may not like this framework, which is fine. But I would encourage you, whatever your preference, not to exclude real-side implications from your analysis of capital flows. If I could get you there, then I would consider this a win.
At this stage of the cycle, the influence of capital flows – or more precisely the global macro fundamentals driving them – seems benign. The US must accommodate the continued inflow, barring a move to capital account closure, which seems unlikely. But America’s ability to do so does not yet seem stretched.
The more pressing business cycle issue is the achievement of full employment. That is an important achievement socially, but it also means we are probably now entering late cycle, although a recession does not seem imminent.
Blame the Fed…
As you know, I think QE was mostly a harmless distraction. It delivered an interest rate signal that could have been – and ultimately was – provided through more direct means. QE probably affected the timing but not the magnitude of the equity market rally. And it may have exerted some downward pressure on bond yields in its early applications, but even that was quite transitory. Later applications had no apparent effect on yields even in the short run.
The dreaded unintended consequences also seem to have been mostly made up, in part by people who had an incentive to overstate the power of QE for good or evil. Included in these people were Fed officials. Mechanically, QE was nothing more than the Fed shortening the effective maturity of the federal debt, acting as an agent for the Treasury, which somewhat ironically was going in the opposite direction on its own behalf.
Why would shortening maturity be dangerous? When the Fed tapered, stopped buying, and then started effectively selling down duration, we saw that it wasn’t dangerous. Or perhaps more precisely, we certainly did not see that it was dangerous.
But there is perhaps one unintended consequence of QE that we are still living with. Proponents of QE have made a strong effort to encourage belief in the so-called portfolio balance effect, which holds that bond prices and yields can be meaningfully affected by marginal manipulations of supply and demand.
There is little actual evidence that the PB effect was very strong over the QE period, during which bond yields generally fell even as the combined influence of the Fed and Treasury provided a massive net increment to the volume of duration that markets had to take down.
But the idea that supply-demand analysis matters seems to have stuck. And it seems really to be confusing people’s interpretation of the influence of international capital flows on the US markets and economy.
…for confusing Bloomberg and ilk
A month ago, I put up a post about how China is most interesting when misinterpreted backwards. There I pointed out that this fixation with supply and demand encouraged a lot of people – about two years ago – to misinterpret financial instability in China as a likely source of upward pressure on Treasury yields, on the grounds that it would encourage further liquidation of Treasury securities by Chinese reserve managers as they tried to defend the RMB.
Yeah, China melting down financially and the dollar spiking would probably put up US yields. Nice work. Way to follow the big picture.
Yesterday, I noticed a piece on Bloomberg making the same mistake in a broader geographical context. There was an accompanying segment on Bloomberg TV, during which one of the interviewers asked a guest economist what Trump could do to encourage foreign holdings of Treasury securities to go back up
The question was a bit silly, because Trump has been pretty clear that he is against “currency manipulation”, which is the main source of adding to those Treasury holdings. But even away from that, why would Trump want foreign holdings of Treasuries to go up? Is that some sort of national objective?
It would be if you wrongly believed that a healthy US bond market depends on the result, which the interviewer apparently does. That piece made me think I might want to write this piece, because the issue is obviously current and because my earlier efforts at weighing in on it have not quite been to my own satisfaction.
And now I see this morning a follow-up piece on Bloomberg reiterating that same argument, as though it were super important or something. In that piece we see this gem:
… U.S. Treasuries have been finding far fewer foreign buyers in recent months — a trend that has so far been offset by higher domestic demand.
Yeah, I’m guessing that trend where every Treasury security is owned by somebody is probably going to continue indefinitely.
More seriously, just look at the price (i.e. yield). That will tell you the net effect of the relative supply and demand shifts to date. And looking forward, if you think that some hands are stronger than others, in this case, that the foreign hands are the stronger ones, then make the argument.
Link to the real economy
It is easy to pick on sensationalist journalists channeling what they just heard from a trading desk with a one-week horizon, one possibly extending backward. But IMV, there is a serious bit of economics involved here, which I will try to elaborate. Financial flow reporting that is not directly connected to an analysis of accommodating or motivating real-economy forces is pretty much useless.
This arises from two problems. First such reporting is backward-looking, along with the inherently ex-post data on which it is based. (All the action on the capital account is ex-ante.)
And second, it has no ability to isolate cause and effect. To cite the China example, were they selling to defend the RMB, which was weakening in response to financial turbulence? Or had China decided to just to let the RMB appreciate because in a moment of serenity they had decided to move away from their export-driven development strategy?
Same capital flows: largely opposite implications. At the time, about two years ago, the street and media picked the wrong scenario, in part because they were unaware that they even had to make a choice. They fell for analysis of the supply and demand for paper claims, just as they did with QE.
Here is a better way to do it. It is an old story, which I will not try to prove but will just remind you of – before showing some data and drawing some implications for the future.
I could not “prove” this perspetive it if I tried, because it is just the standard, bastard Keynesian view, which is obviously not shared by everybody and is incomplete at best. Maybe if you reject this story, you could at least be aware that you are doing so, and then give some thought to another story to replace it.
I will start by looking at this through the prism of the bond market, because that links up with “the” interest rate posited in the standard Keynesian set-up. I will then broaden it out a bit to consider risk assets and the slope of the yield curve, in that odd order, for reasons that will I hope become obvious. And for simplicity, I will just assume that initial displacement happens overseas, in a country or set of countries I will call “China.”
Flow is not the whole story
The trick here is to focus on the real-economy implications and causes of the capital flows and not just the flows themselves. With that in mind, let’s say – somewhat realistically — that China has “surplus” capital to export to the US.
This could reflect that China is pursuing a savings/investment/export development strategy of the sort that Michael Pettis has described in the Great Rebalancing. In that case, a portion of China’s national savings is being recycled into the US economy, via official capital flows, which put downward pressure on US bond yields, although not for the reason you may assume.
Or it could reflect that China has been trying to move away from that development strategy, but has recently run into some financial market turbulence, which encourages private capital flight out of China, which is partially offset by official sales of Treasury securities, but nevertheless also puts downward pressure on Treasury yields.
To see how this works, you don’t look at China’s official flows, which would give you just a .500 batting average. Nor do you look at just the private flows. Nor do you look at the total flows, which by virtue of an accounting identity are not going to move much in the short run.
Instead, you look at what is going on in the Chinese financial markets and economy and then imagine how that links up with real-economy developments in the US. I can imagine some of you thinking by here, man is this guy being obvious. Yeah, I know. Captain Obvious. Very old story. Like I say, I am just reminding you of it.
So briefly, what are the most important things going on here? I will just list them, as I seem them, in point form:
- The Chinese economy has “surplus” savings that one way or another are coming to the US. In the first story, these surplus savings arise out of government policy. In the second story, they reflect a failure smoothly to reorient policy, which has let to risk aversion and a desire to save in low-risk financial assets rather than to consume or fund domestic capex.
- These surplus savings make their way into the US capital market, either as official flows or as private flows. While they are ongoing, they put upward pressure on the dollar, which reduces US exports growth and delivers a disinflationary pulse to the US economy. Both these developments imply downward pressure on US interest rates and therefore bond yields, virtually irrespective of the precise pattern of the capital flows, just so long as they are into dollars.
- The dollar is directly causal or a direct part of the transmission mechanism, as described above. But it is also a signal. The rising dollar signals that surplus savings in China are a direct image of deficient domestic demand in China, which itself will tend to reduce US exports beyond that implied by the dollar move taken in isolation.
- In the second story, the stronger dollar also reflects risk-off in China, which may have global contagion effects, which further reinforce the downward pressure on the fundamental or short-term-equilibrium level of interest rates and bond yields in the United States.
What I am describing here is just the IS/LM/BP framework expressed in words rather than charts. I bury this point because I don’t want to come across as an ISLMic fundamentalist. There are other ways to get at this set of results. The only point I would insist on here is that you have to look at the real-economy image of the capital flows. If you look only at the capital flows, then you will miss the main element of the story.
And of course, the story, as I and others tell it, is symmetrical. If China were successfully to move away from an export-oriented development strategy and/or if the domestic financial market turbulence associated with that effort were to dissipate, then the simple dynamics discussed above would swing into reverse. Again, you will not see this is you obsess over the capital flows in isolation. If you focus on official flows, in particular, then you will systematically get it backwards, just like others did two years ago.
So that is the primary consideration, which I think we should focus on first, and perhaps even exclusively. But there are a couple complications here, which I will mention, just so as not to weaken my case by overstating it.
As I have described it, the composition of those Chinese capital inflows does not matter much so long as they are into dollar assets. To a first approximation, I think that is true, but it is in fairness only to a first approximation.
If the flows were to arise in a serene economic environment, as in the first story, then their private component might more likely be into risk assets than into short-term dollar deposits. Their effect on the exchange rate and US domestic economic conditions would be as described above, and thus favor lower US bond yields. But in the case of the inflows into dollar risk assets, there would probably be some downward pressure on US risk premia.
Conversely, if the flows were to reflect financial turbulence in China, there would not likely be downward pressure on US risk premia and there might even be some upward pressure.
It is a secondary consideration, but I would not say it is totally irrelevant. Does this provide a case for looking at the precise distribution of capital flows? I would say it would make being able to predict the composition of the flow a useful skill. But even here, merely looking at inherently ex-post flow data probably would not tell you much useful, except as an historian. The TICS data don’t usually move the market, for example.
Roughly, the same story applies to the term structure. If the flow of capital from China is being directed into the US bond market via official flows, then there might be a minor net add to the demand for duration in the US. This might put slight (!) downward pressure on the term premium between say the overnight and five-year maturities. In contrast, private flows motivated by risk aversion in China, might be concentrated in slightly shorter maturities, which means that the term premium might rise slightly (and temporarily!) if these flows were to replace the official flows. But it is secondary consideration.
So that is it for my lecture, which actually contains nothing new and probably reads a bit more conclusory than you might like. I am just puking back at you a dumbed down (to my level) version of the bastard Keynesian story, as I understand it.
You can reject it if you want, but just be aware that you are doing so, and maybe come up with an alternative that extends beyond the largely useless errand of looking at capital flow data in isolation.Dollar index is to Feb 10 and financial balance data are to Q3. The macro flows evolve slowly, and are shown smoothed on the chart. So you need not think that is woefully out of date. New data come in second week of March.
But with that story in mind, what can we say about the state of the world – or China – as it bears on the US. That is pretty complicated, obviously, but let me boil it down to just a single chart, which might get your head into the county where the right ballpark is.
- The dollar has been going higher in recent months. This strongly implies that external developments would be a source of downward pressure on US interest rates and domestic demand growth, if they were the main force at work here. There are two caveats to insist on here. First, the dollar move is itself backward looking, although the implications of the move so far, have not yet been fully felt, which I think makes the dollar move practically relevant to some extent even looking forward. Second, the dollar move reflects external as well as domestic forces. To the extent the domestic forces are relevant, we can think of the external forces as providing a partial offset, as evidenced by the dollar move. In other words, the capital flow story has implied downward pressure on US yields, which you can know roughly without even looking at the capital flow data themselves. It is in the dollar move, roughly.
- The US has had to accommodate surplus savings from China by running a current account deficit. In earlier periods, such as just prior to the financial crisis, this implied a very large financial deficit in the domestic private sector, because the current account was large and the US fiscal deficit was not. In recent periods, however, the current account deficit has been moderate and the private sector financial deficit has been small and non-dangerous, in part because the fiscal deficit has been high. (Note to hair shirts: fiscal deficits can be stabilizing. *) I am skipping over a lot of detail here, which was described more fully in this post. But the bottom line, looking at the financial balances data, is that we still seem to be in a sweet spot, in the sense that the private sector financial balance is not dangerously high. If things utterly blow up in China, then that is a separate discussion. But America’s ability to accommodate this stuff is not yet apparently dangerously stretched.
The implication, as I see it, is that there remains room for Treasury yields to move higher, as US domestic influences dominate the external influence, which is already largely in US financial asset prices. And from a financial balances perspective, we do not yet appear to be at end-cycle for the US. The low unemployment rate signals we are late cycle, but that is a separate discussion, and recession does not yet quite seem imminent.
Obviously, we can debate about all of that. I am not in the table pounding mood these days. But the point of this post is just to remind you that you can’t really squeeze much out of the capital flow data taken in isolation. And the way those data are described by the media and much of Wall Street is pretty much a complete waste of time and in many cases just demonstrably flat wrong or even backwards.
* In my view, a larger fiscal deficit is neither required nor a good idea in the current environment. But the fact that the deficit is now moderately large and not likely to contract is probably bullish a continuation of the economic expansion in the short to near intermediate term, i.e., out to, say, two years.