Possible scenarios

What event or shock would trigger a yen up move? It’s a critical question because the dollar is strong only against the yen. Remove that leg of support, and perhaps it’s the occasion of the much-vaunted dollar collapse. While it’s true that exchange rates tend to be highly correlated with growth, and Japan has high growth right now (4.8 percent year over year in Q4 2006), the correlation is usually due to high-growth situations being accompanied by rising inflation. In the Japanese economy, where domestic consumption is relatively lower than in the U.S. and Europe, this connection is weak. It is different for Japan, because Japan can have high growth without getting inflation.

Or maybe the dollar collapses and that causes the yen to rise along with all other currencies. As we have seen, talk of a dollar collapse is mostly based on exaggerated claims of the importance of the current account deficit. Even a massive devaluation of the dollar will not improve trade by much because the playing field is so uneven. The U.S. today imports much of what it used to make, from wooden matches to socks to electronics. And there is a limit to how many Boeing airplanes, Caterpillar tractors, and tons of grain that foreigners can afford to buy from the U.S.

In practice, markets have been willing to accept a six- to seven-percent deficit-to-GDP ratio because the U.S. is such a dandy place to invest: It has size, variety, liquidity, legal safeguards, relative absence of government regulation, and so on.

Still, the countervailing capital flows that “fund” the current account deficit may be drying up. The net portfolio flow in the monthly “Treasury International Capital System” (TICS) report does not literally pay for the trade deficit, which is the main component of the current account deficit.

Trade is almost entirely financed by banks and exporter credit. It is therefore inaccurate to say that foreign purchases of American stocks and bonds “fund” the trade deficit. But since the balance of payments is an accounting convention and balance is achieved via capital inflow, it seems that way. And large capital inflows in 2006 did serve to pound down the crash theorists. The current account deficit was a horrific $860 billion — but foreign investment in U.S. securities was $896 billion.

There are two chinks in the countervailing capital-flow argument. The first is Chinese government plans to re-allocate $300 billion from official reserves into two agencies that will make direct investments in foreign and domestic companies and stockpiles of strategic commodities. This is about 20 percent of total reserves of $1 trillion, so it’s small potatoes — and will be easily replaced by new reserves within one year. Some portion of that may go to U.S. equities or corporate bonds, and will still be considered “reserves,” although there is no rationale for naming domestic Chinese investment “reserves” — it’s simply plain, old-fashioned government spending. All the same, the impetus for diversifying reserves is to get a more varied portfolio and a higher return than in U.S. paper, even at higher risk.

The second chink is the December capital inflow of a measly $15.6 billion after $84.9 billion in November, revised up from $68.4 billion. This is less than 20 percent of the month before, and only 25 percent of the December trade deficit of $61.2 billion.

Before we get all hot and bothered, consider the numbers are always revised. October was revised up to $95.5 from $85.3 billion, itself a revision from $82.3 billion, so we have two rounds of revisions to bring the $15.6 billion up to a higher number.

All the same, it’s unlikely to be revised to the trade deficit level and it is therefore an appalling shortfall. What is the cause? In a nutshell, it is mostly due to a record net outflow of foreign investment from U.S. equities ($11.6 billion in December after being buyers in November of $7 billion), and a record U.S. investment in foreign securities, $18.9 billion in foreign equities and another record $28.4 billion in foreign fixed income. Not only have foreigners decided to find greener equity pastures outside the U.S., the U.S. investor has learned the diversification lesson at last.

By country, biggest investors were the UK, fronting for petrodollars ($15.9 billion), and China ($14.7 billion). Aside from countries adding to U.S. government and agency paper because of foreign exchange market intervention (China, S. Korea, and Taiwan), other official entities bought less, including the Middle East petrodollar accounts managed out of London. Norway, through its Petroleum Fund, was a net seller of $4.1 billion of U.S. Treasuries. This is an unintended consequence of lower oil prices. Private buyers, meanwhile, were also net sellers. Together the Cayman Islands, Bahamas, and Bermuda, considered the domicile of private investors, sold $17.10 billion in U.S. Treasuries.

The private investors are critical, since we cannot expect official reserves to rise by the full amount of the U.S. deficit and every penny of reserves to be recycled back to the U.S. Private investors have a choice to accept higher risk in return for higher yield in emerging markets, junk bonds, and commodities. The U.S. may have the biggest game, but it’s not the only game.

“Portfolio” funds sound sedate and these asset categories are named “long-term,” but in practice, this is fairly hot money. It takes no more than three to five days to sell a stock or bond position and withdraw funds from just about anywhere in the world and wire it to a safe haven if one is needed. We saw the dollar get large safe-haven inflows when North Korea was misbehaving last fall, for example. But we can hardly count on “geopolitical” risk to save the U.S. balance of payments. The U.S. trade deficit is like the supertanker that takes miles and miles to turn around in mid-ocean — $764 billion in 2006 and rising.

The foreign exchange market barely burped when the capital flow report was announced. The timing was lucky — the Friday before a three-day weekend in the U.S. (President’s Day). It’s curious that it’s not a major topic of conversation among analysts and traders — so far. But if the next report comes in similarly short, look for the dollar to get the collywobbles.

We will know that nausea has turned into dollar-selling panic if the yen joins the crowd, since the reasons for the yen to remain weak are so solid. A rising yen would be strong evidence of a major dollar rout. Strangely enough, it could be a technical point coinciding with the capital flow story that could set off the move.