insuranceadvisory

The second way we can approach this general issue of flow analysis is to look at the specific capital flows going into equity and fixed income markets. Here the availability and quality of the data vary widely. For instance, there are data reports focusing on what amounts of money are going into mutual funds. From this, we can of course break those mutual funds down into investment types — equity or fixed income, the destination of the investment and so forth.
Why these flows move over shorter periods of time depends as much on market psychology as economic fundamentals — but how does market psychology work? Moreover, why does a market that is impacted by some political and economic factors at one time then completely ignore them at another? To a large extent, the answer must lie in the very structure of the global currency market. While many people focus — rightly or wrongly — on hedge funds as being dominant currency market players, on any given day the vast majority of transactions are between banks, or “interbank” in market jargon. Hence, bank spot and forward dealers are by a long way the largest single player in the currency market. No one model has been able to forecast exchange rates accurately, because no one model has been able to predict accurately the sum of their intentions, behaviour or feelings towards the market. Yet, while that is the case there are some generalizations we can make about market behaviour given its participants. Firstly, traders have to trade in order to make a living. Hence, even in the absence of market-moving news or economic data, these traders still have to trade. This is of course linked in with the increasing use of technical analysis. As more people use this and more people watch certain levels, so those levels become more important. Needless to say, a break of those levels, one way or the other, thus leads to herding activity.
There is another aspect to market psychology and it is that markets, just as economies, also trade in cycles. This is not necessarily to say that the two cycles occur over the same time period. Obviously, this is a subject that will be covered more fully in this series of posts, but to summarize briefly the longer a cycle continues, the more self-fulfilling it becomes. Speculative elements are increasingly attracted by what appears to be a one-way bet. Of necessity, the type of activity that this reflects is trend-following. The rule of trends is that they have not ended until they have ended. In other words, until there is clear evidence that the trend is over, the market continues to buy into that trend. However, such financial market trends have impact in the real economy. If the trend represents capital inflows, then it causes the current account balance to become an increasingly large deficit. Increasing fundamental deterioration is initially ignored, but after an extended period of time two things start to happen — the size of the current account deficit becomes alarming and investors start to get nervous as a result. Real money investors start to pare back their positions, but speculators continue to pile in. Towards the end of a trend, volatility starts to pick up markedly, until such time as an unforeseen catalyst causes the trend to end abruptly and violently. Indeed, the longer the trend has gone on, the more people are in the trend, and thus the more violent the trend reversal. Yet, just as trends are self-fulfilling, so are trend reversals, which in turn become new — if opposite trends; so works the market cycle, according to technical rather than economic factors.
Cross-border flows are also driven by fundamental considerations such as:
Portfolio diversification
Maximizing total returns
Specific investor risk tolerance levels
When it comes to investment, these are important incentives and guidelines. Our purpose here is to track not incentives but actions. Thus in our first example we look at the US Treasury’s “TIC” report, which examines portfolio flows by non-residents of the US going into the US equity and fixed income markets. As we have seen, as barriers to capital have fallen across the world, so capital flows have become increasingly important in determining exchange rates. The usefulness of this report is in explaining and confirming medium-term flow trends either in favour or against the US dollar in this case.
From this we can tell a lot of useful information. For instance, we can note that total foreign investor inflows to the US asset markets rebounded in August to USD37.6 billion, after falling sharply in July to USD26.8 billion from USD39.5 billion in June. There are both negatives and positives from this. On the negative side, this USD37.6 billion was a rebound from a 14-month low in July and also well below the USD48 billion monthly average for the first half of the year. On the positive side, this month-on-month increase happened at a time of USD weakness. A major positive swing in favour of US Treasuries was largely behind it, from a total of –USD11.5 billion in July to +USD4.4 billion in August. Agencies, corporates and US stocks all saw modest declines in net inflows from non-US accounts.
Looking at the regional breakdown, the largest swing in favour of Treasuries was by European accounts, though the largest absolute buying was by Latin American/Caribbean accounts, which are usually dominated by offshore hedge funds. For the US dollar to trend lower requires that inflows to US assets also trend lower, and as of this report those conditions had not been met. Thus, comparing the spot price action in dollar exchange rates to the other data, we see a flow confirmation of what many in the market called the “surprising” resilience of the US dollar. Subsequent TIC reports from the US Treasury confirmed the US dollar strength through early December, despite the accelerated deterioration in US economic fundamentals. The flow picture thus explained the strength of the US dollar where just using the fundamental picture did not.