Morning Commentary: Flow the Flows

Foreign Exchange - Morning Commentary
Flow the Flows
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Andrew Kositkun
Andrew Kositkun
Foreign Exchange Head Trader
Last week, the US Treasury released its latest monthly report summarizing capital flows for the month of June.  As a reminder, June was the first month that saw material USD retracement lower after the pandemic-induced spike in USD demand.  This release of the Treasury International Capital (TIC) system data is of particular interest given the intensified USD weakening trend that has led to discussions around potential structural drivers of USD weakness.  

The latest TIC report showed a net outflow that is a very small fraction of the net inflows seen during the March-April pandemic market panic.  Within this, it is important to note that nearly all of these net outflows were attributed to an unwind in cash hording.  To this point, outside of banking system flows, foreign demand for securities have remained strong on net. This suggests that, at least through June, USD weakness could be largely attributed to reversal of the previous safe haven bid rather than a broader reallocation or flight away from USD assets.  

While official flows showed a net outflow in June, there are persuasive reasons to believe there should be net inflows over the coming months.  The first is fairly mechanical.  Global reserves have risen sharply over the past two months.  This implies ~192 billion in inflows based on the latest COFER USD allocation share figure.  

The second comes from the historical relationship where official USD flows have a lagged inverse relationship with USD moves, i.e. USD weakness tends to be followed by central bank buying.  Over the past 15 years, central bank behavior in rebalancing their portfolios have, to some degree, reflected changes in FX valuation.  This last point reinforces the fact that, traditionally, USD trends drive reserve manager flows despite the recent narrative that USD weakness is the result of reserve managers diversifying away from the dollar.   

As a result, central bank actions during the second half of the year will be an important benchmark to gauge whether or not the USD is losing its reserve currency status.  Weak official USD buying, despite the summer selloff, could be indicative of central banks allowing their USD reserve allocation percentages to fall and signal that structural shifts are happening.  One place where you could see this structural shift is with central banks bringing euro allocations back up to historical average levels due to optimism around the recovery fund and resulting removal of structural risk premium.
HERE ARE THE KEY NEWS STORIES FROM OVERNIGHT:
  • US-China relations received a boost last night after a call with US Trade Representative Lighthizer, Treasury Secretary Mnuchin and Chinese Vice Premier Liu He reaffirming both sides’ commitment to the Phase 1 deal.  While Chinese purchases have fallen short of the pace needed to meet agreed upon targets, progress has been made on other commitments.  These include steps to ensure greater protection for intellectual property rights and removing impediments to American companies in financial services and agriculture.  
  • US housing data missed expectations with the S&P CoreLogic Case-Shiller home price index rising 3.46% YoY against expectations for a 3.6% YoY increase.  
  • Tropical Storm Laura is set to become a hurricane before making landfall in the Texas/Louisiana area on Thursday.  Laura has led to the shutdown of 82% of oil and 57% of natural gas production in the Gulf of Mexico.  Conversely, Tropical Storm Marco has lost much of its power and is expected to fall apart as it approaches the coast.  
  • Germany’s IFO survey came in mixed with the business climate component beating consensus but the expectations and current assessment components missing estimates.
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