The second large drop in stocks over the past week has caused many to begin rethinking the market.

This week saw higher-than-expected U.S. inflation data being released, with short- and long-term U.S. interest rates moving higher, while stock prices have ended up in positive territory again.

Normally, in this scenario, the dollar would strengthen. But what happened is that the buck fell a full percent in one day.

Most market analysts continue to reassure that the stock market correction was expected, that it is healthy to put a brake on a bubble and that nothing has really changed the fundamental positive forecasts for 2018. But this counter-intuitive move in the foreign exchange market has led us to again re-assess what is going on – and specifically, why is the dollar weakening?

There are two main reasons:

  • A focus on twin deficits, something that has nearly been forgotten since the '80s. With stronger consumer spending and imports, our trade deficit has recently been widening. On the budget front, the agreement out of Washington to increase government spending by nearly $300 billion over the next two years would certainly swell America's budget deficit to its largest fiscal gap since 2013.
  • The second reason is related to capital flows. In recent years we had a net capital inflow that compensated against our twin deficits, but recently there has been a reduction in capital flows into the U.S. In fact, there seems to be a net capital outflow currently. This may be due to foreign investors' uncertainty around the U.S. political outlook and how we will fund our future budget deficit. With an aging society, large pension payouts and a potential reduction in young immigrants into the U.S. workforce, there may be a re-pricing of U.S. credit risk underway.

This has resulted in foreign investors selling 10-year U.S. Treasury bonds, together with the dollar. This may explain why long-term U.S. Treasury yields are rising faster than the shorter end, even as inflation fears are not currently top-of-mind in the U.S.

The 10-Year U.S. Treasury Yield has been rising quickly in 2018

GP-Chart

Source: Bloomberg

My View: The key question here: Is this U.S. capital outflow temporary or permanent?

This is a good debate and a hot topic right now. Quite a few analysts seem to think that we are going through a fundamental correction to our decade-long, low-interest-rate environment.

While there is much credibility to this analysis -which, if true, could justify a tectonic shift in global asset allocations - I don't believe the capital outflow situation will be permanent. The U.S. still enjoys strong economic fundamentals, together with offering the most liquid and efficient financial market in the world. That's an environment that is hard to replace, and will likely lead capital to flow back into the U.S. again.

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