Follow the Money

What we have been hearing through anecdotal evidence is now increasing being reflected in the official figures. There is a significant flow of funds from the US into the euro area. This week's US Treasury TIC data for March show two things: The first, which has been much reported, is that the world, or rather the world's central banks, are happy to continue financing the US current account deficit, with net foreign purchases of long-term securities running at a strong $68bn in March.

 

But this net figure includes some big counter-flows - as US residents have been buying foreign securities of net $40bn. We have no geographical breakdown of these investments. Warren Buffett's recently reported bet on a non-identified foreign economy was widely interpreted as a bet on the yen. And we are sure there is at present a lot of US investment going into Japan - almost a no-brainer at that exchange rate. But the euro area in general, and Germany in particular, have also become favourite location for US investment. The German equity market has recently hit dizzy heights, and there is also a massive inflow of funds into German property.

 

European data are, unfortunately, not as detailed and as up-to-date as their US counterparts. The latest reliable data we have is the euro area balance of payment for February. But these data give us a good picture of what has happening at the other end of that $40bn US outflow. Unsurprisingly, the euro area is registering an inflow. The 12-month cumulative total for portfolio investment inflows into the euro was €350bn, compared to a range of zero and 200bn between 2001 and 2005. Portfolio inflows are clearly rising at the highest level since the creation of the euro. There are, in our view, three reasons why money is currently flowing into the euro area:

 

1. The euro area's economic growth has recovered after a protracted period of below-trend growth.

2. The US economy is slowing down, and US investors are increasing wary of the prospect of an outright recession this year.

3. Excessively low Japanese interest rates are driving domestic Japanese savings offshore - including but not necessarily predominantly into the euro area.

 

Unfortunately, we do not know the precise regional distribution of portfolio inflows, but we do know that those portfolio inflows are shared almost equally between equities and bonds so far this year, while bonds clearly dominated in 2006. In fact, looking at the monthly time series, there is currently significant increase in equity flows - in comparison with the second half of 2006 - and a weakening in demand for European bonds. This surely reflects low long-term bond yields. What is also noticeable is an increase in flows into money market funds.

 

These time series are notoriously volatile - and one should be careful not to read too much into a single month's data. But the overall picture - derived from both monthly data and 12-month cumulated data - clearly shows that there is an extraordinary amount of money flowing in.

 

There is further supporting evidence from the ECB's monetary analysis. One of the reasons for the strong current increase in M3, the ECB's mostly watched monetary aggregate, is the strong foreign inflow into the European money market. There was a net inflow in March of close to €100bn (the 2007 total is so far over €330 bn). It is interesting that this inflow was limited to a few countries in November and December, but is now getting wider. Again, this reflects the attractiveness of the euro area for foreign investors.

 

We think this pattern still has some way to go. In fact, we would not be surprised if net money and equity portfolio inflows would remain strong for the rest of the year - underpinning European equity markets in particular. This also raises the question whether raising interest rates even high is the best strategy to contain M3 growth, but this will be the subject of another note.

Eurointelligence ECB Watch

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