By Nick Olivari - Analysis
NEW YORK (Reuters) - An unexpected drop in demand for U.S. financial assets in late 2006 bodes ill for the dollar unless December's data on capital flows released on Thursday proves an anomaly instead of the start of a trend.
During the month, foreign private investors cut their purchases of U.S. securities by two thirds and U.S.-based investors plowed a record amount of cash into international stock markets. This resulted in a net $11 billion of capital leaving the U.S. financial system in December, the U.S. Treasury Department said on Thursday.
It marked the first net outflow of capital in two years. The weaker-than-expected Treasury International Capital (TICs) data triggered a bout of dollar selling, which was exacerbated by weak U.S. industrial production data released just afterward.
The dollar has been propped up in recent years by strong demand for U.S. Treasuries, especially in Asia, where the U.S. trade deficit is most pronounced.
But with returns in foreign stock markets a better bet, U.S. investors have sent cash overseas and in the process sold dollars to buy those foreign securities. Non-government foreign investors have also gone the same way.
For the U.S. to return to an inflow scenario, foreign and U.S. investors would again have to see the U.S. as the best place to invest based on risk and return.
"One number doesn't make a trend ... but it's going to totally heighten expectations for the next figure," said Tim Mazanec, senior currency strategist at Investors Bank & Trust in Boston. "If it comes out (with a January inflow of) $120 billion, people would see (December) as a one-off but if we get back-to-back $15 billion (outflows), you don't want be long the buck."
The dollar, which fell to a six-week low against a basket of currencies, is sensitive to foreign demand for U.S. assets because increasing amounts of foreign capital are needed to finance the country's external deficit.
The dollar index (.DXY: Quote, Profile, Research) last traded at 84.09, close to the session low of 83.94. The euro changed hands at $1.3137, up 0.1 but off the session high of $1.3172. The dollar ended 1 percent lower against the yen at 119.48 yen.
"Today's TICS report is negative for the dollar as it raises questions about the continued funding of the U.S. current account deficit," said Bank of New York's Woolfolk.
U.S. residents purchased a record net $47.4 billion of foreign securities in December, beating the previous record of $37.4 billion in November 2006.
"Total U.S. net purchases of foreign stocks and bonds soared to an all time high of $47.4 billion, signaling that the reason for falling net flows into the US is not only a result of foreigners' actions with US assets but also US residents' surging interest in non-U.S. assets," said Ashraf Laidi, chief currency strategist at CMC Markets.
U.S. equities experienced net outflows of $11.6 billion compared with a $6.9 billion inflow in November. That comes as international equity markets continue to outperform major U.S. stock indexes by about a two-to-one margin, a persistent trend over about the past five years.
Net long-term capital inflows, cross-border investment into securities with an original maturity of 12 months or longer, fell to $15.6 billion from a $84.9 billion inflow in November. November's number was upwardly revised from $68.4 billion.
Camilla Sutton, currency strategist, at Scotia Capital emphasized most of the decline in purchases came from the private side, with official buying still evident.
Private net purchases of U.S. securities totaled $39 billion in December, down from $115.7 billion in November. Official net buying totaled $24 billion, up from $6.5 billion.
Federal Reserve Chairman Ben Bernanke, speaking to the House Financial Services Committee, said on Thursday he did not anticipate any massive selloff of foreign holdings in U.S. Treasury Securities.
Net purchases of U.S. Treasuries added up to $10.58 billion, below November's $34.12 billion. It was the smallest purchase of U.S. Treasuries since September's $1.66 billion.
Bernanke said that foreign demand for U.S. assets remains strong though there is a risk of weaker demand for dollar assets in the future.
(Additional reporting by Gertrude Chavez-Dreyfuss and Amanda Cooper)