U.S. Dollar and stock market may be standing on a precipice

Excerpts from Morgan Stanley

On February 28, the U.S. is expected to report a revised fourth quarter GDP figure that will be lower than initially announced. This report will remind markets that the U.S. economy is weakening. Expectations for a Fed rate cut may rise, but that may not prevent stock markets from selling off.

The US Treasury's latest report on international capital flows came as a shocker. Net foreign inflows into longer-term US securities fell to just $15.6 billion in December 2006 -- the weakest monthly reading in nearly five years.
This stands in sharp contrast to America's enormous external financing needs -- about $3.5 billion of foreign capital inflows each business day required to fund a current account deficit that was running at close to an $875 billion annual rate in the first three quarters of 2006. Does an external financing shortfall of this magnitude finally spell trouble for the US dollar?

Reflecting persistent structural government deficits and the first back-to-back years of negative personal saving since the early 1930s, the US net national saving rate has held at a record low of 1% of national income over the past three years.

Lacking in domestic saving, America has placed heavy demands on the rest of the world -- absorbing about 70% of global surplus saving over the past couple of years -- to fund its ongoing economic growth.

The rest of the world is waking up to the notion that there are alternatives to low-yielding dollar-denominated assets, especially in Asia where the bulk of excess reserves are held.

Talk of portfolio diversification has intensified, culminating in China's recent announcement that it would allocate around $200 billion of its more than $1 trillion in reserves toward the start-up of a Singapore-GIC-style multi-asset fund.

With most reserve managers having massive overweights in dollar-denominated assets, such diversification strategies can only complicate America's external financing needs.

A monthly TIC report can hardly be viewed as a decisive verdict on anything. But the December collapse in foreign demand for longer-term US securities also coincided with a sharp widening of the monthly trade deficit to $61 billion -- drawing the narrowing trend of the preceding three months into question.

With America's external financing needs remaining huge by any standard, it becomes tougher and tougher for the US to attract the requisite capital inflows under the best of conditions.

It may well be that we will look back on the December 2006 TIC report as a warning shot of what was to come -- an increasingly difficult external financing climate for a saving-short US economy.