Net foreign capital flows into the US rose 8% to $87.4 billion in July from a revised a $80.9 billion in June (initial reading was $71.2 bln). Capital flows stood well above the $57.9 billion deficit for the same month; covering for the trade imbalance for the second straight month.

POSITIVES

• Net foreign purchases of US government and agencies soared 81% to $28.5 bln and 86% to $37.7 bln respectively. But it's worth noting that the jump in US treasuries followed a tepid $15.8 bln in June, which was the lowest since December.

• Net foreign purchases of US stocks soared 210% to $10.1 bln, the highest since January. This is crucial in broadening the destination of foreign capital across US assets rather than focusing inflows largely in fixed income securities as has been the in the past few years.

• Non-official net purchases of US treasuries soared over 1,200% to $25.0 billion, making up 87% of the $28.5 bln in foreign net purchases of treasuries for the month. This more than covered for the decline in treasuries by foreign investors.

NEGATIVES

• The massive increase in private purchases of US treasures shadowed the tepid rise in official purchases (which largely comprise central banks). Whether this overconcentration of private interest in US treasuries is a "positive" or a "negative" depends on the perspective adopted. Since these private accounts largely make up hedge funds, their inherent volatility seems to be controlling the extent to which the US is financing its swelling trade deficit.

• Net purchases of US corporate bonds fell 54% to $25 bln.

• Gross holdings of US Treasuries by the major holders appears to be on the wane (see chart below). Most significantly is the waning interest by OPEC, whose holdings have fallen by more than 20% from their $67.6 billion high attained in January. OPEC holdings may not be as significant as those by China or Japan since they rank 8 th in the league of top holders. Nonetheless, the fact that the cartel may not be recycling its petrodollars back into US assets to the same extent as it was doing in the 1970s may be cause for concern. This is also inconsistent with last month's reports from that Saudi Arabia was working to repatriate a total of $360 billion invested abroad in the last 18 months. Foreign Minister Prince Saudi al-Faisal said the government was looking into returning these "national assets" back to the oil-rich kingdom and that it has "established qualified institutions for that purpose".

Twin Deficits back in the news

Although the US trade deficit shrank 3% in July to $57.94 billion from a revised $59.49 billion, the external woes of the US economy are by no means over. The latest figures on the current account deficit showed that imbalance slipped 2% to $195.6 billion in Q2 from a revised $198.7 bln in Q1. Aiding the retreat was the upward revision in the Q1 deficit from an initial reading of $195.1 bln. The chart below shows that at the average quarterly growth of 8%, the current account deficit could reach 7% of GDP by year end.

The external situation remains disconcerting for the dollar as far as foreign flows into the US. While foreign purchases of US assets shot up 61% to $393 billion--nearing the Q4 record high of $457 billion--, US ownership (outflows) of foreign assets soared 207% to $251 billion, the third highest ever.

The Balance of payments statement shows that the net financial account (difference between foreign- owned assets in the US and US-owned assets abroad) continues to be comfortably in the black ($142 billion.) But rising US interest in foreign assets is gradually weighing on the overall balance. US investors are increasingly turning to foreign stock and bond funds, seeking to diversify in the former and to snap up capital gains from fixed income securities where monetary tightening is a thing of the past. The bounce in US foreign direct investment abroad is also weighing on the imbalance.

The Budget Side

With only 1 month left in the fiscal year--when the federal deficit was estimated to drop to $331 billion in fiscal 2005 (ending October) from last year's $413 billion - the spending package on Hurricane Katrina is expected to add about $5-10 billion in the red for the current fiscal year. "Substantially greater costs will be incurred in fiscal year 2006" the Congressional Budget Office said in its latest statement. One week barely elapsed for after Congress initially approved a $10 billion recovery bill for the Hurricane, the figure became $62.3 billion in emergency aid. The Senate Budget Committee now states that another $50 billion could be approved within a month.

But the politically sensitive decisions of deciding upon which spending programs to cut will not be avoided. There is talk of cutting as much as $10 billion Medicaid, the federal-state health-care program for low-income citizens. But at a time when tens of thousands of people have been rendered homeless from the Hurricane, Senators might have to look elsewhere.

More importantly is the fate of the 2003 tax dividend tax reform and the chances of it being extended beyond its scheduled expiration in 2008. House Republicans are proposing a $70 billion tax-cutting bill that would extend the 15% rate on dividends beyond 2008 on the grounds of maintaining the economic stimulus, but bipartisan opposition to further tax cuts to the wealthy at a time when the poor are in most need and when emergency spending bills are on the rise, such decision may be delayed until next month.

Indeed, the dividend-backed tax bill is a boon for US equities and is an indirect source of increased receipts from capital gains. But the impact on revenues appears fragile compared to an increase in taxation or a phasing out of tax cuts. It took a serious topic such as the social security debate to bring about speculation of a rise in taxes by the current Administration. Hurricane Katrina emerged as the second major event to shed light on the dangers of cutting spending rather than extending tax breaks. The reemergence of these imbalances could be reason for renewed concern with the US currency.