Net foreign capital flows into the US soared 15% to a record $101.9 billion in September from a revised $88.9 billion in August (initial reading was $91.3 bln). This was the sixth monthly consecutive increase in net foreign inflows -- the longest back to back increase since the creation of the series in 1988. Equally positive for the US dollar is that the capital flows have comfortably exceeded the $66 billion record trade deficit for the month.

POSITIVES

• Net flows into US corporate bonds rose 27% to $51.1 bln in September, the second highest level on record, after having soared 63% in August. Indeed, we have noted the volatility in corporate-bound foreign flows. Yet the sustained increase this time cements another pillar to the dollar's foundation.

• Net foreign purchases of US stocks soared 540% to $24.5 billion, attaining the highest level since February 2000. The $20.7 billion increase accounted for 160% of the total net increase in the September TICS figure. Most notably, the $24.5 billion of net flows into US equities made up a quarter of the total figure, well up from the 7% average in Q1.

• US residents' purchases into foreign stocks fell 56% to $7 billion, after having increased 85% in August. This component has shown tremendous volatility and does not provide any reliability ahead . It is not feasible to use the currency return element as an explanation to US residents' disinterest into foreign stocks as foreign indices have performed just as well-or better - than the US counterparts - which would be a solid offset to any currency loss.

• Interest in US treasuries from the top holders remained sustained, with China and the UK adding 3% and 5% to $252 bln and $182 bln respectively, while Japanese holdings barely budged at $687 bln. Holdings from Caribbean offshore centers eased negligibly while OPEC's holdings edged up by less than 1%.

• Nonoffical interest in US treasuries (from private flows) made up 105% of $21.7 billion in net foreign inflows of US treasuries as official holders (central banks and supra nationals were net sellers). The fact that private flows (usually hedge funds) stabilized at a steady $23-24 throughout Q3, gives the required stability to treasury-bound flows especially amid the retreat in interest from foreign central banks.

NEGATIVES

• Foreign official accounts (central banks and supra nationals) were net sellers of US treasuries at $1.1bln in September after providing only 13% and 11% of the total net flows in July and August respectively . While the contrasting interest between official and private accounts raises immediate concerns about the trade deficit being at the mercy of speculators, it may well be argued that central banks are snapping up US treasuries via hedge funds and currency overlay managers which fall under the "private" portion.

• US residents' purchases of foreign bonds soared 153% to $9.1 bln after a 436% plunge in August. We had estimated that the August drop was a result of the rising dollar , which dilutes the currency return of foreign bonds to US residents. This is especially the case when the yield attraction on foreign bonds is sharply curtailed by the accumulation in US yields. It remains to be seen whether the September rebound is part of a gradual payoff from the August decline or just a one time thing. The prospects of continued purchases are reasonably strong considering signs of improved growth in the Eurozone and the UK.

FX Outlook

The US currency is being fed by a virtuous circle of an increasing interest rate environment, continued dollar-bound flows of the Home Investment Act and emerging obstacles to tightening policy in the Eurozone, the UK and Japan. While we stick with our forecast for further dollar upside, we expect the early signs of a dollar cooling to materialize amid the bond markets' pricing of lower growth in Q1 dictated by the lowest 10-2 year yield spread in 5 years at 8 bps. Traders are pricing in increased rate hikes (on the short end) and downside growth risk (on the long end). The combination of renewed acceleration in the US trade deficit with the looming conclusion of the Fed's tightening campaign could pave the way for the next dollar decline. This would be especially compounded by when Q2 GDP growth drops below the in 3.0% handle. The September trade deficit is expected to erode as much as 0.5% of GDP, thus dragging the advanced 3.8% Q3 release back to 3.3% in the event that there is no continued boost in government spending as was the case in the advanced report.

November 2005 FX Forecast

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