Capital flows and FX

20160820 Capital Flows

When data is irritating to get hold of, guess what, folks don’t bother looking at it (or at the very least fewer people take a look at it). When it comes to FX, one dataset which seems to suffer from this is capital flow data. First what are capital flows? To quote that arbiter of all things informational, Google’s definition via Investopedia is below:


Capital flows refer to the movement of money for the purpose of investment, trade or business production.


When these flows are across borders, by implication there will be an impact on currency markets. Let’s say a corporate with the home currency USD, buys a business in the UK, that transaction will involve selling USD and buying GBP into order to buy the business. The impact will depend on a multitude of factors. Is that currency flow hedged (ie. will the corporate do the reverse FX transaction so the value of the UK business is unaffected by the change in GBP/USD)? Is the flow cash based, or a stock swap? Capital flows might also be related to long term portfolio allocations. Real money (ie. pension funds) can manage very large flows of capital. As a result, when they shift allocations between assets and also different countries, it will take a significant amount of time. In a sense, we can think think of these flows being like the turning of supertankers.


Yes, research desk in banks do publish reports on capital flows when new data is released and there is a large body of academic research on it. However, it never seems to get as much attention as it deserves, compared to other data. One reason is that it is available on quite a lagged basis. Hence, it might help to explain currency moves historically, but it is more difficult to infer how future flows will move. It is nevertheless useful to understand long term trends in capital flows, because they can give you an explanation why certain currencies have weakened or strengthened considerably over time. Having a view on where flows will go, is also an important component into long term views on currencies. Indeed, one of the reasons why Brexit has concerned many GBP traders is its potential impact on longer term capital flows into the UK.


Obviously not all flows are long term in their nature. There are also short term speculative flows, so called “hot money”, which by their nature tend to be less sticky and more volatile. Again using a ship analogy, these flows can be thought of as a nimble sailing boat turning. In currency markets, this can triggered by changes in central bank policy as investors seek to invest in higher yielding currencies (vs lower yielding ones). Given “hot money” are speculative short term flows, they can also be reversed very rapidly in the face of market turbulence.


So whenever you think of FX, try to think about capital flows. Whilst, they might be trickier understand, and the data more difficult to deal with, they can often help to explain longer term moves in currencies.