According to Federal Reserve Flow of Fund tables for Q2 2009 (F.107 Rest of the World), non-US residents are moving out of US private debt instruments, favoring US Treasuries despite record-low interest rates.

The “flight to safety” which started with the Crash of 2009 has accelerated as the economic policies of the Obama administration are becoming evident.

The following graph shows a net swing away from selected private debt accounts on the order of USD !.5 trillion, between 2006 and Q2 2009:

Fed Flow of Funds Table F.107, US$ billions (annual flows) to Q2 2009
Fed Flow of Funds Table F.107, US$ billions (annual flows) to Q2 2009

This movement seems to reflect avoidance of three types of risk:

  1. OTC counterparty risk: Flight from security repurchase agreements and interbank lending reflects fear of sloppy trading and settlement practices in over-the-counter markets.
  2. Credit risk: Lack of confidence in the opinions of the traditional credit rating agencies grew even faster, following the Crash of 2008 and combined with the obvious risks of over-leveraging and difficult loan roll-overs due to the credit squeeze, to drive investors out of corporate debt markets.
  3. Inflation risk: Debt with the strongest credit and most efficient settlement markets cannot withstand a fall in value due to an increased rate of inflation. The Obama administration is doing what it can to scare bond investors away by gargantuan “spending is simulus” packages, passed in the dead of night, written by unknown parties, and unread by legislators or even the President.

Foreign flows to Treasuries and Equities at pre-Crash levels

Foreign net flows to US Treasuries, US$ B, to Q2 2009
Foreign net flows to US Treasuries, US$ B, to Q2 2009

After brief and sharp spikes during the last quarter of 2008, foreign flows into US Treasuries have returned about to the levels of 2004, and about twice the levels of 2005-7.

This seems to indicate that the panic of the Crash of 2008 has already subsided, but that there is no where near the amount of money available from the Rest of the World that would be needed to finance the Obama administration’s “spending is stimulus” packages in order to avoid inflation.

The non-debt foreign investment flows are indicated by the accounts “corporate equities”, “mutual funds”, and “foreign direct investments”.

Fed Flow of Funds Table F.107, US$ billions (annual flows) to Q2 2009
Fed Flow of Funds Table F.107, US$ billions (annual flows) to Q2 2009

These equity-type flows suggest that, following the boom years of 2006-2007, the appetite of the Rest of the World for US non-debt investments has returned to levels similar to those of 2004-2005.

In Q2 2009, foreign flows into US equities (annual basis) were $114.6 billion, compared to issues of foreign equities into the US market of $ 148.9 billion.

This means that by Q2 2009, the Rest of the World was, on balance, avidly avoiding new investment into US equities and private debt, while failing to show enthusiasm for financing the vast Obama stimulus packages which are coming down the road.

With these statistics and the historic importance of foreign investment in the US capital markets, one is left scratching one’s head, wondering why the US stock market was rising throughout the first half of 2009?



The US Federal Reserve flow of funds accounts for Q2 2009 provide a clear explanation of the causes of the recovery in stock prices in the first half of 2009.

These statistics show a pattern of behavior quite different from that which has prevailed since 1982.

It is too early to say whether Q2 2009 is the precursor of a new paradigm in US equity markets, or whether the Stock Buyback Era will return.

The (temporary?) demise of stock buybacks

For the last twenty years, the upward trend in the US equity markets has been driven by massive net stock buybacks on the part of non-financial corporations, matched, more or less, by huge net sales of equities by US households as corporate executives exercised stock options in amounts that far exceeded net stock investments by other individual investors.

New York City skyline in 1970s, before the Buyback Era began ...
New York City skyline in 1970s, before the Buyback Era began ...

During this period, prices moved upwards, which, according to the Motivation Axiom of Capital Flow Analysis, meant that corporate buybacks were causing the upward movement in stock prices.

In Q2 2009, this flow pattern was suddenly reversed — returning to a type of behavior seen prior to 1982 when the US SEC issued Rule 10b-18 granting safe harbor to corporations that wished to manipulate stock prices in order to give value to executive stock options.

The stock buyback movement has been, essentially, a trillion dollar Ponzi scheme that required ever greater gobs of corporate cash to succeed.

The Crash of 2000 signaled the first weakening in the buyback movement, as a point was reached where buybacks could no longer be easily financed just from current earnings.

The post-2000 recovery came about as corporations began to finance buybacks by dipping into depreciation reserves and, in the last five years, by borrowing from banks.

In 2007, the collapse of the sub-prime mortgage market began to restrict the availability of credit.

By the last quarter of 2008, imprudent bank lending had reached such proportions that global financial markets collapsed, bringing what seemed to be, the end of the buyback era.

Capital Flow Analysis made it possible to predict the 2008 collapse in equity prices as far back as September 2007.

Now the pattern has changed.

Radical shifts in market behavior in Q2 2009

Federal Reserve flow of funds table F.213 shows the dramatic difference in the equity market in 2007 (before the Crash) and in Q2 2009 (after the Crash):

Federal Reserve Release Z.1 (F.213 Corporate Equities)

Green = net buyers; Red = net sellers.

US$ billions (Annual rates) 2007 Q2 2009
Issuers of securities
Domestic, non-financial corporations -790.1 88.0
Foreign corporations 147.8 148.9
Domestic financial corporations 28.1 55.0
Exchange-traded Funds 149.9 149.0
Total Issuers -464.3 440.9
Purchasers of securities
Households -794.2 288.1
Federal government 0.0 -127.9
Foreign investors 218.5 114.6
Life insurance companies 84.1 15.4
Private pension funds -217.0 -170.6
State, local gov’t pension funds -35.3 2.8
Mutual funds 91.3 225.7
Closed-end funds 18.7 -7.9
Exchange-traded funds 137.2 106.7
Broker-dealers 25.4 -30.1
Miscellaneous purchasers 7.0 24.1
Total Purchasers -464.3 440.9

This table shows a striking shift in market behavior pre- and post-Crash.

Before the Crash, Domestic, Non-Financial Corporate issuers were net buyers of securities; after the Crash, these corporations were net sellers.

The 2007 pre-Crash flows were typical “buyback era” behavior — exactly the opposite of issuer behavior one might expect from Economics 101 in which corporations are supposed to go to the stock markets to raise capital.

After the crash, Issuers became “net sellers” and investors became “net purchasers” — which is what one would expect from Economics 101.

In Q2 2009, stock prices were rising and the principal buyers were individuals, directly as Households, and indirectly through Mutual Funds.

According to the Motivation Axiom, this means that the behavior of individual investors was the driving force that caused stock prices to rise in the first half of 2009.

By analyzing the flow of funds accounts for Households, we see that individual investors were moving out of fixed income investments into stocks, apparently due to low interest rates on short-term investments and fear of the impact of inflation on longer-term bonds.

What else can be deduced from Q2 2009 equity flows?

From the above table, other patterns can be discerned, beyond the shift of motivated buyers from domestic, non-financial corporations to households and mutual funds (individual investors).

  1. Rest of the world: Foreign corporations continue to use the US capital market as a source of funds (sellers of equities). However, the willingness of foreign investors to buy into the US equity markets has dropped significantly relative to 2007.
  2. Federal government: The US government is now a major player in the US equity markets. However, the government has not entered directly onto the stock exchanges, preferring direct deals with corporations. In Q2 2009, the government reduced their equity positions (net sellers) as companies sought to rid government from their lists of shareholders. The prices at which these transfers took place were not determined by supply and demand on the open market.
  3. Sophisticated investors: Insurance companies and broker-dealers tend to be more sophisticated in their investments than individual investors, acting directly (households) or indirectly through mutual funds. Sophisticated investors showed a reduced appetite for equities, despite rising prices. In the case of broker-dealers, activity shifted sharply towards net selling compared to their position as net buyers in 2007. This suggests that institutional investors might have been skeptical of the sustainability of the 2009 recovery in equity prices.
  4. Private pension funds: These long term investors have been strong sellers of equities since before the crash, indicating an excess of withdrawals over new investment in pension plans. As Baby Boomers retire in greater numbers, private pension funds might be expected to continue to be a drag on equity price levels.

These indicators suggest that the more sophisticated institutional investors have been avoiding US equities and that a furtherance of the 2009 price bounce may depend upon the motivation of less knowledgeable individual investors.

Risk of investment in equities increases substantially

For a generation prior to the Crash of 2008, with equity prices being driven primarily by corporate stock buybacks, investors could rely, over the medium term, in a continued rise in stock values.

The motivation the caused corporations to buyback their own stocks (at the expense of dividends and to the detriment of long-term investors) was pure, selfish greed, without a trace of fiduciary responsibility. This crass motivation proved extremely reliable, as seen by the behavior of top executives in saving their own remuneration schemes during the Crash of 2008, despite public outcries and the woes of ordinary investors.

However, if the buyback era is over — which is not yet certain — investors will have to get back to fundamentals and try to determine the intrinsic value of securities before trusting their life savings to a portfolio of equities.

This is easier said than done, since the market has changed since the days of Graham & Dodd.

Many unsophisticated investors still believe in the Efficient Market Hypothesis, as demonstrated by the continued high level of investment in Exchange Traded Funds.

Furthermore, the extreme, radical changes in the US economy being introduced by the Obama administration and the Democrat Party that controls the US Congress, with an outlook of fiscal deficits beyond anything most investors have seen in a lifetime (except in third world countries), combined with expectation of massive tax increases on most of the population (directly and indirectly), creates foreboding in the minds of most Americans (at least those who own stocks) as to the future of the country.

Furthermore, the are technical barriers to a continued recovery in stock prices, including:

  1. Over-hang of executive stock options: Corporate executives are still holding huge quantities of under-water stock options (perhaps on the order of a trillion dollars) that will be triggered if stock prices ever get back to 2007 levels.
  2. Rising interest rates: Sooner or later, the Federal Reserve will have to give up on trying to artificially hold down interest rates. When inflation kicks in, interest rates on money market funds will rise substantially, as happened in the Jimmy Carter years. At some point, investors will opt out of risky long-term investment in equities and move to tangible returns in the form of high interest rates.
  3. Persistent high unemployment and tight credit: Motivation towards increased personal savings are stimulated by high unemployment and tight credit. As seen in Q2 2009, personal savings rates have already risen substantially, causing savings to be channeled into equities, in lieu of extremely low interest on money market funds and bank time deposits. However, once interest rates start to rise and inflation kicks in, these savings may be moved out of equities into what is perceived as safer investments.
  4. Tendency to cash out of equities, once pre-Crash levels are reached: Most individual investors saw their net worth decline by twenty percent or more in the Crash of 2008 and many of these are approaching or are in their retirement years. Chances are that if stock prices ever get up to pre-Crash levels, these investors will be strongly tempted to cash out — placing a barrier to further recovery in prices.

In any event, uncertainty as to the future of equity prices has risen to the highest levels in a generation and uncertainty is just another name for risk.

We’ll see …


We won’t have to consult the Consumer Price Index to know when the much feared Obama-inflation monster has finally arrived to devour what savings we have left. All that will be necessary will be to look at the average yield on short-term money-market funds.


In the 21st Century, money market funds are now the center of the short-term banking system — and are largely unregulated by the US monetary authorities.

In Q1 2009, total assets of money market mutual funds, according to Fed flow of funds table L.206, were $3.7 trillion, 5.6 times the $666.6 billion in checkable demand deposits with commercial banks. Demand deposits are now only 5.1% of commercial bank liabilities.

The MMF: the non-bank bank

Although money market funds are classified as securities and regulated by the SEC, rather than by the banking authorities, they are, in fact, a banking operation. They take money from “depositors”, with the understanding that it may be withdrawn at any time, on demand, by checks that are cleared along with drafts on commercial banks.


The “depositors” in money market funds do so with the understanding that they will be able to withdraw the amount deposited, plus a variable rate of interest, whenever they feel like it.

Of course, technically, “deposits” in a money market fund are not a liability of the fund, but rather equity in the form of shares, usually with a net asset value adjusted daily to a one dollar benchmark by issuing additional fractional shares in the amount of the interest earned in one day.

Like commercial banks, money market funds invest “depositors’” money in short-term loans, usually commercial paper.

However, unlike commercial banks, money market funds do not have to maintain reserves with the central bank, nor do they normally set up reserves for doubtful receivables. Furthermore, unlike commercial banks, their “deposits” are not guaranteed by the government (until the Crash of 2008).

For practical purposes, a money market fund is the same as a bank. A fund borrows short and lends long and promises to pay depositors on demand, principal plus interest.

An unfair advantage

Because money market funds do not maintain reserves with the central bank, they are able to pay substantially higher interest than available on demand deposits at commercial banks. Nor do money market funds normally offer drive-in tellers, night depositories, or the myriad other services that regular banks offer depositors.

In 1968, when the first money market fund was set up in Brazil, during the years of the economic miracle, the Minister of Finance quickly realized the dangers of this new instrument and slapped strict restraints on marketing.

However, three years later, when money market funds were introduced in the United States, the authorities did not perceive any potential problems, mainly because the instrument seemed to fall under the jurisdiction of the SEC, rather than the banking authorities.

In order to see systemic risk in a new product or operation, regulators must have multiple jurisdictional understanding, reponsibility, and authority. Because the SEC saw only the risks of investors losing money, they could not perceive the larger threat to the banking system.

The problem was, however, that banks, particularly savings banks, had legal limits imposed as to interest that could be paid on deposits. As the Jimmy Carter stagflation grew during the 1970s, and as asset-backed securities were invented to provide a virtually unlimited supply of short-term debt securities to the new money market fund industry, the position of savings banks became untenable.

Since savings bank assets consisted of long term mortgages with fixed interest rates, they were not able to raise rates on deposits to match the rise in short-term interest spurred by the inflation.

The result was the “great sucking sound” (as Ross Perot might put it) of savings bank deposits being transferred to money market funds.

Inflation's vortex. A great sucking sound.

Because American officials were not as smart as their Brazilian counterparts and were hog-tied in a tangle of conflicting regulatory jurisdictions, the savings banks were ultimately destroyed by unfair competition from money market funds, leading the savings and loan crisis of the 1980s and 1990s.

Short-term interest rates and inflation

When the first money market fund was set up in Brazil in 1968, the internal rate of inflation was about 25%. Six month to one year commercial paper, in retail denominations, yielded rates of from 28% to 32%. Interest on bank deposits were limited by usury laws.


As a result, the first money market fund was able to offer rates on what essentially were demand deposits, of about 24% — double commercial bank rates — and still charge an annual “administration” fee of 4% on fund assets! Because there are no capital requirements to manage a money market fund, the potential return on the equity of a money fund manager is virtually limitless. The only limit is marketing ability.

In these extreme circumstances, it is no wonder that the Brazilian authorities saw the dangers posed by the money market fund instrument and drastically reduced marketing options.

Years later, after the prudent ministers of the Brazilian miracle were gone, and as money funds had become popular in the US, the Brazilians copied the American example and allowed money market funds to flourish.

After the Crash of 2008 and the 2009 budgetary madness of the Obama-Pelosi-Reid team, we now look forward to the possibility of inflation rates in the United States to which most Americans have never been exposed. In this context, the regulatory status of money market funds becomes extremely relevant.

With inflation of 25% a year, or more, and with money market funds not subject to bank reserve requirements, the Federal Reserve will be unable to control the money supply.

The reason is simple:

  1. At 25% a year inflation, long term bonds become worthless. To cover deficit spending, the Treasury will only be able to sell short term bonds. This will push short-term rates to extreme levels.
  2. As the Treasury issues checks to pay for the Obama “spending is stimulus” plan, the money will leave commercial banks to be deposited in money market funds, which will have no reserve requirements and therefore will be able to pay much higher rates of interest than commercial banks.
  3. As interest rates rise on short-term paper soar, money market funds will be able to charge higher and higher “administration” fees. With the demise of Glass-Steagall, banks will place depositors money directly in money market funds they control.
  4. Without the control of reserve requirements on money market funds, the “multiplier effect” of these virtual banks will kick in, as the public moves money from one fund to another, and inflation will get really serious.

What this means is that unless the government cracks down on money market funds, placing them under virtually the same regulatory regime as commercial banks, including the ability to set reserve requirements that can be adjusted upwards as needed, the United States will be at risk of much higher inflation than many can imagine today.

So, what we must watch is the regulatory moves made on money market funds. So far, from the anti-inflationary point of view, noises made by the administration are not encouraging.


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