It’s standard textbook stuff. Convention has it that “capital flows” are determined by the portfolio effects of interest rate differentials. Quite simply, if yields aren’t very high for low risk US instruments (like UST’s) or their European counterparts, fixed income managers must go hunting for yields overseas in Emerging Markets who offer fatter returns by comparison. Thus, “capital” is said to flow into them, which aids in their own domestic monetary conditions (see: Brazil).

The catch is when this thing reverses; or so they say. Should Treasury yields begin to rise, then it’s said “capital” flows back “home” leaving the EM system from which it came vulnerable to standard ill-effects. Conventional of all convention, here’s Brookings in January 2014 laying out the typical view on 2013’s taper tantrum inspired EM crisis:

Global investors began to rethink their investment strategies as the potential returns on U.S. assets increased. Who is likely to get hit hardest? The economies with the largest imbalances who have become most reliant on foreign capital.

Is that what really happened? No

First, yes, UST yields did indeed rise from the middle part of 2013 forward – but not due to some “taper tantrum.” On the contrary, rates in the US and Europe had been rising as the global bond market processed a slightly better likelihood for global recovery (compared to the awful year 2012). In the US, Ben Bernanke was talking about tapering QE because economic fundamentals appeared to be improving rapidly (the unemployment rate most of all).

How could that have been a problem for EM’s? A global recovery increasing in probability shouldn’t have been thought consistent with what was actually happening in those places – involuntary “devaluation” brought about by what sure seemed to be a shortage of local US$ availability.

And that was a currency crisis; the dollar began to rise against them which, at first, appeared consistent with the rise in yields. But then from early 2014 onward, UST yields reversed while the dollar…did not. In fact, US rates would keep on going lower before eventually the US exchange rate exploded higher later in 2014 while it did – making 2013’s EM crisis tiny by comparison.

A very different sort of capital was flowing in reverse (Euro$ #3, not textbook portfolio effects of rate differentials).

Since Economics textbooks are rarely, if ever, rewritten, when all these things repeated in 2018, the “capital flow” excuse revisited the mainstream conversation at the time trying to figure out all sorts of liquidity and market gyrations wholly inconsistent with the inflationary recovery scenario being offered as guaranteed fact in all these same media outlets.

Nominal rates rose then, too, just as they had in 2013. And in April 2018, suddenly the dollar caught a huge bid, as well.

For instance, markets seem to have moved on from the formation of the “Fragile Five,” a group of countries that suffered heavily when the U.S. Federal Reserve started to roll back its bond-buying program in 2013. Made up of Brazil, India, Indonesia, Turkey and South Africa, this group was marked by heavy currency depreciation, high current account deficits and political instability at home.

But markets are feeling a sense of déjà vu [in 2018]. Blame it on a stronger dollar, escalating tensions since President Donald Trump came to power, worries over a full-fledged trade war with China or rising interest rates in the U.S., this time around the crisis seems to have entered a new phase.

The damage is far more widespread.

Yep, and it had nothing whatsoever to do with rising interest rates (or those other things, either). The “stronger” dollar had simply announced – like late 2013 – the perhaps inevitable recurrence of then Euro$ #4. Rising yields, a reflation signal otherwise, isn’t at all incompatible with at least the first stages of the next dollar shortage.

And like Euro$ #3, by 2019 the dollar kept on surging while UST yields reversed and fell sharply moving into the next, more serious stages. Again, no portfolio/rate differential effects could be detected, nor should any have been inferred, only just the latest global dollar shortage becoming more acute.

You may have noticed that in 2021 the US$ has once more caught a bid. Sure enough, timing being everything this occurs at the same time UST yields are rising. This time conventional views on “capital flows” and rate differentials?

Likely not. While still nothing more than a short-term disturbance, and not even a big one (yet), it has all the same hallmarks and therefore potential as these others.

The textbooks really need to be rewritten, only starting with bank reserves.