Stupid headline of the day

"Dollar Soars as China Surprises Markets with Reserve Requirement Hike" (source not disclosed out of kindness).

The dollar may be "soaring" (by a full 0.81% !) today, and China may have hiked rates, but the two events are in no way related. You see, when a country has a fixed exchange rate, it has no control over monetary policy: reserve requirement hikes will induce more hot money inflows (looking for a higher return then dollar-denominated money funds, with no currency risk vs. the dollar), which means a higher money supply - since the central bank has to print the yuan needed to be sold to foreigners in exchange for foreign currency so as to keep the exchange rate constant. China has tried to sidestep this with controls on capital flows but everyone knows they are looser than the US-Mexico border. This is econ 101 and is known as the impossible trinity.

What is the relation between this and my saying the above headline is stupid? Because if China is hiking rates, it shows at least an intent, a signal if you will, of tightening monetary policy. But as I just discussed, this can only happen if China lets its exchange rate appreciate.

And that would be everything but positive for the US dollar.

The euro is starting to get oversold

The euro has dramatically fallen against the greenback this month, since the surprising U.S. employment report (which was actually not really good behind the appearances, although there has indeed been some moderately positive developments in the job market).

I don't think the euro has much more to fall. From a fundamental perspective, nothing has changed: the Fed is and will remain more dovish than the ECB. Two year bunds yield a lot more than two year notes. And the structural current account deficits of the U.S. are not being addressed.

From a valuation perspective, although the euro is a bit expensive, in my opinion the current price is about halfway from fair value (~1.20) to the all time highs of 2008 (~1.60). As the euro is not at all undervalued by any measure (quite the contrary), I believe there are better ways to play dollar weakness. However I do think the risks are tiltled towards a higher euro in the near term: from a technical perspective, it's already oversold, with 12 down days in the past 15 trading days:

Watch gold, which is usually a good leading indicator of EUR/USD turning points.

More on the U.S. Dollar carry trade

Paul Kasriel believes that proponents of the dollar carry trade hypothesis do not have much evidence on their hands:

There is a lot of chatter that global speculators are borrowing greenbacks at bargain basement interest rates and buying higher-yielding assets denominated in foreign currencies. Some have suggested that this dollar-carry trade is creating yet another asset-price bubble. Other than the fact that the U.S. dollar has been depreciating on a trade-weighted basis in recent months, where is the evidence for this dollar-carry trade? In other words, where is this alleged massive bubblicious U.S. dollar credit creation showing up? I will tell you where it is not showing up – on the books of U.S. commercial banks. In the 26 weeks ended October 28, 2009, loans and investments at U.S.- domiciled commercial banks have contracted at an annual (Devil’s) rate of 6.66% (see Chart 1).

Two remarks here: first, the fact that total loans are contracting does not mean that loans for carry trade purposes are contracting as well. It could mean that loans to the non-financial sector are contracting at an even lower pace than that of the total figure. Second, the top U.S. banks hold large amounts of FX and FX derivative exposure (see Reggie Middleton, subscribtion required). Some of this exposure may be off-balance sheet and thus may not appear in the Federal Reserve figures used by Kasriel and be a part of the carry trade story.