China continues to drive and surprise the world economy.  An overnight release that China’s banks would be required to increase their reserve requirements sent ripples throughout global currency, commodity and equity markets.  The surprise announcement also served to give notice that China would not tolerate the lax lending policies western countries utilized to ignite the recession.

The People’s Bank of China had raised the reserve requirement last month.  A second increase was projected but not expected this quickly.  Global markets reacted with concern.  Fearing that a tightening of credit would harness world economic growth, all commodity markets reeled.

The 50 basis point increase takes effect February 25^th, 2010 and comes in the wake of some fairly encouraging news.  On Thursday, China announced an unexpected inflationary slowdown falling back to 1.5%.  The Central Bank viewed the news as a seasonal slowdown and focused on the longer-term.  The Central Bank’s January announcement failed to slow aggressive lending policies.  The country’s banks lent $203.4 billion in the month, the third largest monthly total on record.

The new requirement means that China’s largest banks will now have to place 16.5% of deposits on hold at the Central Bank.  Aggressive lending by commercial banks will be severely curtailed.  The increase raises reserves by about $43.9 billion.  The bank indicated more increase were forthcoming.

Gold Slides Down

Early Friday morning, gold gave up 1.5% and fell below $1,080 per ounce.  The dollar hit a seven-month high against a basket of currencies.  On Thursday, gold reached a high of $1,097.75.

Early morning equity losses were broad based.  In the U.S. triple digit losses struck the DOW, before a brief rally formed.  The dollar picked up the slack as investors reacted to the tightening monetary policy.  The dollar hit its highest levels since late July and drove dollar-priced commodities lower.

Gold priced in euros had captured gains on Thursday but were off sharply on Friday.  Silver, platinum and palladium also fell well back of Thursday’s gains.

Oil Falls Below $74

After topping $75 on Thursday, oil quickly shed more than $1 per barrel Friday morning.  The International Energy Agency still maintained that oil consumption would increase by 1.6 million barrels in 2010.  China is the world’s second largest oil consumer.

U.S. crude fell to $73.96 from $75.28 on Thursday.  London Brent Crude fell $1.20.

The severe winter experienced by the easy coast of the U.S. led to a 4% rise in consumption last week.  Despite pledge’s to resolve the financial crisis in Greece, it is perceived there are harder times ahead for euro zone economies, and especially the Portugal, Italy, Greece (PIG) economies.

U.S. equity markets closed the week at nearly flat.  There will surely be some soul searching on the holiday weekend as U.S. policy and politics continue to clash.

These days, it’s hard to offer a fresh perspective on the Dollar. The factors driving its short-term momentum – namely low interest rates and its perception as a financial safe haven – have been in place for nearly a year. It’s long-term prognosis, meanwhile, also hasn’t changed much. Since the beginning of the decade, the Greenback has been in a state of perennial decline as a result of its twin deficits and the related notion that it will be soon be replaced as the world’s pre-eminent currency.

Since the last time I posted about the Dollar (October 6: Dollar’s Role as Reserve Currency in Jeopardy), then, there haven’t been many developments. Fears that oil will one day be priced and settled in an alternative currency – such as the Euro – continue to reverberate through the markets. Several ministers from OPEC countries have already officially dismissed such claims as baseless. A parallel debate is now taking place on the sidelines as to whether or not such a shift even matters.

Dean Baker argued in a recent article for Foreign Policy magazine, that pricing oil in Dollars represents a mere “accounting convention,” adopted by most simply by default, since the US is the cornerstone of the world economy. Argues Baker, “World oil production is a bit under 90 million barrels a day. If two-thirds of this oil is sold across national borders, then it implies a daily oil trade of 60 million barrels. If all of this oil is sold in dollars, then it means that oil consumers would have to collectively hold $4.2 billion to cover their daily oil tab.”

Unfortunately, Baker’s “simple arithmetic” is both erroneous and slightly irrelevant. Assuming a price of only $100 per barrel (pretty conservative if you believe the notion of peak oil), current consumption of 85 million barrels per day implies a daily turnover of $8.5 Billion per day, or $3+ Trillion per year. If the price doubles to $200 per barrel….well, you get the point.

Taking this line of reasoning further becomes somewhat problematic, however. First of all, while OPEC members currently hold the majority (70%+) of there reserves in Dollar-denominated assets, it’s unclear how this would change in the event that oil was no longer priced in Dollars. It’s conceivable that just as many of these Central Banks currently diversify their Dollar-denominated proceeds into other currencies, that they would “diversify” Euro-denominated proceeds back into the Dollar. Of course, it’s also conceivable that a combination of inertia and investment strategy would cause them to hold a larger portion of there reserves in Euros.

If OPEC Central banks continue to prefer Dollars, than Baker is right in arguing that the currency in which oil is priced has no implications outside of accounting. If, on the other hand, he is wrong, and a change in pricing causes/coincides with changing preferences, then the implications for the Dollar would be disastrous. [Consider that $3 Trillion/per year which is at stake currently represents more than 15% of total foreign ownership of US assets.] The problem is that we just don’t know.

Regardless, the status quo favors the Dollar, since creating a new reserve currency would take at least a decade, if not more. For that reason, the World’s Central Banks (we’re not just talking about OPEC anymore) continue to prefer Dollars. “In the five weeks through Oct. 7, foreign central banks bought more than $48.55 billion in Treasury securities, an average of $9.71 billion per week, according to the latest data from the Federal Reserve.” In addition, “Finance Minister Hirohisa Fujii said he expects the dollar will remain the key reserve currency for some time to come.” Private foreign investors, meanwhile, are dragging their heals a bit, perhaps waiting for the Dollar to fall further before jumping in. Asks one columnist rhetorically, “Why buy now if the dollar might be even weaker in six months’ time?”

What else is new? The US budget deficit came in at $1.4 Trillion for the fiscal year, the highest level since World War II. On the bright side, the deficit was $200-400 Billion less than earlier estimates. Meanwhile, members of the Federal Reserve’s Board of Governors restated the unlikelihood of higher rates in the immediate future. “Richard Fisher, president of the Dallas Fed and thought to be a rare hawk on the Fed’s Open Market Committee, chimed in that no one at the Fed thinks this is the time to raise interest rates.” Finally, the US trade deficit is once again narrowing, due in no small part to the declining Dollar.

At this point, it seems reasonable to assume that much of the bad news has already been priced into the Dollar. Sure, the Australian rate hikes came as a surprise and forced many to rethink their calculations. Investors have already begun to separate the healthy currencies from the sick (to borrow an analogy from a previous post), but that the Dollar would be grouped with the “sick” currencies has long been anticipated. Given that the currency has already fallen by double digits in 2009 and is nearing the record lows of 2008, some are wondering how long it can continue.

Exports rose as U.S. consumption of oil declined, helping to narrow the trade deficit in the month of August.  According to the U.S. Commerce Department report this morning in New York, the gap between imports and exports in the world’s largest economy slimmed down by 3.6 percent to just under $30.7 billion.  The main driver in the positive news came from the fact that U.S. made goods were increasingly attractive to overseas consumers on the weakened value of the greenback during the last four months.  A good piece of news, the report is likely to have a rather weak effect on the market as concerns over budgetary and monetary policy continue to weigh on the underlying dollar ahead of the weekend.  The sentiment is countering earlier comments by Federal Reserve Chief Ben Bernanke.  During a Board of Governor’s conference yesterday, Bernanke noted that interest rates would be raised in the near future should economic conditions improve greatly.  However, with the economy still on the road to recovery, the view can be maintained that rates in the U.S. will likely be the last to change among G-7 countries

Only two weeks ago, analysts were singing about a new day for the Dollar, which had risen on the basis of good news for the first time in months. In hindsight, it looks like such talk was premature, as the Dollar has returned to its old ways. Good news once again causes the Greenback to fall, while bad news causes it to rise.

This development (or lack thereof) suggests that investors may have gotten ahead of themselves, when they sent the Dollar surging after the employment picture brightened slightly. At the time, the news was interpreted as a sign that rate hikes were imminent. On a broader level, it was a sign that investors had dumped the paradigm of risk aversion, in favor of a model based on comparing economic fundamentals. Since then, investors have slowly moved to distance themselves from the notion that the Fed will soon hike rates, and in the process have moved back towards trading based on risk dynamics.

As a result, positive news developments over the last couple weeks have coincided both with a rise in equity prices and a decline in the Dollar. When the Chinese stock market collapsed one day last week, investors responded by dumping high-yield assets, and moving temporarily back into “safe haven” currencies. “Diving Shanghai Helps Dollar” read one headline. “Worries over the continued fragility of the world economy outweighed a firmer tone in overseas equity markets to underpin the U.S. dollar versus major counterparts,” explained another report.

Meanwhile, a divide is forming among fundamental analysts. There is one school of thought which argues that the US will be the first industrialized economy to recover, and hence the first to raise rates. Based on this line of reasoning, then, positive economic news provides a foundation upon which to buy the Dollar. A competing school of thought, meanwhile, has suggested that regardless of if/when a US recovery materializes, it will be overshadowed by out-of-control inflation. In this regard, then, the Dollar is not such an attractive buy.

No less than the venerable Warren Buff has insisted that the Fed’s quantitative easing program and the US economic stimulus plan – while necessary – threaten to create even bigger problems than the ones they purport to solve. “But enormous dosages of monetary medicine continue to be administered and, before long, we will need to deal with their side effects. For now, most of those effects are invisible and could indeed remain latent for a long time. Still, their threat may be as ominous as that posed by the financial crisis itself,” he said.

If this true, then the Dollar is damned either way. Damned in the short-term as a result of a pickup in risk appetite, and damned in the long-term due to inflation.