China is Earning Negative Carry

China's foreign exchange reserves currently approximate $1.5 Trillion, the majority of which is denominated in USD. Moreover, the Central Bank of China earns interest on every Dollar it adds to its reserves but must also pay interest on every RMB note that it must issue to offset the Dollars. Since the Fed began easing monetary policy, the amount of carry (the difference between what the Central Bank receives on Dollars and pays on RMB) earned by the Central Bank has completely inverted, such that it now loses 250 basis points on average for each Dollar exchanged for RMB.

Based on the rate at which China is currently accumulating reserves, this amounts to between $5 Billion and $10 Billion per month, depending on which method of accounting is utilized. Furthermore, this trend has been exacerbated because China is accumulating reserves at a faster rate than its economy is growing. Some analysts have speculated that this could turn into a major political issue, with important implications for the RMB/Dollar exchange rate. The Financial Times reports:

The renminbi has started to appreciate more rapidly in recent months, rising at an annualised rate of about 20 per cent, compared with 6-7 per cent over the whole of 2007. In the longer-term, say economists, China will have no choice but to allow its currency to appreciate faster, even in the face of entrenched domestic resistance.

Dollar Very Lows

The dollar continues to reel from last weeks 50-basis point Fed rate cut, falling overnight to a fresh record low against the euro at 1.4129 and stumbling versus the sterling to 2.0316. Renewed fears of a faltering US economy will continue to drive the foreign exchange market this week as concerns of a possible recession weigh on the greenback. However, given the abrupt nature of the Feds aggressive ease, traders must keep a close eye on US inflation data for fear that the 50-basis point rate cut may strengthen inflationary pressure over the coming quarters.

Economic data slated for release this week will provide further clues on the US outlook, with reports to shed light on growth, the housing market, inflation, manufacturing, and consumer sentiment. On the whole, consensus estimates look for weaker data compared with the previous releases. The housing market slump will continue to lead the deterioration in US fundamentals, with August existing home sales seen falling to 5.49 million units, versus 5.75 million units previously and new home sales forecasted to drop to 830k units compared with 870k units in July. The final reading of Q2 GDP is estimated to be revised lower to 3.9%, from 4.0%, while the Feds preferred gauge on inflation is seen unchanged in Q2 with core PCE standing pat at 1.3%. Additionally, durable goods orders and Chicago PMI will provide more clues on the extent of the slowdown in manufacturing. Although durable goods orders are typically a volatile figure, estimates are calling for the number to fall by 3.1% in August, reversing the previous months 6.0% increase. The excluding transports reading is also seen declining, down by 1% versus a 3.8% gain a month earlier.