The big financial story today is the dollar’s rally --

The dollar fell when oil rose, and now it is rising as oil falls.

Plus, a couple of the key factors that have supported the euro against the dollar -- the ECB’s tightening bias and Europe’s resilience (and specifically Germany’s resilience) in the face of the US slowdown -- seem to be withering away. I agree with John Jansen: this is more a story about incipient weakness in Europe than strength in the US. Only yesterday US Treasuries rallied (i.e. yields fell) on the back of bad US news.

A dollar rally is one way for the RMB to strengthen against its largest trading partner -- though at the end of the day, the RMB needs to strengthen against both the euro and the dollar to help reduce the world’s imbalances, not just to strengthen against one or the other.

Most of the data I follow looks back not forward -- even the weekly custodial data reported by the New York Fed. I though was struck by the strong increase in the Fed’s custodial holdings (money the New York Fed holds for foreign central banks) last week: Total custodial holdings were up $24.5b, with a $25.6 increase in the Treasury holdings and a slight $1.0b fall in custodial holdings of Agencies.*

The $24.5b weekly increase is almost as large the $29.1b increase in July. And the $25.5b in Treasury purchases isn’t that much smaller than the roughly $35b sovereign funds have invested in US financial institutions.** It is a huge number.

Right now there are only three countries adding to their reserves at a rate than could explain this kind of growth: China, Russia and Saudi Arabia. Of course, a large country that isn’t adding to its reserves could also shift funds over to the New York Fed, increasing its custodial holdings in the absence of an increase in its overall reserves -- but I suspect that at least one of the countries now adding to its foreign assets at a rapid clip is making heavy use of the New York Fed’s custodial accounts.

And it is striking that all the increase went into Treasuries. Treasury Secretary Paulson is in Beijing for the Olympics. I would be a bit surprised if he also doesn’t swing by SAFE and explain how the US government plans to backstop the Agencies ...

* This is the change from the July 30 to August 6, not the change in the weekly averages.

** I haven’t updated by calculations for the latest Merrill recapitalization, so I don’t have a precise number. The total before the last Merrill recapitalization was $31.4b. This number also excludes the money sovereign funds have invested in European institutions like UBS and Barclays.