Taken together, yesterday's economic news looks worrying for the markets

THE SHORT VIEW By John Authers
Copyright The Financial Times Limited 2006
Published: November 15 2006 02:00 | Last updated: November 15 2006 02:00


Taken together, yesterday's economic news looks worrying for the markets. More worrying still, foreign exchange markets appear to have shrugged it off.

In Japan, third-quarter economic growth was better than expected (at 2 per cent rather than the forecast 1 per cent). This would be good news, except that huge sums are betting on the yen to stay weak through the "yen carry trade", in which yen-based deposits are sold short and used to invest in higher-yielding currencies. This is a great supply of liquidity to world markets. Stronger gross domestic product numbers boosted the chances of a rise in Japanese base rates. That would mess up the yen carry trade.

Growth figures for Europe were uninspiring. But the US figures truly astounded. Producer prices plunged 1.6 per cent in October (compared with a forecast 0.5 per cent fall), while core prices fell 0.9 per cent, when they had been expected to rise slightly. Retail sales excluding cars fell 0.4 per cent, double the predicted fall.

Any one month's numbers can be noisy, but this data looks appalling. The US bond market's judgment is clear. The yield on the benchmark 10-year treasury dropped to 4.57 per cent. Three weeks ago it stood at 4.83 per cent, so this signals a strong belief that the economy is weakening, and that the next move in the Fed Funds rate will be downwards.

The gap between 10-year and two-year yields widened to more than 16 basis points, with the two-year yielding about 4.73 per cent. This is the biggest gap of the year. Normally, longer-term bonds have higher yields, as longer-term investing involves higher risks. Such an "inverted yield curve" is a classic signal that the economy is slipping into recession. It is an excellent reason to sell the dollar.

But forex traders saw a "buying opportunity" for the dollar yesterday. After an initial dip, the currency was soon stronger against the yen and the euro than it had been before the PPI data came out. They must hope that the PPI is a fluke, and that tomorrow's consumer price inflation report will allow a rebound. Yen carry trades are a risky game. Only a brief pick-up in the yen can inflict nasty losses. Much now rides on tomorrow's CPI.