Short view By Philip Coggan - If inflation is tamed, what's next?

Short view By Philip Coggan - If inflation is tamed, what's next?
Copyright The Financial Times Limited 2006
Published: August 30 2006 03:00 | Last updated: August 30 2006 03:00
Traders creeping back to their desks after the summer will find the mood of the markets has changed significantly. Producer and consumer price data in the US have calmed the widespread worries about accelerating inflation.

Bond yields have fallen accordingly, with the 10-year Treasury yield down at 4.8 per cent, against 5.24 per cent in June. But even though the yield curve is now significantly inverted (with the Fed funds rate at 5.25 per cent), few are worrying about recession.

Even though the US housing market is showing severe signs of strain, optimists, such as Chris Watling of Longview Economics, cite the UK and Australian examples as evidence that the end of a housing bubble need not automatically lead to recession. And falling bond yields have brought down mortgage rates, which may stabilise demand.

In addition, the recent fall in oil prices, following the ceasefire in Lebanon, may bring some relief to beleaguered US consumers. Gasoline prices have dropped back below $3 a gallon.

Equity markets have taken heart from the recent economic news, particularly the perception that US interest rates have peaked. The UBS risk index, which looks at factors such as credit spreads and volatility, indicates that investors' appetite for risk is elevated. The growth-sensitive MSCI Emerging Markets index has risen 15 per cent from its mid-June level.

But other factors may have been at work. Tim Lee of pi Economics sees the recent weakness of the yen as a sign that the "carry trade" is still in full swing. The inverted US yield curve means it is no longer sensible to borrow at short rates and invest on Treasury bonds. But with Japanese rates only at 0.25 per cent (and the balance of Japanese economic data rather weak), there is plenty of scope to borrow in yen and earn higher returns elsewhere.

However, if the Japanese economy is slowing, that ought to give equity investors pause for thought. In an ideal world, Japan and Europe would be taking up the slack from the US consumer. That may be too difficult a trick, especially given yesterday's decline in US consumer confidence.