What bird flu and the yen carry trade have in common

A US recession is looking more and more likely. That's bad news for the dollar - and bad news for the carry trade which, though it doesn't always hit the headlines, is always there waiting to cause havoc.

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What with the credit crisis, and the housing market collapse, the odds on a US recession are growing shorter by the day.

Mainstream commentators are still reluctant to admit it, but there's a very strong chance that the US economy is set to go into reverse. But just how early could such a recession start?

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Well, there's no time like the present

The final three months of this year could well go down in history as marking the beginning of the next US recession.

Recent data shows that wholesale inventories rose 0.8% in September, far more than the 0.2% that analysts had been expecting. That could be bad news for growth this quarter. Companies will have more stock to sell, which means they won't be ordering as much from manufacturers in the coming months.

As Reuters puts it, usually an inventory build-up like this is seen as a temporary problem that the US can soon sort out. "But with consumer confidence sliding and recession fears mounting, this inventory spike raises questions about demand."

Indeed, the Institute for Supply Management's survey for October suggested that customer inventory levels were at their highest since January 2001, which was two months before the US's last recession begun. Meanwhile, according to research group Retail Metrics, 70% of retail chains saw weaker-than-expected October sales.

With consumption slowing, and shops ordering fewer goods, David Rosenberg at Merrill Lynch reckons that GDP for the fourth quarter could come in "perilously close to flat, or even negative."

Of course, this isn't great news for the US. But it could be very bad news for the rest of us too. The worse the state of the US economy, the worse the outlook for the dollar. And the wobblier the dollar gets, the more chance there is of the yen carry trade unwinding.

The yen carry trade is a bit like bird flu. Every so often the papers will get a sniff of it and it'll be front page news for a day, and then it'll die back down again. But it's always there, waiting to cause havoc.

As regular readers are probably aware, the yen carry trade has come about because Japan has extremely low interest rates. That makes it attractive for investors - both domestic and international - to borrow money in yen and then invest it somewhere where it pays a bigger yield.

Trouble is, while this can seem like a no-lose situation (which it has been for many years now), if the currency exchange rate goes against you, your gains can rapidly turn into losses. And as investors become more risk averse, this potential problem preys on their minds more, and they try to close their yen positions before anything nasty happens.

But if everyone closes their positions at once, then of course, the currency strengthens rapidly, which can cause a panicked rush for the exits. In 1998, after the Russian debt default and the problems at Long Term Capital Management, the dollar fell 10% against the yen in the space of two days. The more paranoid everyone is feeling, the more likely this is to happen.

A rapid unwinding of carry trades could see another market sell-off, as hedge funds and other carry traders are forced to ditch profitable positions to cover their loss-making yen-fuelled positions. And in an unstable environment where shocks are hitting the market left, right and centre, this seems a very likely potential outcome.

"Carry trades do not work in this sort of environment, they work in a low-volatility stable environment," David Brickman of Lehman Brothers told Reuters. "Therefore carry trades get unwound and dollar/yen has further to go."

Certainly, of the two currencies, I know which one I'd be backing over the longer term - particularly as the market volatility is only just getting started. We'll have more on the dollar - and the yen - in the next issue of MoneyWeek, out on Friday.

Just before I go, I wanted to alert you to a very telling and entertaining little dispute posted on thisismoney.co.uk. This Is Money which as most of you will probably know, is the site for the Daily Mail group, so we're not talking about an obscure source here - has recently featured a house price crash calculator feature, which clearly has upset the Council of Mortgage Lenders. I won't tell you anymore just click on the link following to get a sense of just how worried the CML is about the state of the property market: The house price crash-ometer that has lenders worried

Oh yes, and just a reminder that for those who are still searching for that elusive perfect Christmas present, MoneyWeek can come to your rescue - "How Much?!", a compilation of the finest moments from our "Bottom Line" column is out now. Usually priced at £9.99, MoneyMorning readers can buy it for just £6.99 by quoting the promo code 'MoneyW'. Click here: How Much?!

Turning to the wider markets

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London's FTSE 100 index ended yesterday 33 points higher, at 6,337, thanks to a bounce for banks. Royal Bank of Scotland and Barclays led the risers, whilst lower metals prices saw miners dominate the fallers. For a full market report, see: London market close

Elsewhere in Europe, the Paris CAC-40 was up 11 points at 5,535. And in Frankfurt, the DAX-30 fell 5 points to close at 7,806.

On Wall Street, the Dow Jones ended an up-and-down day 55 points in the red, at 12,987, the first time it has fallen below the 13,000 mark in three months. The tech-rich Nasdaq was 43 points lower, at 2,584. And the S&P 500 was 14 points lower, at 1,439.

In Asia, the Japanese Nikkei was down 70 points, at 15,126. And in Hong Kong, the Hang Seng was up 137 points, at 27,803.

Crude oil had fallen back to $94.12 this morning, whilst Brent spot was at $91.03.

Spot gold extended Monday's heavy falls today, falling as low as $790.80 in Asian trade before rebounding to $806.20. Silver was at $14.75.

Turning to the currency markets, the pound was at 2.0683 against the dollar and 1.4167 against the euro. And the dollar was at 0.6847 against the euro and 109.91 against the Japanese yen.

And in London this morning, the Royal Institution of Chartered Surveyors announced that its house price index fell to its lowest level in two years in October. The number of estate agents reporting falling prices outnumbered those reporting rising prices, adding to evidence that the UK property market is cooling.

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John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.