How economists have a yen for the carry trades

IN DECEMBER, ruminating on 2006 and peeping into 2007, I muttered about things that might go wrong. Here are a few candidates, not that you should let this piece spoil your breakfasts.

Actually, this week delivered us a nice surprise in the UK inflation numbers, a fitting poke in the eye for those predicting a second back-to-back rate increase after the "'shock horror" of January's change. Not only did the Consumer Prices Index (CPI) slip back to 2.7 per cent as favourable base effects in energy prices kicked in, the "core" CPI also retreated (to 1.6 per cent). At the other end of the chain, industrial input prices also fell. Mervyn King still hasn't had to write that letter but I suspect the monetary policy committee (MPC) will not relax just yet; the pay round isn't over.

The real elephant in the UK room is further away. With the public finances in a hole and still digging, higher taxes and slower government spending are certain; this is what you get when an irresponsible Chancellor of the Exchequer drives the economy like a sports car. This'll hammer the growth rate; then right on cue there's the looming financial disaster of the 2012 Olympics, sure to leave the Millennium Dome looking a well executed bargain. But of course nobody's interested in that - yet.

So let's look elsewhere, at what the G7 did not say about the yen; it's the world's most irritating depreciator yet they said nothing - nothing, that is, other than some head-masterly strictures about carry trades.

Carry trades are fast becoming the loose women of the day - great fun (so I'm told) for those who have access but eliciting varying degrees of disapproval from everyone else, especially central bankers. Carry trades exploit anomalies (free lunches); anomalies are supposed to get arbitraged out but this one has staying power. If this one were in the space-time continuum you'd be expecting a battered police box to come spinning through it.

Borrowing very cheaply in yen and lending at three times the interest rate in dollars is clearly fun. Take your borrowed funds to a real high-yield market place, Brazil say, and fun becomes pure joy. Then, when the currency you are borrowed in steadily falls against where you are invested, that's unimaginable bliss. And that's what the yen carry trade of which you read so much is all about. Delightfully simple, delightfully profitable and oh so dangerously seductive. As any time-traveller can tell you, be on your guard when messing with anomalies.

We've already had a dress rehearsal for how this one could implode. It's all to do with nobody wanting to be the last through the exits; a bit like boarding with Ryanair, you all hover nonchalantly near the gate looking cool yet when the flight is called there is a scrum. So last May they called the flight; a (spurious) conviction that yen rates would rise aggressively led to the predictable scrum and the yen itself rose. It doesn't take much adverse shift in the currencies for unimaginable bliss to become unimaginable pain, pain that was felt by the traders who were looking the wrong way at the time, for the high-yield markets (Iceland, New Zealand) on the other side of the trades and indeed by financial markets everywhere.

This was all very silly and unnecessary and for most of us it blew over quickly. Next time, if there is a next time, it might not.

On a different tack, notice how a few long-anticipated negatives are starting to present themselves across the pond. The housing market is indeed in trouble and the optimists are wrong when they say the worst is over. Already we have the signs of a feed-through to consumer demand although at this point you still have to look for it "upstream" in the household credit data rather than in actual sales. This could get nasty. Meanwhile, fourth-quarter earnings came in below expectations (even if we politely draw a veil over Ford's contribution); this might be a sign of things to come. Oh and then if we add in for good measure that private equity seems to be overbidding for deals, that hedge funds have become far too directional and equity correlated, that bankers everywhere are intent on withdrawing liquidity and that the global geopolitics seem to lurch from bad to worse then perhaps the bacon and eggs don't taste so good after all.

Of course there is always a ready list of things that can go wrong. That they can go wrong does not mean that they will; fortunately they usually don't though I reckon a financial disaster over the Olympics is a dead cert. When I'm looking at asset allocation this year, though, I'm conscious the risks feel more real - and bigger - than they were. Act normal but keep the tin hat handy.

• Peter Bickley is director of economics at Tilney Investment Management.