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Clouds gather over US economy

Like a thunder clap too close for comfort, the US bond market last week issued its time-honoured warning of recession. This time for real. The yield on 10-year Treasuries slid below the short-term rates, an emphatic signal that investors are more worried about a US housing bust than surging inflation.

Fear is creeping into the markets that a hyperactive Federal Reserve run by a chatterbox novice, risks sinking the global economy by tightening too hard - supposedly to curb prices, in reality to combat his fatal reputation as an easy-money ideologue.

Yes, bonds issued the 'inverted yield curve' warning in February. But those were halcyon days when the world was still awash with liquidity. The central banks of Asia, Europe and America have since succumbed to a belated and fierce bout of orthodoxy, raising rates in unison for the first time since the early 1980s.

Bernard Connolly, global strategist for Banque AIG, says the Fed, now chaired by Ben Bernanke, has already gone too far by raising rates sixteen times from 1pc to 5pc since June 2004, too much for an overspent economy running on fumes.

"Unless the Fed begins cutting rates by this summer, which it won't, then the US economy could be in for a nasty recession. The stock market has not yet woken up to the full gravity of this," he said.

If past is prologue, we have three or four months to find shelter before the full lightning storm begins. Buy government bonds, horde cash and shun risk, advises Joachim Fels, credit strategist at Morgan Stanley.

"Only once global GDP growth slows significantly - my story for the second half of this year and the first half of 2007 - and a new monetary easing cycle begins, can risky assets start to rally again," he said. Mr Fels has pencilled in the next upturn for mid-2007.

Beware the dollar too, warns HSBC's currency guru David Bloom. "Inflationary concerns will dissipate as the economy cools and it will become clear the Fed has over-tightened. This will herald the next wave of dollar weakness."

For now, Mr Bernanke seems determined to steam ahead with a quarter point rise to 5.25pc this month - and damn the icebergs. His pilloried "pause" talk in spring gave way last week to studied words about the "unwelcome" level of core inflation, now 2.1pc. Within hours the effects of this volte-face hit Turkey, South Africa, India and Thailand, all compelled to raise interest rates to defend their currencies and slow an exodus of foreign investors.

"He reintroduced testosterone to the inflation-fighting resolve of the Fed," said Diane Swonk, an economist at the US firm Mesirow Financial. She told the Washington Post: "This is a pure male thing. 'You think I'm a wimp? Take me on,' he said to the markets."

Yet the Fed's own staff said in May that inflation will peak over coming months before slowing later in the year. Hourly earnings are remarkably tame, rising just 0.1pc in April, down from 0.6pc in March. The Economic Cycle Research Institute's ECRI index, which signals future inflation, dropped 0.2pc in May and is now well below its peak in October.

Fed doves are pleading for caution. "We want to be looking through the windshield, we don't want to be just looking at the rear view mirror," said Governor Randall Kroszner.

Yet Mr Bernanke has buckled to the will of the Fed's monetary Ayatollahs - Dallas and St Louis come to mind - although he knows the risks of interest rate overkill all too well.

It was he, Professor Bernanke, who wrote the seminal 1995 paper - Inside the Black Box: The Credit Channel of Monetary Policy Transmission - describing how inflation lags the cycle, flashing amber long after the real danger has switched to recession.

And it was he - scholar of the Great Depression - who blamed the Fed for crushing the American banking system in the early 1930s by starving it of funds. "You're right, we did it," he said theatrically as a junior Fed governor at the 90th birthday party of Milton Friedman. "We're very sorry. We won't do it again."

Talk about hostages to fortune.

Mr Bernanke is counting on a "soft-landing" for the housing boom, the central pillar of the US consumer economy.

It provided $600bn of spending last year from home equity withdrawals - ie, from ever-bigger mortgages entailing ever-more debt.

This rosy assumption is looking shakier by the day. The inventory of unsold new houses is now at the highest level in a decade, rising by 1m properties to 4m over the last year.

The Philadelphia index of US construction equities has crashed 23.3pc since early May, pointing to an immediate wave of lay-offs.

Some 32pc of the 4.22m jobs created by the US economy since the expansion began in 2001 have been in the housing sector, more than four times the usual ratio, according to a study by Merrill Lynch. HSBC warns that US property has already tipped into a downturn, with the likelihood of outright price declines in the overheated markets of the East and West coast.

Ian Morris, the bank's chief US economist, said the combined cost of mortgage payments and house insurance for new buyers in California takes up 70pc of pre-tax income.

"Affordability is now worse than in 1981 when mortgage rates were 16pc. This is pretty scary stuff," he said, predicting a property slump lasting four to five years.

The Federal Reserve's blunder was to hold interest rates at almost free-money levels of 1pc until the summer of 2004, yet blowing fresh asset bubbles at home and abroad, and stealing prosperity from the future by pushing spending to the reckless level of 107pc of GDP.

The time for tough love was then, not now, sixteen rate rises later - with delayed effects only just starting to exact their toll.

If Ben Bernanke had guts, he would now be holding the ground he staked out to Congress in April, explaining patiently that inflation lags the cycle. Are the bond markets telling us he has failed his first test of nerves?