As regular readers well know, we begin with our view of where the stock markets are going, as we see the bond market being very dependent on investors' enthusiasm for equity. Yet in reality the interaction is mutual. A number of commentators believe that bond yields are so low that stocks are again attractive for lack of better opportunities. Many also see a steepening of the yield curve as a sign of an upturn, just as its inversion signalled the downturn. A more subtle argument is that stock prices are basically past their lowest, except there will still be another test of the bottom before a durable expansion. We have even read one leading commentator claiming "average PE ratios of 20-22 on normalised earnings are quite appropriate".

We wish we could agree. Our view is, however, that earnings will get worse before they get better, and likewise for stock prices. This implies that interest rates will be lowered further by all Central Banks, with the Fed still having up to one more percentage point to go. Already real short-term interest rates in the USA are effectively zero (Fed rate 2.5% vs. 2.7% inflation). Negative real interest rates can only be seen as an aberration, although that aberration in the high-inflation 1970's took years, not months, to correct. Negative interest rates are associated with increased savings, not because the savings rates are so attractive, but because ready cash is very desirable in times of uncertainty. Since consumers are nervous, banks can reward savings with less than the inflation rate. The US savings rate reached 4.1% of revenues in August, a sign we would see as positive in rebalancing the US economy, but negative in the short term because it implies that the hopes of consumer spending pulling the economy along, while corporate investment caught up, were as much wishful thinking as we have been saying these past twelve months.

The likely scenario now is that consumer aversion to spending will compound the reluctance of corporations to invest. While lowered corporate investing impacts Asia even more than the US itself, a consumer-ledecession has mainly direct domestic repercussions. Decidedly, these are not happy days for the American economy, and the whole world will suffer as a result. The best we can say is that some areas, notably Europe, should be able to cope a little better.

Those who see a steepening US yield curve and concluding from it that recovery is round the corner may not be looking at the same curve as we are. The USD yield curve is not steepening, it is moderating, i.e. moving lower in parallel. We have therefore been fully justified in resisting the temptation to shorten our recommended bond maturities. If a steepening yield curve is a signal of a recovery, it has not yet been made. In the meantime spreads on corporate bonds are continuing to broaden, which is another negative indicator of future stock market behaviour. There may come a point when corporates are oversold, but the Swissair fiasco is another example of the nasty surprises that sometimes lie in store for holders of what may seem the safest of corporate bonds.

Our perception is that inflation is at bay. Admittedly the return of US Government deficit financing is inflationary, but weak corporate and consumer demand is deflationary. It is reasonable to hope that the deflationary threat is the lesser, but the path Japan has taken (low interest rates available to a public that refuses to spend) has led that country to positive real interest rates by inducing falling prices. The future direction of inflation needs continual monitoring, as we can only be relatively sanguine about the threat one way or the other. With such uncertainty about future inflation, many investors will be attracted to the planned offer of "France Trésor" to pioneer an index-linked bond in euros with the index based, not on French CPI, but on inflation in the entire euro zone. The Trésor are expecting a considerable broadening of their investor base, when this bond is launched in late October.

September 11 reversed portfolio flows to the USA (M & A flows had already reversed). Previous experience provides no clear example upon which the current crisis may be modelled. In some cases, like the 90/91Gulf War, flows picked up again very quickly, while in other cases, like the 79/80 "second oil shock", many months were required. Our own feeling is that the long-term flow of investments to the USA (which allows the dollar to be continually overvalued in terms of balance of trade) must await the outcome of military action. Even President Bush warns that positive results will take a long time. The G7 may want to keep a moderately strong dollar, but a large number of forces are gathering against it, e.g. what do the Japanese do with their overseas holdings when the return in the USA is so low and at home it is negligible? Answer, put a lot of it in euros, and benefit both from a higher interest rate and likely appreciation.

Recommended average maturity for bonds in each currency (still as on 15.08).

Yesterday, the Fed cut its Fed Funds rate again by 0.50%, to bring it down to 2.50% (the lowest since 1962). Hopes of an imminent recovery of the US economy have, for the first time, been put severely into doubt by US officials saying that the economy is most probably moving into recession for at least two quarters. Over the last ten days, and ahead of this weekend's G7 meeting, all equity and forex markets have somewhat stabilised. It looks like that the day of US military action is approaching and nobody can tell how financial markets are going to react. We continue to believe that some range trading will take place with a slight bias towards seeing the euro gradually moving higher.

The determination of the BoJ to weaken the yen has borne fruit. There was no hesitation in their stepping into the market again after the book closing. A substantially weaker yen may finally materialise, although the alternative is that a continued jittery stock market will again cause huge capital repatriation, pushing the BoJ to intervene yet again.

EUR/USD: All crosses like EUR/JPY, EUR/CHF, and even EUR/GBP, have moved in favour of the euro, correcting the exaggerations seen after September 11. However, a weekly close above 0.9280 is still needed to further the advance in the direction of 0.9400, followed by 0.9550. Solid support comes in 0.9050/80 area.

USD/CHF: The determination of the SNB, the shock on the economic front with the disappearance of Swissair, with its huge consequences, together with too illiquid a forex market, will probably stop investors from buying the CHF aggressively. Selling interest above 1.6300, with the first supports coming in at 1.5950 followed by 1.5820

USD/JPY: After taking out successfully 119.00 and 121.30, the next hurdle for this pair to clear on the upside is 122.30. Despite our continuing to favour a weaker yen over time, some consolidation in a 119 to 122.- range looks quite probable. Only a weekly close above 122.30 would open the door for 124.10, with 125.50 as the next price objective.

EUR/JPY: With the psychological barrier at 110.00 broken, the next levels are 111.80 and 113.50 on the way towards 115.00. Here as well, a period of consolidation might come in, and only a weekly close above 113.00 might provoke further purchases of EUR/JPY.

USD/CAD: Owing to recession fears, all commodity currencies are suffering at present. We prefer to take a wait and see stance for the time being. Support comes in at 1.5480, and next resistance area 1.5780, followed by 1.5900.

AUD/USD: The interest rate cut by the RBA of 0.25% took a bit of pressure off the Aussie. A broad consolidation range is expected between 0.4850 and 0.5050.

GBP/CHF: Extreme volatility will remain in this cross and only a clear break of the resistance at 2.3850 will take off the pressure and push it towards the next target of 2.4100 , followed by 2.4350. Major support comes in 2.3580.