Artificiality, useful shorthand to summarise our main criticism about the American economy and of those responsible for its management, must eventually give way to reality. A "reality check" is now underway. Its most obvious manifestation is the declining dollar and the bearishness of stock markets. These two are intimately linked to each other via the US current account deficit and the decline of investment flows towards the USA. The most obvious resistance to accepting reality is the American consumers' spending, both on goods and housing. Their spending remains strong because of the cheapness of money, plus Government propaganda that all will be well even if the imbalances are allowed to continue indefinitely in the way they have been for years.

The current process of readjustment is the culmination of market forces rather than a reflection of an admission by "the powers that be" that a rethink (our word from last week) is necessary. Curiously enough, it may even be a good thing for the US Administration to continue with its (self-?) delusion, for, if ever the extreme imbalances of the US economy were officially recognised, the effect on markets and the dollar could be catastrophic. There is a parallel here with European Governments: if France and Germany begin to demonstrate competent economic management, the euro could really take off and cause more problems than it solves. For France, at least, it will be "no excuse" time for Chirac when it comes to implementing the reforms he himself has claimed for so long to be essential. It will be another miserable autumn in France as the nation protests in the streets and with strikes.

As we have written many times, one of the key US imbalances is the trade deficit. It implies US domestic consumption growing faster than domestic supply, with the surplus of imports over exports making up the growing gap. Two things have allowed the USA to get away with living on the "never-never": one is the willingness of the world to hold dollar bills and bank balances, the other is the flow of capital to buy US assets. The second of these has faded away. The first is, however, still in place, although we muse about the possibility of the euro sharing this role of reserve and trading currency. But to return to our argument about the US external deficit. To correct it will require US domestic demand to grow more slowly than domestic production, and for many years. That implies that the assumption that the world's economy can be led into recovery by the USA is looking very questionable. Can the world reduce its dependency on the USA? Only with the greatest of difficulty and in a framework of slow re-adjustment. Maybe China can provide a new demand motor, maybe Europe, but in neither case would we hold our breath.

For the moment we can be hopeful that the adjustment be a gentle one, equivalent to the "fluttering down" of the dollar to which we have been alluding, rather than to a drastic fall. That is far more desirable than delaying the inevitable (for then the adjustment would be still more wrenching), and certainly to be preferred over a collapse in the dollar, equity prices and the economy as a whole.

The outlook for interest rates is now much clearer than even two weeks ago. Expectations of a rise have been postponed everywhere. Our recommendation of the last few weeks (to lengthen but with bar-bells in dollars and euros) was essentially defensive (against a sudden rise in rates). This danger has faded, so that we can now remove our bar-bells and recommend further lengthening, except in Sterling, where the yield curve keeps us at 5 years.

The dangers of contagion from Argentina have led us for some weeks to steer investors away from Latin America. The dangers are far from over, with Brazil in the firing line. Lula and the likely success of the Workers' Party are part of the problem. Other aspects include a falling Real and difficulty for the Government to borrow locally, plus the overconfidence early this year that Brazil would be such a good bet for emerging markets.

By the way, the "sacrifice" of Paulo Cantarella of Fiat Auto, as foreseen by us a fortnight ago, happened faster than we thought!

Recommended average maturity for bonds in each currency
Discontinue bar-bells and lengthen except in GBP.

The pressure on the US equity markets is still giving a lot of support to the euro. The strength of the US recovery has been put into question, with household spending and capital investment most probably postponed until a bottom has been found on stock prices. Despite the recent improvement in the unemployment rate, a couple of Fed Governors remain doubtful about the economy already being on a sustained improvement path. Recent polls among US primary dealers clearly show that any hike in interest rates is going to be postponed from August into the last quarter of this year.

EUR/USD: A weekly close above 0.9450 did not materialise last week, but the euro has gone through that level this week, opening the door for the next target of 0.9600. No meaningful correction has been seen so far, and we still advise caution in taking further euro gains for granted. Supports levels are at 0.9390, 0.9330 and 0.9250

USD/CHF: The upside still looks toppy in the 1.5700/50 area. A weekly close below 1.5500 would open a target of 1.5410 followed by 1.5350. Here also, we rather expect some consolidation first.

USD/JPY: It seems that the BoJ has managed to put a temporary floor around the 122.50/123.00 area. The exchange rate has moved above 125.50, but the supply of dollars from Japanese exporters is blocking further advances. Resistance levels are at 126.20, 126.80 and 127.30.

EUR/JPY: The bottom in this cross has moved up from the key support of 114.50 to the next major level of 117.80, offering the likelihood of a retest of the outstanding high of 119.50. Consolidation in a 118.00 to 120.00 range may be expected.

USD/CAD: All commodity currencies continue to be well supported but some consolidation is likely first, for the Canadian in a range of 1.5250 to 1.5450.

AUD/USD: The targets on the upside are 0.5730 and 0.5780. The downside should remain well supported around 0.5650 and 0.5500.

GBP/CHF: The pressure on the GBP continues and our target of 2.2850 has been reached. The next target is 2.2650, and break out on the topside at 2.3000