Last week we alluded to (but did not recommend) short-term trading opportunities by lengthening dollar maturities, but in the context of an overall recommendation to remain short. This trading opportunity was stronger and came quicker than we expected, and, to that extent, our recommended average maturity was inappropriate. The reason for the rapid drop in yields has been a sharp fall in consumer and business confidence, and a shift in mood towards our own long-held position that the US recovery cannot be better than mediocre, and is insufficient to reduce unemployment. To this may be added the growing loss of confidence in George W. Bush over both Iraq and the current investigation about the leakage from the White House of the identity of a CIA agent.

One way of seeing the present situation is that investor attitudes have partly returned to where they were before the summer: lack of faith in the recovery and the search for protection in quality bonds. That is, however, an insufficient characterisation today, given that there have been serious rallies on the stock markets, bond investors have already been through one "greenscam", and the G7 meeting has changed the currency outlook by sanctioning the inevitable fall of the dollar.

Our economic reasoning begins with the indebtedness of all major aspects of the US economy, and the absence of corrective tools, except for a devaluation of the dollar. Not that a weaker dollar is a panacea, but it is an essential step on the way to rebalancing (other steps must include trimming the domestic deficit). Yet, too sharp a fall in the dollar would do more harm than good. The trick will be to manage, i.e. slow down, its decline. Surely the BoJ and the Fed are communicating on this issue, and probably the BoE. Higher US interest rates will probably have to be offered to slow the currency realignment and to attract buyers, both domestic and foreign, of the 2-10 year T-Bonds, now being issued massively. Thus, overall, we see the pressures for higher yields dominating in the medium-term, even though short-term corrections will happen when (it is not "if") US investors realise that the economy is fundamentally flawed.

That is exactly what happened this week: the downward pressure of the flight to quality has overcome temporarily all our careful reasoning about higher yields. The question we must face, as must all bond investors, is whether the current fall in yields is a short-term trading opportunity, or whether it could be a trend reversal. Yes, it could be. For yields to decline and stay low would imply, however, not just a mediocre recovery, but a recession combined with deflation and severe disruption in international trade. All this year we have envisaged two outcomes from the mess the US Administration has created: stagflation or deflation. The latter would be so awful that we prefer to stick to the stagflation scenario, and believe that the Administration cum Fed will prefer it also, even if faute de mieux.

Our conclusion for dollar maturities remains the same: stay short until the air clears, although we admit short-term trading opportunities abound.

We recommend short maturities in Sterling also, but on the grounds that higher rates are more likely in the UK where, against all trends, the economy is in risk of overheating.

Not so for the euro, and, by association, for the Swiss Franc, which is once again benefiting from the "safe-haven" effect. A strengthening euro not only allows, but demands, lower yields. Moreover, when Trichet takes the helm at the ECB, he is a likely to mark his arrival by lowering the rates. Curious (some would say "impossible") though it may seem, we actually envisage a decoupling of USD and EUR rates and yields. We mark this point by recommending a modest lengthening of EUR and CHF maturities. By "modest" we mean that new cash should be put to work at longer maturities.

Doubts about economic recovery suggest profit-taking in corporates and a move to sovereigns. We believe corporate spreads will now widen.

Recommended average maturity for bonds in each currency

Modest lengthening in euros and Swiss Francs.