Remember the three possibilities: stagflation, recovery with inflation, deflation. For the USA, the view we have taken since the Fed pulled its greenscam on investors (by first implying and then denying it would buy long-dated T-bonds) is that stagflation is the most likely. Recovery is unrealistic in an economy over-indebted in every way possible, dependent on cheap money for its remaining strength, and with surplus production capacity. Deflation, on the other hand, looks unlikely when everything is in place for continued weakening of the dollar, which would seem incompatible with deflation, since it pushes costs and prices up. Higher input costs are now combining with more expensive money as the US Federal Government borrows massively, and with households losing the option of refinancing their mortgages to maintain their spending. That means slow expansion of the economy at best, combined with rising prices, i.e. stagflation.

This conclusion, to us inescapable for the USA, should not be assumed to be universal. In major economies with smaller indebtedness and less spare production capacity, the case for stagflation is weaker, and that for deflation stronger. A weaker dollar does not remove deflation for the world stage, but shifts it from the USA to countries with appreciating currencies. Chief among these is the euro, not least because Asian currencies are stubbornly held down with the dollar. It is commonly assumed that, whatever the USA, does, the rest of the world will follow. It may now be possible that a dichotomy sets in, at least between the European and US economies, as they follow paths of deflation and stagflation respectively.

Some major bridport clients appear to accept this dichotomy, as they have massively lengthened their bond holdings in European currencies. In addition, a comparison of European and US yields suggests less upward pressure in Europe (66 bps yield increase in Bunds and 55 bps in Gilts, vs. 120 bps for Treasuries from mid-June to end-July). Our own view is that it is too early for lengthening in Europe. Two reasons make us think that yields will rise further: increased government borrowing and improved household spending as reforms take hold in Germany. The very idea that Germany could be the engine of growth in Europe seemed ridiculous a few months back, but today it seems at least possible. All in all, Europe has a better chance of avoiding deflation than the USA has of avoiding stagflation.

There are still a couple of unresolved issues about US economic policy. One is whether the Fed will, despite its past "on again/off again" policy, intervene to buy T-bonds at mortgage-sensitive maturities of 5-10 years. It must be tempting for the Fed, as lower mortgage costs would return the consumer prop that has just been knocked away. However, such a move could only have temporary impact and would so smell of desperation that we doubt that even Alan Greenspan would try it. The other issue is the 30-year T-bond. The Treasury denies it will come back. However, if the Administration wants to borrow without competing directly with the private sector, the only option is to move to very long maturities. Watch out for a gradual re-adjustment of public statements to prepare for this possibility.

The recent events of USD ten-year T-bond yields moving higher than Bunds and Gilts, and the abrupt breaking off of US re-mortgaging opportunities mean a period of financial turbulence has begun. Just about every possible view may be found among commentators at present, ranging from Snow's propaganda about the US economy being like a coiled spring ready to expand, to an anonymous writer who sees gold at USD 3,500 per ounce and massive collapse of the dollar and of the US economy. Our own reflection leads us more moderately to stagflation in the US, to hesitation between deflation and modest recovery in Europe and to hope for economic leadership from Asia. Emerging markets are rather out of the limelight. We nevertheless re-affirm our long-term faith in Russia, and note that Lula has converted totally from revolutionary to reformer. The market is having doubts about him, not so much over intention as over the time it is taking.

In the meantime, in Europe, countries with much lower labour costs will soon be members of the EU. In which direction will they push Europe as a whole? To deflation or recovery? A likely subject for us to consider in a week or two.

Recommended average maturity for bonds in each currency

Stay short until the current turbulence passes.