Bond markets, we often claim, are more sensitive to economic developments than stock markets. They are sounding a clear warning this week over the banking industry. Spreads for the banking industry, led, but not limited to German banks, have widened (now up to 200 bps for senior debt) over swaps, while bid/ask spreads have increased from around their traditional 25 bps to 2 or 3 times that amount. Bids for subordinated debt are even more difficult to find, with bid/ask spreads increasing approximately fourfold from their typical 50 bps. In addition, bank loan delinquency is on the increase. US data show a move from 1ѕ% at the end of the 1990s to about 3ѕ% today - and the curve is steeply rising. A 4% bad load rate among banks is thoroughly unsustainable, unless, of course, the banks keep carrying the loans, as in Japan.

One of our senior traders states in the context of finding bids for corporate bonds in general and banking bonds in particular, "In all my years in this company, this is the most dramatic situation I have ever seen, and that includes the Asian and Russian debt crisis of 1998."

Germany is consolidating its position as the sick man of Europe. We have already drawn attention to the "Japan-look-alike" nature of that country's GDP decline and deflation. Other features reinforce the parallel, notably a fall from stock market peaks so far of 65% (c.f. 68% in Japan), bank cross-holdings, and, now, a growing bank crisis. Those are not the only problems facing Europe:

• French recalcitrance over the Growth and Stability Pact (where we happen to think they are right but there might be better ways of handling these issues!),
• The likelihood of an Irish rejection of the Nice treaty and its implications for delaying Eastward expansion (that also may not be such a bad thing)
• A ganging up on Switzerland plus inter-member fights over banking secrecy (nothing like threatening the Swiss to make them obey!)
• An ECB fighting inflation and not addressing deflation.

Not surprisingly, therefore, the euro is not making the breakthrough it should given the inherent weakness of the fundamentals on the dollar, and the euro zone is far from taking over the role of engine of growth from the stalling USA.

In Europe the problem is that one country is deflating and others inflating. In the USA, one side of the economy (manufacturing) is deflating, while the other, services is inflating. Manufacturing indices are negative, service positive, continuing the movement of the US economy away from manufacturing in favour of services. That is an inexorable trend anyway in a modern economy, but it does not help rebalance the external account.

The vital question of "inflation vs. deflation:" is hard to call, which may partly explain the interest our clients are showing for the new 30-year French inflation-indexed bonds. These bonds protect on both sides, since they include a deflation floor. We see a strong case for the Swiss Confederation issuing indexed bonds, especially as a step to resolving the emerging crisis in pension funds. (A subject we address in our article in the "l'Agefi" supplement of 14th October dealing with Swiss pension funds.)

The Norwegian Krona continues to strengthen, offering an attractive "carry trade" between, for example, JPY and NKR. As GNI warn us, however, beware that so many participants have taken the same position.

Brazil has almost gone "on hold" as Lula is perceived as bound to win but with more constraints than had he been elected in round one. We still see rescheduling of the external debt as inevitable.

We leave Iraq and the Longshoremen dispute till last. Both are, of course, threats to the US and world economy. However, they have diverted the attention of the US Administration and of the press away from the underlying problems of the US economy. A tough George Bush will help the Republicans, while the Democrats want these two issues out of the way to let voters refocus on the economy, a subject where the Democrats feel they can shine.

Recommended average maturity for bonds in each currency.
Remain long across the board, except in Sterling

Attacks by the European Union and the UK on Switzerland over its banking secrecy continue, with the UE threatening to impose sanctions (not applicable till 2010), while Gordon Brown seeking to protect or reinforce the role of the City. Wim Duisenberg (ECB) has again made it clear that his current monetary policy is appropriate. Normally influential voices like that of Hans-Werner Sinn of the ifo Institut fьr Wirtschaftsforschung are falling on a deaf ear. Duisenberg is also expressing his disapproval in changing the rules of the stability pact. George Bush's speech on Iraq was rather moderate and an imminent attack now looks improbable. In Japan, it is conceivable that, after the Government reshuffle, banking reform will finally start. It will imply continued JPY weakness. We still think that sideways trading in the well-established ranges is the most likely near future.

EUR/USD: A broad trading range of 0.9580/0.9610 and 0.9980/1.0020 still looks valid. A clear break on either side would be good for at least 150 to 200 points.

USD/CHF: Here, it looks like that the market has some interest in buying USD at around 1.4700 and in selling USD between 1.5250 and 1.5330. Only a clear break on either side would open the door for a move of at least 200 points.

USD/JPY: Major support has been established at 120.30/50 and is even moving up to 121.10/30 area. Only a weekly close below would indicate a temporarily firmer JPY. On the topside, 124.30 to 124.80 might be difficult to break for the time being due to continuous offers by exporters. The objectives remain 125.50, followed by 126.

EUR/JPY: consolidation in a 120.00 to 122.00 trading range. Major support is at 119.50. The trend remains towards the upside.

USD/CAD: The CAD continues its weak behaviour in trying to establish itself above its support of 1.5780, but still eyeing the 1.6000 area. We prefer to wait to establish our long CAD/short USD position until we have a clearer view of how the US economy is going to perform.

AUD/USD: Same comment: it looks like that the Aussie has a struggle to sustain levels above 0.5500 for a long time. Consolidation in a 0.5350 to 0.5550 range may be expected until further notice.