A mere three weeks ago we foresaw only two alternatives in the development of the US economy, and suggested that the Administration would have us believe them both despite their mutual incompatibility:

• "EITHER, the US economy recovers and deflation is defeated, causing inflation to return, interest rates to go up and leading to a massive and sudden shortening of maturities. Judging the moment to jump will be very difficult, but once the move starts it will be huge.
• "OR, if the recovery is still off the radar screen, there is every reason to stay long in bonds with their locked-in cash flow (despite the bouncing of yields around between support and resistance, the secular trend is firmly down"). (Remember that was three weeks back)

We overlooked a major third alternative: stagflation. On 11^th July the following data were released. "Producer prices for finished goods increased by 0.5% in June, making up some of their losses of the last two months. Through the first half of 2003, prices have risen at a 4.8% rate." Such data would support the first of the two above scenarios and, indeed, that would seem to be the market belief. The alternative however is that inflation is returning within the context of a low-growth economy, i.e. of the cost-push variety rather than demand pull. Eight weeks ago we made a wild guess that the weaker dollar would take a year to abolish the risk of deflation in the USA; now it looks like the effect is arriving much sooner, first affecting manufacturing costs and a little later (less than a year) retail prices.

All this leads us to a modification of our view. We still have no faith in a US recovery - the economy is too badly flawed and dependent on cheap money. Yet we can no longer hold strongly to our belief that "the secular trend in interest rates is firmly down". Neither can we dismiss the recent fall in bond prices as being a "mere trading situation".

The source of confusion in the current situation is the Fed's "on again/off again" hints about buying back long T-Bonds. As of Greenspan's speech of the 15^th July, the mooted policy is "off again" - hence the bond price falls. The great unknown is whether the policy will be "on again" (in which case, better be relatively long in maturities), or will the Fed give up and allow inflation to return (in which case, better be short). No one can tell, but what is clear is that, whether or not the Fed goes through a period of long buy-back, it can only be a temporary policy, one in which, incidentally, we have as little faith as in the loose money policy of the last three years. Sooner of later (and we are talking months rather than years), the huge issuance of new US Government debt will push up rates despite the jobless, mediocre recovery. In which case stagflation will be upon us. The great evil of deflation can be beaten only by embracing the lesser evil of stagflation.

The fall in the Bund price reflects hope of a German recovery in the wake of Schroeder's taming of IG Metall, his progress on social reforms, tax cuts and the euro not being quite so strong. His policy is very like that of the Bush Administration's, although German economic imbalances are less severe. The German Government, like the USA's, will have to finance its growing deficit by borrowing, lifting long-term interest rates and ensuring only a weak recovery mired by higher longer-term interest rates.

The fixed-income situation today is so uncertain that we cannot recommend further changes in average maturities, which we have already moved to market neutral. We do, however, recommend the accumulation of cash while awaiting clearer signs about interest-rate trends, and a component of inflation-protecting assets in a bond portfolio (index-linked and floaters).

Real recovery, when it comes, will come from the East, but China and Japan must revalue to allow domestic demand to grow. Part of that process will be convertibility of the Renminbi. Maybe we shall add a fifth column to our recommended average maturities!

Recommended average maturity for bonds in each currency

Be market neutral until the stagflation vs. deflation issue is settled.