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Bond Outlook [by bridport & cie, September 18^th 2002]

Inflation, deflation or stagflation? The same opening question as last week. Our view is hardening towards deflation as the dominant risk, low inflation as the most likely general condition of the world's economy, and the sudden arrival of inflation very unlikely. Why should we be even more pessimistic that usual? Because:

Even Greenspan is cautioning against further stimulus of the US economy The IMF has warned of a growing credit crunch T-Bond yields at levels so low that they suggest deflation is in sight Germany is fast going the way of Japan Stocks would be overvalued even if earnings could be maintained And, our "catch-all" reason, nothing has been done to correct the balances of the US economy, since the Administration (Greenspan apart) remains in a state of denial.

These are all themes we have tackled over and over again in the Weekly, but let us this week take a closer look at Germany. Like Japan, Germany's situation includes:

Too many elderly people and a declining population, The loss of control over real interest rates Constraints on the Government budget (Stability Pact) Declining bank lending Inefficient labour markets.

In addition, Germany has its own unique problems, confirming its place as the "Sick Man of Euroland". The overbearing costs of integrating the former GDR have now been massively increased, and the timing delayed because of the floods, while all hopes of Berlin becoming a thriving capital have disappeared under the weight of 17% unemployment and a municipal debt of EUR 41 billion.

Germany is on the brink of a Japanese-like deflationary spiral. Our prediction of a few weeks ago that Stroiber would replace Schroeder is now less confident, although we would have thought that an unproven Chancellor might be a better bet than one who is "proven" as someone who cannot address deep-rooted problems. The slow motion decline of Germany also parallels that of Japan in the total inability of the politicians to face or deal with reality. That implies that the German decline will not be reversed in any foreseeable future. This is not good news for the EMU. The largest but stagnant economy in the Zone needs a loose monetary policy, probably a couple of percentage points below the common interest rate, while everyone else needs the moderately high rates now pertaining. Our expectation is that the ECB will eventually lower rates, although not enough to save Germany. Indeed, the Bank has let it be known that a cut is possible if the recovery stalls (already the case!).

As for the chances of the (relatively well managed) UK joining the euro, they get more remote by the day. What a distance has been travelled since the argument in favour Britain being part of Europe used to be that "we shall be hitched economically to the German powerhouse of the European economy".

We wrote off Japan long ago, but note the desperation measures of the Bank of Japan in buying shares from commercial banks to save them from the embarrassment of their portfolios falling to a level challenging their capital adequacy ratios. At around 8000 on the Nikkei, the banks fail to meet the 8% minimum ratio. A further decline in the Nikkei is clearly expected by the Government. This "solution" is only a palliative.

Our general message in recent months has been that investors should be content with bonds, despite low yields, as they at least offer capital protection, but that bonds of Mother Russia can add a little zest to performance. It is possible however, for bold investors to take advantage of the expectations we have of still lower interest rates. Investment in long-term zero coupon bonds and strips will provide impressive returns if rates come down, as we believe they will. To offset the risk of inflation striking, despite all our doubts, a place should now be found for index-linked bonds, notably the French "OATs", which along with the indexed US Treasuries and Gilts, offer reasonable liquidity.

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

Currency:	USD	GBP	EUR	CHF
As of 10.07.02	2012	2007	2012	2012

Dr. Roy Damary

Currencies (by GNI)

The news at the beginning of this week that Iraq is accepting the arm inspectors back sent gold and crude oil lower, and gave a nice push to the equity markets and the USD. Once again, however, the rallies were short lived. Saddam is buying time, and military action by the USA has most likely only been postponed, as it looks unlikely that Iraq will accept complete disarmament. Mixed economic figures out of the USA and poor data out of Europe still speak for range trading to continue. This morning, the BoJ surprised the market by announcing a start to buying stocks from banks after been pressured by the MoF and the LDP to come up with some fresh measures to "stimulate" the economy.

EUR/USD: A broad trading range of 0.9580/0.9610 and 0.9980/1.0020 still looks like most likely scenario over the coming weeks until (it is to be hoped) the Iraq story is out of the way. A clear break on either side would be good for at least 150 to 200 points.

USD/CHF: Here it looks like the market has some interest in buying USD around 1.4700, and in selling 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: Same comment: as stated last week, the bottom of the USD has again moved higher, from 118.80 to 120.30/50, an area which should show strong support. The topside might be difficult between 123.30 to 123.80, where exporters are keen to sell USD.

EUR/JPY: Same comment: the break at 117.80 opened the door for a retest of the outstanding high of around 119.30. The cross remains well supported for the time being, but an early break above 120.00 is needed to keep the momentum going for higher levels.

USD/CAD: The CAD has continued to weaken and has broken 1.5780 to test 1.5880 so far. We prefer to wait a little longer and try to sell USD in the 1.59 to 1.60 area.

AUD/USD: Same comment: the Aussie is still struggling to sustain levels above 0.5500 for a long time. Consolidation is to be expected in the 0.5350 to 0.5550 range until further notice.

	USD/CHF	EUR/USD	EUR/CHF	USD/JPY	EUR/JPY
Resistance/Breakout	1.5150	0.9780	1.4730	122.30	118.80
Current spot level	1.5090	0.9730	1.4680	121.55	118.30
Support/Breakout	1.5020	0.9650	1.4650	120.50	117.80
	AUD/USD	NZD/USD	USD/CAD	GBP/USD	XAU/USD
Resistance/Breakout	0.5550	0.4730	1.5850	1.5450	323.00
Current spot level	0.5475	0.4695	1.5820	1.5390	317.75
Support/Breakout	0.5350	0.4610	1.5730	1.5310	313.50