Events this week, like the third largest US bankruptcy, Conseco at $ 6.5 billion (after WorldCom and Enron), and McDonald's heading for the red, make it difficult to maintain even the modest note of optimism we interjected last week. The relative lack of fuss about Conseco even suggests that illusion still reigns in the USA: discount the bad news, inflate the good. Thus, there is rejoicing at the continued high spending of consumers in the shops and on housing, and still nary a thought about why industrial spending refuses to pick up.

Still we believe that John Snow is a man with the potential for realism. He recognises that US industry needs a still lower dollar to renew its export competitiveness and thereby reduce the unsustainable current external deficit. The process of dollar adjustment has clearly begun. It had to begin anyway, but O'Neill was fighting it tooth and nail. Even mere acquiescence by Snow to economic forces will move the dollar lower.

The US external deficit has been offset by the inward capital flow, which already dropped drastically at the beginning of the year (which alerted us then to the inevitability of a weaker dollar). The external deficit is also mirrored by internal deficit, entirely in the private sector in pre-Georgian days, but now moving steadily to the public sector. Welcome the "twin deficits" of the Reagan era. Does anyone remember what happened to the dollar then?

The shift from the private sector spending more than it earns to the Government taking over this "noble" role reflects the corporate sector pulling in its horns. That is why industrial spending cannot pick up; the level of indebtedness of corporate America and the associated problem of spare capacity just cannot allow high investment by corporations, unless and until foreign demand picks up. We have often described the US Administration's policy as irresponsible. In letting the internal public deficit grow, and in encouraging households to continue spending like there is no tomorrow, the Administration is holding back industrial development. It is as if three "deficit spenders", Government, households and corporations are struggling for the same funds, except that corporations have no incentive to fight. John Snow's row will be so hard to hoe!

The euro is strengthening by default, held back by the total incompetence of German economic management. In Euroland, increased domestic spending would help the world economy, but all the governments can do is tax more and argue with each other and the Swiss about the taxation of savings. The proposed fiscal amnesty on undeclared assets for Germans is not even worthy of the name. The drama in Europe is one of unrealised potential, except in the UK, which seems to be a bit too much like the USA in its imbalances.

Inflation in the UK has moved above the target of 2.5%. Elsewhere inflation is under control, and even in the UK it is the housing phenomenon most at cause. The deflation risk is still present, though weaker. In fact, this is one of the key questions for which we are really struggling to find an answer. When will inflation return? Some months ago, central banks stood accused of fighting yesteryear's battle against inflation. Now, they seem to have understood that the greater risk is deflation, and they are opening the spigot of money supply. Even in the euro zone! The USA has little further to go in lowering the short-term rates. The Fed may therefore be expected to intervene by buying long-dated T-Bonds, seeking to offset the impact of increased Government borrowing and even to flatten the curve. It is by no means obvious that they will succeed (unless the internal deficit is addressed, which is an echo of our discussion above). In the meantime, Europe as a whole has more room to lower short-term rates and surely will. At this point we cannot come to grips with the impact on the overall yield curve, particularly for the euro. Will it flatten or steepen? Allow us to return to this theme in the New Year, for it has an obvious impact on our recommended average maturities, which, for the moment we leave unchanged.

The main argument in favour of inflation-linked bonds is, of course, that inflation may be expected. That expectation is low, so "linkers" are not proving very expensive. The result is that their real yield is rather high (between 2.3 and 3.4% at ten years according to the currency), making them quite attractive in their own right. Those who buy them at their current prices will be well served when inflation eventually does return, whenever that may be.

The entire team at bridport Investor Services wish our readers a Happy Christmas, and a New Year in which the glimmers of hope we have detected in US economic policy begin to glow more strongly! Back on 8^th January.

Recommended average maturity for bonds in each currency

No move yet from an average of five years.

• the huge current account deficit in the USA (expected to be at $ 500 billion in 2002, compared to $ 393 billion in 2001)
• capital flows favouring the euro zone (€ 25.1 billion inflow into the euro zone from January to September, compared to an outflow of € 85.2 billion for the same period in 2001)
• the new US economic team probably looking to stimulate export industries.

Thin markets and heating up of the Iraq situation might exaggerate market movements between now and year's end. Use option strategies to protect portfolios against possible further USD erosion.  

Merry Christmas, Happy New Year; we shall be back at the beginning of January 2003.

EUR/USD: The euro finally broke out on the topside and nearly reached 1.0350. A weekly close above that would trigger further stop-losses, direction 1.0500. Downside support comes in at 1.0230, 1.0180, 1.0100 and parity.

USD/CHF: More safe-haven buying of CHF has continued and taken out the strong support at 1.4350, to reach 1.4250. The next support comes in at 1.4180 and 1.4100, and the barrier at 1.40. Upside resistance is at 1.4330 and1.4380, followed by 1.4500.

USD/JPY: With an increasingly negative sentiment towards the USD, the support zone at 122.50 has been broken and 120.40 been tested, so far. A drop of the dollar to 120.- would trigger further stop-loss selling, direction 118.-. It would also serve to strengthen the resolve of the BoJ. We still believe in medium-term JPY weakness and would advise establishing a short JPY position in the 118 to 120.50 window.

EUR/JPY: Same comment: the big support zone of 120.50 seems to be holding and has moved up to the 122.- area. Upside resistance is at 125.50, 126.20 and 127.50. Here also we believe in further upside potential in the medium term, but expect extreme volatility to continue.

USD/CAD: The key support at 1.5480 has been broken and next support comes in at 1.5410 and 1.5350. We have put a stop profit at 1.5530 on our short USD/CAD position established at 1.5930.

AUD/USD: Same comment: consolidation in a 0.5510/30 to 0.5650 range with a "buy-on-dips" strategy for the Aussie below 0.5550. A drop below 0.5480 would send the Aussie immediately lower, with 0.5430 as the first objective.