Two questions are preoccupying us this week:

• Will the slide in share prices have a negative impact on the real economy?
• Is the economic outlook tending towards inflation or deflation?

Since the bursting of the dot.com bubble, households, rather than corporations, have kept the US economy going, at the cost of an enormous and unsustainable trade deficit. We continue to be amazed at the Americans' insouciance about spending in the face of rising unemployment and stock market losses. The Administration is playing every card to keep consumers spending. However, when "paper losses", amounting to some $2 trillion in the last fortnight alone, are seen to wash through to the real value of pension funds, then consumers are likely to start saving again. Increased saving, good, even essential, in the long run, will mean decreased demand in the coming months.

On the corporate front, few companies are investing. Greenspan states, "Evidence for a sustained recovery will include a pick-up in business investment, so far elusive". Telecom companies have massively over-invested, as have media firms. Banks and insurers are suffering directly from the market slide and the absence of M&A and underwriting business. Banks are no longer willing to lend, the commercial paper market has shrunk, and the corporate bond market is resistant to new issues. The corporate world on both sides of the Atlantic is in the paradoxical situation of suffering a credit squeeze, even though there is so much liquidity around. Those who want to borrow cannot, while those to whom the banks would like to lend do not want to borrow. This has a familiar and Japan-like ring to it! The IPO market pretty much dried up about three months ago, and rights issues are at fire-sale prices (e.g. Ericsson). Currently, therefore, corporations have very little access to debt or equity funding, and cannot even sell off their unwanted subsidiaries at a decent price (e.g. WorldCom and MCI, or SwissLife and Banca del Gottardo). There is a lot of securitised debt around plus outstanding derivatives; much of this is collapsing in value from WorldCom and knock-on effects, but it is not even clear who is exposed. There is every likelihood of class actions against banks, against which, in the current anti-bank atmosphere in the USA, the banks will not stand a chance. Rarely can the need for caution in investments have been greater.

So, yes, we do believe the current financial market crisis will have a negative impact on the real economy, although this is all part of the great disillusionment that the USA is now going through and to which the rest of the world can scarcely remain indifferent. How symbolic of the loss of confidence in US financial institutions is the fact that even J.P.Morgan and Citibank are now following Andersen along that bumpy road from pillars of the establishment to subjects of criminal investigation.

The answer to the second question follows from the first. Corporations cannot raise their prices. Imported goods to the USA will cost more, but that is part of the rebalancing of the external deficit. Although the trade gap is enormous (4.3% of GDP), as a percentage of the economy as a whole, imports are fairly small (15% of GDP) with only modest inflationary effect. In the USA therefore we expect low inflation to continue. The starting point is so low (a mere 1% per year at consumer level), that, even though import prices will push up the rate, the absolute level is likely to stay modest (e.g. 2.5%), and there will be a long delay until further tightening. In Europe the stronger euro is helping dampen inflation, while Japan still has falling prices. Between the twin risks of inflation and deflation, we see deflation as the greater and more serious.

"TIPS" have outperformed other T-Bonds in recent months, a phenomenon which has rather surprised us. This is apparently due to an increase in CPI, despite core inflation staying low. Unless we are completely wrong on our inflation assessment, TIPS have had a good run and profits could be taken.

Our recommendation to lengthen bond maturities across the board has proven very right. The above logic can by no means lead to reversing our view. Nevertheless, government bonds have a slight "over-bought" look about them, so that a short-term correction is possible.

Japanese households are said to have starting spending. Should one month's data turn into a trend, the world could yet be saved from an unlikely quarter, but no one should hold their breath!

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

WorldCom's filing for Chapter11, banks having helped Enron, and probably many other companies hiding losses, are together continuing to put pressure on the US markets, dragging the rest of the world's down also. For a week now, the correlation "weak stocks equal weak USD" no longer applies. Capital repatriation by US funds liquidating investments in Europe and in the commodity currencies, as well as the under-funding of European insurance companies in the US, are capping the euro on the upside and putting a temporary floor on the USD. However, market sentiment towards the US remains extremely negative and the trend for a lower USD will continue over time.

EUR/USD: No more follow through took place in the 1.0150/1.0200 area and we've been down again below parity to retest 0.9850. Some consolidation around the parity is the most likely outcome with the buy on dips strategy for the EUR still valid. Supports are at 0.9880 0.9830, 0.9750, and resistance at 1.0030, 1,0150 and 1.0250.

USD/CHF: In this uncertain market environment, the CHF remains king. After testing strong support at 1.4350, the USD recovered to nearly 1.4800. Consolidation is in a broad 1.43 to 1.48 range, with a good strategy to sell on the rallies. Resistance is 1.4850, 1.4910 and 1.5000. A loss of support at 1.4310 would target 1.4250, followed by 1.4100.

USD/JPY: Consolidation is underway in a 115.50 to 117.80 range. If the key resistance 118.30 is broken, this would immediately send the rate to 120.00. Downside, any loss of 114.80 would send it down to113.00.--

EUR/JPY: Same comment: key support 117.80 has been broken and our objective at 115.50 has been seen, with a low close to 115.00. In the meantime this cross has recovered well and stopped just below 117.80. A very broad consolidation range of 114.50 to 119.50 is the most likely outcome.

USD/CAD: As we pointed out last week, it looks like the recent sharp appreciation of the commodity currencies has stopped and that a period of consolidation has been entered. Key resistance at 1.5500 was broken and the CAD weakened to nearly 1.6000. We have used the current weakness of the CAD and established a long CAD/short USD position at 1.5950. S/L 1.6300, T/P 1.5550.

AUD/USD: Here as well, the key support around 0.5500 was broken and the rate reached 0.5350. Supports are 0.5280, 0,5250 and 0.5180 and the upside 0.5410, 0.5460 and 0.5520.

GBP/CHF: 2.2850 remains the magic pivotal point: opening the door for 2.2550 below and above for 2.3150.