The invisible hand of Adam Smith is functioning. As we foresaw three weeks ago, it is doing its job of bringing the American consumer back to sense of reality in his/her confidence, spending and savings habits. This reinforces the view that "scenario III" (a long recession without inflation, as we spelt out in May) best describes the state of the US economy. The rate cut "medicine" continues, but the patient does not respond. His illness needs time for him to address the imbalances about which we have so much spoken these recent months. History will look at this period as one of curious irresponsibility on the part of the US authorities, when they have done everything they can to encourage spending instead of saving. How intriguing it is to see the ghost of Adam combat the wisdom of Alan!

Let us suppose that it has now sunk in that the USA will be in a downturn of greater severity and duration than generally expected a year ago. The stock markets have further corrections to go through to reflect this realisation, and the dollar has considerably further to fall. Indeed, another major realisation of recent days is that most of the productivity miracle in the USA was a mirage. Even the part of it which was real can only explain a tiny proportion of the dollar's appreciation. In fact, the dollar's exchange rate is as cyclical as it ever was. It suffices to recall the extremes of recent years to realise that the USD can be fully expected to fall below parity with the euro next year. Moreover, calculations by economists to see what exchange rate is needed to halve the US trade deficit suggest several cents above parity for the euro.

Much is being made by the press about the worldwide nature of the growing recession. All major economies, with the possible exception of China, are moving down in parallel. The dependency of almost every economy on the "US motor of growth" has been widely accepted, to the point where the assumption is that there is no hope of recovery without the USA leading the way. That assumption is one we would like to challenge, at least in its extreme form.

In our worldview, there are three economies with inherent demand for goods and services: North America, Japan and Europe. The rest of the world is basically in the business of supplying these three. The first consumes a lot more than it supplies, the second supplies a lot more than it consumes, while only Europe has a reasonable balance between what it buys and sells to the rest of the world. The ageing population of Japan and the poor macro-economic management of the aftermath of its 1980's asset bubble put Japan hors de combat for the foreseeable future. That leaves Europe as the only chance for a consumption-led expansion in economic activity. At this point, conscious that this is an area where opinions differ greatly, we come down in favour of a modest degree of optimism for Europe, as expressed in last week's bulletin. Recent German economic data give rise to the hope that the Euroland economy is bottoming out. The ECB has the potential, almost the obligation, to cut interest rates. The new deal between VW and the Unions could be a precursor of more sensible labour and social policies in Germany. The UK inside the EMU will be a reforming force. But, above all (and sorry to be repetitive, readers) the "euro in the pocket" will give a powerful tonic to the European economy. We therefore nail our colours to a European mast. To say Europe will drag the world out of recession would be to go too far, but Europe may be expected to play a major role in economic recovery as this recession runs its course.

Last week we mentioned our belief that Russia was the most positive emerging bond market. It is "furthest" from the dangers of contagion from Argentina and, more importantly, it is an economy on the mend. It is true that the country plumbed extreme depths before starting to turn round, but that recovery is firmly underway. Russian bond spreads came in last week, and that is pleasing after our recommendation, but our positive view on that economy is long-term one.

Our scenario of a "hunkering down" of the world economy, with further cuts everywhere and the risk of deflation actually being greater than the risk of inflation, speaks well for the bond market. The obvious interest of rebalancing in favour of the euro has been recognised by many of our clients.

Recommended average maturity for bonds in each currency (changed 08 and 15.08).
Now that we have made the move to long positions, we see this as being held for some time.

Despite a still solid housing sector, yesterday's consumer confidence came out much lower than expected. Housing and consumer spending are the two main components that have so far prevented the US economy from slipping into recession. Today's 2^nd quarter GDP revision could well show zero growth and add some additional pressure on equities and the dollar.

A much higher M3 in Germany could postpone the long awaited rate by the ECB on Thursday.

Europe continues on a regular basis to revise GDP numbers downwards.

The market behaviour remains negative on the dollar and the strategy remains to sell the USD on rallies.

No change regarding Japan. More and more repatriated capital flows are being detected in the context of the book closing end of September, and of covering losses from a battered Nikkei. Repeated verbal intervention by monetary officials to weaken the yen remain ineffective for the moment. Only a rapid move below USD/JPY 118.00 might provoke the BoJ to step into the market.

EUR/USD: Consolidation in an expected range of 0.9010 to 0.9250. A clear break would bring about the next movement of at least 100 to 150 points.

USD/CHF: 1.6500/30 remains a major support area. A weekly close below opens the door for the next target at 1.6350 followed by 1.6100,. 1.6800 is capping the upside for the time being.

USD/JPY: The verbal interventions by the Japanese authorities have put a floor at around 119.00, but sooner or later capital flows might test the resolve of the BoJ. Any loss of the support area at 118.00 should cause rapid movement in the direction of 115.00. USD/JPY 121.30 still acts as a major break out level on the topside with first target of 123.

EUR/JPY: Consolidation is continuing in a 108.50 to 111.30 range. Despite the fact that we see a higher EUR/JPY over time, short term appreciation of the yen cannot be excluded.

USD/CAD: We keep our short position established at 1.5480, S/L 1.5480 and T/P at 1.5350.

AUD/USD: The break at 0.5280 has put the Aussie on a positive path. Next target on the upside is 0.5380, followed by 0.5550, while 0.5280 is now acting as a major support.

GBP/CHF: Consolidation in a 2.3850 to 2.4200 range. 2.4350 is acting as a break out level, while long term support comes in at 2.3700.