It is time that authorities recognise that economic growth cannot be generated with macro-economics alone. Micro-economics, especially the encouragement of innovative entrepreneurship is also an essential component.

The fall on gold, China’s downgrade and an unexpected result of Japan’s ultra-loose monetary policy are all adjustments to the 'new normal'.

After five years of waiting for a return to normal economic and market behaviour, let us recognise that “normal” will not return any time soon and needs redefining.

The Cypriot bank bail-out has implications well beyond Cyprus, especially concerning the protection of depositors. The loss of banking trust may have a silver lining.

Some ideas are so stupid that even their proponents will back down. Such is Cyprus bank deposit confiscation. See also the key points of a bridport/Hunt conference.

The Italians are not alone in protesting against excessive austerity. Everywhere, traditional political parties are being disavowed and unconventional parties growing, some explicitly committed to euro or EU withdrawal.

The Italians have mightily protested against excessive austerity, and they are not the only ones. Maybe some good will come out of what most see as a bad election result. Maybe not.

Consider whether there are sufficient good signs in Europe to see this month as the “end of the beginning” (Churchill 1942).

Is the US economy really in better shape than Europe’s?

Some specific issues related to the primary market may be additional signs of a credit bubble.

The outcome of the Japanese experiment is only one question unanswerable except with the passage of time. This week we have three more to consider.

Japan is undertaking an experiment in inducing inflation. Whether the experiment works or not, it will provide many lessons.

Is the current market optimism justified? We look at the USA, EU, the UK and Japan and inclined to “yes, but”. And we ask whether safe havens are dangerous?

We present summaries of the two opposing views of the US economy without hiding our own. We cannot claim Europe is in any better shape.

Good returns on bond portfolios in 2012 have been very dependent on the narrowing of spreads. That is unlikely to continue in 2013, just when yields will scarcely match inflation.

As the euro zone moves slowly federalisation, the question is how to fiscal achieve discipline for each member country. Decentralised à la USA, or centralised à la Germany.

Sadly, our hopes that QE would be ended soon in the UK and USA have been dashed as both King and Bernanke say they are open to continuing their programmes

For many, quantitative easing is good news. We would see its ending as far better news. When might that be? Who might be first?

This week we have challenged ourselves. We have highlighted the positive news which may help the economy in the future! While October revealed a lot of bad news, behind those, there are some long-term trends which developed. Of course, it will take time to solve all fundamental issues and investors need to be patient.

A “phoney war” is underway on both sides of the Atlantic. Like its predecessor in 39/40 all hell will break out quite soon. With the Fiscal Cliff?

Despite low coupon rates, bonds have provided respectable returns based on spreads narrowing. The same seems unlikely for next year and the danger of interest rate increases remains.

Severe austerity is not working, so the time has come to consider alternative routes to regain sustainability. Reconsider the attraction of inflation and of good micro-economics.

Indecision by politicians is now knocking on to corporations, who are obliged to withhold investment until the economic uncertainties are resolved.

Stagnation or slow growth everywhere in the West, but a little optimism about UK employment may be justified. How can jobs grow by the GDP stagnate? Mystery!

In June we saw only headwinds. Now everything seems resolved. Is it really the case?

Rejoice that hope has returned to the euro zone, but keep your eyes on whether and how reforms are pursued, and be worried that printing money has become universal.

Draghi has acted where politicians hold back, giving Europe the break so needed to continue its move to a federal structure for the euro zone.

The banking supervisory role of the ECB and its bond-buying plan may be necessary but lack democratic support. Draghi the politician strikes while European leaders argue.

The August calm has given way to a mood of relative optimism; positive signs are present in the USA and Europe but in the context of a world still cooling.

While markets and commentators are focusing on euro break up, the European functionaries and politicians, if they are working at all, are drawing up rules for the banking union.

Draghi is proving a great political maneuverer: “This is what we all agree is needed to save the euro, now, Germans, stop us if you dare”.

You have to look very hard to find any positive developments on either side of the Atlantic. How strange that the USA’s currency and sovereign bonds have become havens for investors despite the chronic problems of the world’s largest economy in terms of internal and external deficits, political stagnation as well as chronically underfunded future pension and health care costs. The reason, of course, is that confidence in the euro and in the survival of the euro zone is so low that even the dismal outlook of the US economy looks good by comparison.

'Worry is the interest paid by those who borrow trouble’

What looks good can have unintended consequences, witness LTRO the low interest rates of the ECB and the entire “Target2” intra EMU settlement system

So the vision of a fiscal union is being slowly backed into via a nascent banking union, thereby lightening the mood in financial markets. How durably?

The EC has come up with a vision for future Europe. Now it will be seen if first the politicians then the voters sing up to it.

Bailing out banks is a necessity, but let us examine the real purpose (the depositors, the “system”, as well as the conditions and the price paid by creditors and shareholders.

If a federal system for the euro zone comes about, it is worth considering Merkel’s seven “neins” to see which will yield in what order, precipitated by Spain’s banks.

The threat of Greece “walking away” from the euro should add some realism to Hollande/Merkel talks and give a push towards Germany taking its responsibility.

How interesting to see if, how and when Merkel and Schäuble react to a widespread rebellion against an excess of austerity and a desire for a serious growth programme.

The French must now choose between the Hopeless and the Horrible. If it is the former, say goodbye to European cohesion and competitiveness. Maybe the Horrible is the lesser evil!

The debt crisis cannot be solved by pretending it is not there. Yet the leaders in at least two major countries have their heads in the sand.

Is the SNB’s policy stance sustainable in the medium term?

We try to define the real problems on both sides of the Atlantic to see if political leaders are actually addressing them. It is not encouraging.

The recovery is weak but enough to cause a rise in the yields of those government bonds considered safe-haven. Consider the impact on corporate bond yields.

When risk is “on”, serious analysis is “off”, allowing many unknown companies, from all over the world, to tap the corporate bond market

We see this as a major reassertion of sovereignty and democracy. It will not be the last “rebellion”.

To explain the lack of bid liquidity in European corporate bond markets, we hypothesis the existence of a yield barrier below which buyers refuse to go.

An unusual mixture of rising markets in both equities and corporate bonds allows cleaning up of fixed-interest portfolios ready for a long period of little economic expansion.

A benign atmosphere has set in, we hope for a few months. What a pity the underlying barriers to sustainable growth remain in place, thanks mainly to political inaction.

Europe seems to have joined the USA in showing a few silver linings in the dark economic clouds. The ECB’s massive bank lending may be thanked. For increased liquidity.

Rejoice in the improved employment situation in the USA, but do not confuse breathing space provided by cheap money with a real solution to economic weakness based on rebalancing.

What is in Merkel’s mind as principal decider for the euro crisis? She is too smart for her ludicrous description of political union to be anything but a political ploy.

“Federalisation or bust!” should be the slogan of the euro politicians and bankers now meeting.The ghost of Alexander Hamilton must be wryly smiling. Is Sarko a latter-day Hamilton?

At the moment, bond market yields are being driven not by economic fundamentals, but by mass psychology and political issues. How long can this continue?

With the departure of two Prime Ministers, some breathing space has been given to the euro zone to find permanent solutions, and to fixed-income investors to adjust their banking portfolios.

As panic gives way to reflection on Papandreou’s referendum call, there may be good results from this after all, such as a more decisive rescue and federalisation with democratic underpinning.

There may be lessons from the Swiss national Banks’ negative repo rate and the failure of Dexia. Both reflect aspects of how the euro crisis has become a banking crisis.

The main features of the euro rescue plan are now appearing and there is hope that they will crystallise at the G20 meetings, including an outline of the “federal” structure.

Though euro crisis is not yet over, the banks are being made to recapitalise in readiness for Greek debt restructuring.

Little from Jackson Hole, but opinion is changing in favour of recognition that the West faces years of slow growth and that central banks can do no more to help

The objective of the Chinese Government is first to implement Renminbi internationalization, then convertibility. To be considered as a international currency, China should development its financial markets. In this context, bond markets is gradually opening to international investors.

Will the politicians save the euro before Greece defaults? What are the Chinese doing? Already the RMB is bond issuing and Asian trading currency. Reserve currency next?

Flattening the yield curve, clearly the objective of the Fed at least, sounds like a good idea to improve borrowing. Unfortunately it ignores the problems created for banks.

Bridport Investor Services thought the Federal Reserve's Ben Bernanke would announce a third round of quantative easing, however the lack of announcements at Jackson Hole has been hailed as a disappointment

“True economic governance”? What a fudge! We ask whether the weak announcement from Sarkozy and Merkel is a measure of poor leadership of political realism.

The best hope now is that the ECB stop gap measures work, that federalisation of the euro zone advances and that the recession is “L-shaped”, not a double-dip “W”.

Now that the Congressional brinkmanship is over, markets clearly see the inadequacies of the US budget plan as well as the chronic structural problems of the euro zone.

Bond Outlook

Palliative measures to economic malaise are being proposed on both sides of the Atlantic, with little attention to underlying problems of budget deficits and a needed monetary union.

In view of the public disapproval of banks, it might be thought that banks would be wiser to acquiesce to proposals to separate retail from investment banking

Trichet agrees with us that federalisation is the answer, too! The movement is underway but with opposition in both the rich North and the poor South of the EU.

A temporary solution to the euro zone’s problems is on the cards, along with federalisation as a longer-term outlook. Meanwhile the situation in the USA is not improving.

Whether the EUR or USD is “stinkier” is debateable, but it is clear that political considerations are taking precedence over economic both for possible QE3 and defence of the euro.

Prevarication is the order of the day: postpone the day of reckoning for the Federal debt ceiling to August 2nd and delay proper resolution of Greek’s problems by extending maturities.

Consider the parallel between the USA and China today and the USA and UK of yesteryear. Massive indebtedness of one country another implies ceding much power to the creditor nation.

The USA is in an economic and political impasse. Economically Bin Laden's demise my not matter much, but politically it is crucial, giving newfound authority of President Obama

The EUR has problems, the USD falling, gold and silver soaring -- can this be a full-blown monetary crisis, or a controlled change in the world monetary system?

S&P has now followed the Chinese Dagong in questioning the AA rating of Treasury debt, another step in the loss of the “exorbitant privilege” of owning the reserve/trading currency.

Many months ago, when we first suspected that the USA could not face up to austerity, we reckoned it would be forced upon the nation by the market.

The US economy is recovering, but only because of cheap money. In contrast, Europe appears to on a path to normalisation of bond markets and central bank policy.

Two major riddles: when will inflation hit the US economy and will quantitative easing be extended beyond June? We suspect QE extension but the inflation issue is a full mystery.

Japanese rebuilding, the Arab Awakening and China’s “Lewis turning point” all point to good news for Western economies wanting to increase exports, but bad for T-Bonds and interest rates.

Every central bank has tightened or expects to, except the Fed. Inflation lets debt decline. Is someone whispering as much in Bernanke’s ear? Does that mean a QE3 come June?

Which way now? So many dilemmas. For Bernanke, to print money or tighten. Has the USD lost its shine? Safety or yield for investors?

Three great dangers to the world economy have become more apparent in the wake of the Libyan uprising. The G20 meetings achieves little on the issue of monetary reserves.

A falling dollar, rising commodity prices, and inflation in Asia threaten the standard of living in the West and especially in the USA, and undermine the reserve currency system.

Back to the future: the return of the securitised asset-backed bond, issued this time by banks for their own needs. This plus Irish shenanigans on bank debt.

Good news all round except for the sting in the tail that US GDP growth is mostly dependent on deficit household spending. When will the unsustainable end?

Note well what King of the BoE is spelling it out, echoed by Trichet: an income squeeze in the West is unavoidable. No such recognition by Bernanke in the USA.

Struggles are emerging between governments nurturing weak recoveries and central banks wishing to dampen inflation. Bond markets may encourage central banks in raising rates, the BoE first, ECB later.

Europe’s bottom-up problems may be on their way to solution, contrasting with the USA where Federal budgetary deficits are spreading down to States and Municipalities, with rising yields for “munis”.

We consider whether yield curves will steepen and overnight rates be raised, and reach a conclusion as to the likely order for four major currencies.

Our faith that the EUR will somehow by held together by the efforts of European leaders is reinforced by the expanding role of the Chinese in buying European sovereign debt.

Trust in governments is declining, not least because to bail out banks on the backs of tax-payers is creating a political backlash. Yield curves are steepening.

It is back to normal in the USA: spend more, print money, collect fewer taxes and ignore market forces, which act far less severely on the USA than on Europe.

In a panicky market, opportunities abound for the cool-headed. We remain sanguine that the ECB’s resolve will succeed in a short-term bail-out, but that the EMU must be revamped.

The USA simply ignored the Dagong attack. Why spend energy battling the Chinese when there is quite enough conflict within the USA over QE2 and the competence of the Fed?

The USA simply ignored the Dagong attack. Why spend energy battling the Chinese when there is quite enough conflict within the USA over QE2 and the competence of the Fed?

Bond Outlook [by bridport & cie, November 10th 2010]

Constipation may better describe the situation of the US economy than champagne cascades, and the risk investors face is that relief may come in too big a dose!

For the moment this recommendation concerns only instruments in euros: cash or cash equivalents offer a return as high as 3-year corporates while allowing lengthening when long-term rates rise.

The Chinese are turning their attention to bailing out the Euro Zone with profound consequences for the EUR and for interest rates: the “Beijing Committee to Harmonise Euro Interest Rates”.

Economic management of encouraging M&A while ensuring SMEs have no access to capital is an excellent way to ensure little job creation, but can it really be what governments want?

When their indebtedness becomes really unsustainable, governments will not default in any classic way, but practise “financial oppression”, particularly on bondholders and retirees. Inflation will be part of this.

Whether or not Europe or the USA are in worse shape economically, their problems and therefore their solutions are quite different. Stimulus versus austerity.

Whether or not Europe or the USA are in worse shape economically, their problems and therefore their solutions are quite different. Stimulus versus austerity.

To suppose a flat economy in today’s world is to be optimistic. So be it, as we think the differences between the USA and Europe favour the latter.

We believe the fears of a double dip to be exaggerated, which makes bond markets vulnerable to likely yield rises. China takes a new step toward RMB internationalization.

The evidence is growing that the route taken by European governments in restoring confidence is proving more effective than the indecision and doubts across the Atlantic.

Did European governments have any choice in opting for austerity? We think not, as confidence must be maintained not just in financial markets generally but in sovereign bonds as zero-risk.

As the USA follows one path and Europe another, time will tell which is the better route to renewed prosperity. This is an experiment of historic import.

Politicians might say recovery and retranchment can go together, but that is clearly not the case. Recovery might now be four years off.

“Everyone” is into retrenchment, Europeans by political will, Americans under market forces. It remains to be seen whether sustainable growth lies the other side of the pain.

Recession to the left and stagflation to the right. Good luck to government on that tightrope! Be grateful for a moderate calm in Europe with the creation of the EFSF.

Look for two historic changes as a result of recent crises: the Euro zone will have more centralised influence on fiscality, and financial markets will never be as free again.

Three emergency operations in a row – US subprime, euro debt and UK deficit – apparently controlled for the immediate future. But the longer term still demands action. Some action is appearing.

From Greece to other “southerners” to the euro zone as a whole: yes, entirely possible but the powers that be will do everything possible to save the single currency.

From risk accepting to risk aversion in under a week! What lies behind the present emergency? Greece, of course, but what more, and where will it lead?

The SEC’s investigations of the behaviour of Wall Street banks reflects a major shift in the US political will and of popular opinion. Financial markets are nonetheless more risk receptive.

In the USA rebalancing is now underway, implying establishing the long-term basis for a modest recovery. We lengthened government debt too soon and too much.

Three emergency operations in a row – US subprime, euro debt and UK deficit – apparently controlled for the immediate future. But the longer term still demands action. Some action is appearing.

After weighing two fundamentally opposing arguments about government borrowing crowding out the private sector, we have come down in favour of longer recommended maturities.

Occasionally an analysis brings you up short and makes you rethink what you thought was obvious. Such is the case in the light of Koo's (Nomura) "balance sheet recession".

This week we raise ten questions yet without clear answers. Together they are disturbing. Readers might think of their own answers, but “status quo” is unlikely to be amongst them.

A period of calm let us reconsider the impact of the end and eventual reversal of quantitative easing. Long-term rates must rise, but what of inflation?

Illiquidity has returned to bond markets. Confidence everywhere is falling. Profligacy has moved from the private to the public sector. Where can it lead?

The bond market went quiet last week because of lost working days. The issue of liquidity may be temporarily resolved, but next week will determine if normality has returned.

If it is not the worsening economy in the USA, it is the Greeks creating mayhem in the Euro zone. Rescue will come, but time to batten down hatches!

The Western government deficits are simply unsustainable. The bond markets may have been tolerant so far, but they will eventually perceive government debt as high risk and demand better returns.

It is a case of economists versus traders. Guess which are optimistic and which pessimistic. Which are right? Just as important, which view is gaining credence?

To help cope with contradictory data and opinion, it is helpful to distinguish the likely development of the swap yield curve from the government bond curve.

Growing disconnect between financial markets and the real Western economy makes us urge great caution, especially regarding the issuance of so many “junk bonds”. Diversifying currencies is to be recommended.

With so much positive sentiment reflecting the assumption of a “normal” recovery, there is reason for caution. Government borrowing needs will increase interest rates in the USA and UK.

Bond Outlook [by bridport & cie, December 16th 2009]

Not since the Argonauts has the challenge of steering between two dangers been so great: for the Fed (inflation vs. recession) and, consequently, for all investors (safety vs. risk).

What a paradox: Bernanke’s exit strategy with its “reverse repo” plan, now under test, seems deliberately designed to discourage bank lending and prolong the period of mediocre growth.

A Chinese-made spanner has been thrown into the rebalancing works with their RMB pegged to the USD. The existing economic situation is untenable, but how will it end?

Cheap money always looks for a home, even a risky one, and that builds bubbles. But where? Can emerging markets without currency manipulation avoid them?

Maybe the end quantitative easing will not lead to inflation, but it will add to the pressure to steepen yield curves as government borrowing moves to financial markets.

Two problems are looming: the end of quantitative easing in the short term and reduction of debt to GDP at government level in the long term. Both look inflationary.

New issues of both the US Treasury and the private sector are moving to longer maturities. They will collide once quantitative easing is stopped, and steepen the yield curve.

Current improvement in corporate earnings and stock and credit markets depend on cheap money, lower wages and higher productivity. Can that last? Is it a way out from the impasse?

Some investors see credit and inflation risk so high that capital protection is their main preoccupation; others see the rewards of low-credit bonds continuing for some months. Who is right?

In revamping the current failed regulatory system in the USA, an HBS professor proposes moving from shareholder to stakeholder capitalism, replacing opportunism for an elite.

There is a way of making good returns in fixed-income – bidding for new corporate issues, but its sustainability is uncertain, to the point where it looks like a mini-bubble.

Can the increase in US wholesale prices mean that the switch from deflation to inflation is nearer than we thought? Profits taking may be the best option for bond investors.

It is still no easier to invest, but the arrival of RMB bonds has implications for the structure of currency reserves. Even UNCTAD says one reserve currency is not enough.

This is not an easy time for investors to find acceptable returns. Maybe this is one of those rare times when cash is the best means of protecting capital.

Bond Outlook [by bridport & cie, August 19th 2009]

With a US economy “pumped up” with an unsustainable stimulus package, what happens when the stimulus is withdrawn? See our alternatives and be grateful for China’s growing domestic consumption.

For a few months we were more optimistic than financial markets. Now, however, we have take a tack different from theirs and introduce a large dose of scepticism.

Much cash chasing financial assets may have led to disconnect between positive financial markets and a negative underlying economy. And is China’s recovery sustainable (infrastructure building versus consumer demand)?

Talk of an exit strategy seems premature when the whole process of rebalancing, led as it is by China resurgence, will take so long, and the US fundamentals out right.

Is this decoupling that we behold? An L-shaped recession for the USA and something approaching a V for the rest of the world may be in the making.

A positive side in the shift in economic power from West to emerging Asia: growing consumption in China inter alia looks like pulling the world economy out of recession.

Moving from overpriced government bonds to quality corporates, our recommendation last October, is now commonplace. The Madoff scandal has very negative implications for New York and for hedge funds.

If the savings rate has moved from -2% to +6% and industrial capacity usage has dropped to 65%, can the official drop of 3% in GDP be correct?

Moving from overpriced government bonds to quality corporates, our recommendation last October, is now commonplace. The Madoff scandal has very negative implications for New York and for hedge funds.

Much is going as we have supposed in recent weeks, but the great unknown is the timing of the inevitable switch from a deflationary environment to an inflationary one.

Merkel is speaking out where others keep silence: just are the long-term implications of the hyper-loose monetary policies for inflation and taxation? A grim choice: inflation or higher taxes.

Markets for corporate bonds in USD and in EUR are going different ways. We examine possible macro-economic implications, as well as the inflation risk generated by such heavy government borrowing.

Fixed-income investors appear to have lost their powers of discrimination as to what is a good versus a bad corporate bond, and lead managers are certainly taking advantage of that!

Fortunately Ben Bernanke has a plan to dampen inflation once the recession ends in the sense of GDP stops falling. We attempt to describe it and its implications.

If the stimuli work, it will be inflation, if not deflation. Not a nice choice and a daunting, if not impossible task for central bankers to navigate between them.

The same facts today are being interpreted in opposing directions; the usual “optimism vs. pessimism” is more extreme than ever. Today we define our own optimism and its inherent caution.

While we urge caution about recovery signaled by the stock market rally, we are quite optimistic about the operations of financial markets, especially for fixed-income instruments and credit in general.

Macroeconomics has led us a view that this recession is L-shaped. A parallel socio-political argument that the USA is undergoing a massive change in outlook points to the same conclusion.

The G20 look a divided group, but at least they are coalescing on issues of expanded regulation. Evolution nor revolution -- the lesson of Sarbanes-Oxley has not been lost!

There may be no alternative to printing dollars and buying toxic assets, but beware future inflation and further dollar weakness. Europe is taking a different route focusing on inflation.

Optimism after Bernanke’s speech and higher housing starts is probably overdone. The banks’ problems are not yet fixed and underlying causes of the recession will take years to clear.

Bond markets, both primary and secondary, are taking a further step towards fulfilling role of credit suppliers as banks abdicate this task. The “L-bend” should be in autumn, then stagnation.

While hope of a “bend in the L” for summer looks forlorn, we still see chinks of light in darkness: China\s stimulus, corporate bond issues and the US anti-foreclosure programme.

When the sense of outrage has calmed down, the entire risk-encouraging bankers’ bonus system will require a second look. Prudence has to be reclaimed by the banking industry.

In a sense the bank lending market is handing over to the corporate bond market, which offers opportunities alongside many dangers. Select bonds very carefully!

To encourage bank lending in the USA, the new Administration is following a stealth policy of moving bad assets to the Fed and good assets to the banks.

One month into 2009 and the world seems to have reached a fork in the road: either some positive fruits of the many rescue packages will start to appear, or the recession will really worsen and turn into a depression.

Rebuilding the balance sheets of banks, households and governments, with all that implies for higher savings rates and taxation, means the leg of the L-shaped recession will be years long.

There is no denying the current strengthening of the USD and the deflationary environment. However, we see both as limited in time when the USA is “printing money”.

The Keynesian remedies are all very well, probably essential, but what about Schumpeter and his “creative destruction”? That is quite the opposite of the Greenscam remedies past and present.

Moving from overpriced government bonds to quality corporates, our recommendation last October, is now commonplace. The Madoff scandal has very negative implications for New York and for hedge funds.

The Madoff scandal crowns a year of serial disasters. Neither regulation not the hedge fund industry will ever be the same again. Obama is the focus of much hope.

The flight to quality is leading to a bubble in government bonds. A better yield/credit risk can be found elsewhere, notably in young corporate bonds and emerging markets.

Bernanke is walking a fine line between deflation and inflation. For the moment deflation is more to be feared, so his actions are all about stimulating inflation, including printing money.

When first the crisis broke, the USD strengthened, but there are good reasons to ask whether it was only a short-lived phenomenon, including the practice of "printing money".

How long will the recession last? One answer is as long as it takes for households to achieve a 3%-5% savings rate from the negative pre-crisis rate. One year? Four?

President-elect Obama has an intimidating task to repair the damage of the outgoing Administration, but they have more or less fixed the capital markets ready to face a long downturn.

Bond markets are moved back into difficult trading as market making is proving inadequate faced with large-scale liquidation even of quality bonds by funds facing margin calls or redemptions.

As investors move from panic, through shell-shock to quiet reassessment, they should separate the capital market crisis, which governments are solving, from the recession, which they cannot.

Weekly Comment

The UK Government injecting equity capital (preference shares) into banks before they need to be nationalized outright in panic may signal that exit from the storm is in sight.

This week we dare consider the moral implications of the GSE bailout, as well as reviewing the financial impact. Pity the next generation as they will pay the price.

The peril in which the entire US financial system now stands, with many banks and the GSEs fitting the category of “the walking dead’, is growing from week to week.

A return to a healthy level of household indebtedness and savings by the middle of next year? Just about conceivable, but the new film, “IOUSA”, needs a big impact.

As the turbulence in forex and commodity markets continues, we review this week where the world has reached in the rebalancing process. This may help in reaching a long-term view.

When stock markets enthuse about the Fed going on hold and commodity prices falling back, we can but point out that the underlying problems are worsening.

Major commentators (IMF, ML) are expressing what we have been emphasising for a year: this is no cyclical adjustment but a major realignment to match US earnings to spending.

A ray of sunshine with a fall in commodity prices and financial market optimism, but it can only be a brief respite as clouds return and spread beyond the USA.

While the CPI is way above target, asset prices, notably stocks and housing are falling. It may be therefore more meaningful to see this as a deflationary environment.

In combating inflation the credit squeeze may suffice in the medium-term, but, while waiting for its impact, central banks want to hold the fort with one or two rate increases.

The American consumer is now noticing the diversion of his already restricted spending power to costly food and fuel, squeezing his ability to pay back mortgage and other debt.

Inflation and recession together, and central bankers recognising that they had better fight the former now than risk a greater recession later: what does that mean for fixed-income investors?

In the debate dual-mandate versus inflation-focus for central banks, the ECB approach of “control inflation and the rest will follow” seems ahead with even the Fed coming round.

This week is seeing three turning points to do with the commodities bubble, vehicle technology and the attitude of the Fed towards inflation. The credit crisis’ second phase is underway.

High oil prices and a credit squeeze together: no coincidence. In fact, knock-on and secondary effects of the cheap money policy of the USA are our themes this week.

Against a background of unrelenting bad economic news, we consider the looming dangers of the world’s largest unregulated insurance and financial market: credit default swaps.

The data used to calculate LIBOR may be improved by threatening the participating banks, but how can we deal with official statistics which have been creatively manipulated for decades?

All the economic news is negative or not so bad as expected. We therefore suspect a bear trap, which may even extend to some bonds. Beware Credit Default Swaps.

The central banks have done a good job on liquidity, but the credit squeeze, the US recession and inflation rather suggest the current calm is the eye of a storm.

Three dangers: credit crisis, recession and inflation. Only the first is being dealt with, and then essentially only in terms of liquidity. Expect a “U”-shaped recession with a long base.

We have long identified three underlying causes of the crisis, but this week the figure three arises again in the dangers threatening an orderly move to a rebalanced world economy.

Neither excessive optimism or pessimism is appropriate. US recession is a key component of economic rebalancing and just may be being given the time and conditions for orderly work through.

Can central banks give an implicit guarantee that they will allow no bank to fail without reintroducing the moral hazard which has done so much to cause the crisis?

The consequences of the credit squeeze have so many dimensions that we can appropriately speak of the end of an era, or of history in the unfolding.

Another Fed boost, another stock rally, but this is all palliative. Inflation and recession in the USA, but the Rest of the World may get off lightly.

This crisis is not just about illiquidity but also about insolvency and the fear that borrowers, including banks themselves, will not repay. The Fed “boost” misses the point.

The disarray in US economic policy in both the contradictory appeals by Paulson and Bernanke regarding mortgage bail-outs, and by a constantly changing approach to the monoline problem.

If you thought that banks had already recuperated off-balance sheet vehicles, think again. Variable Interest Entities, an Enron device, have yet to play out with the downgrading of monolines.

Cannons to the left of us, cannons to the right. In this case sub-prime losses being revealed across Europe, not just the USA, and monolines in slow collapse.

The signs are that, while talking reassurance, the US authorities are really moving towards damage limitation. What the Buffett intervention really implies is that monoline insurers can go hang.

If Europe and Japan authorities are reluctant to follow the same path their US counterparts, are we really moving towards serious rebalancing, even if via a shared recession?

Be a fly on the wall for a discussion amongst US policy makers. Any resemblance to people living or dead is purely deliberate. Be duly frightened!

Greenspan put Mark II has been put into action, but seems unlikely to reverse economic decline. The UK is as bad as the USA, but inflation is more explicitly admitted.

Systems failure, first cited by us last July, is now apparent and will demand months or years to repair. Contagion from the USA is looking more serious than we thought.

For perhaps the first time in a hundred years, the world economy may be able to expand despite a slowdown, or even a recession, in the USA.

The central banks are doing all they can to resolve the liquidity crisis, but they can do so little about underlying solvency problems. Only time can solve them.

Against his better judgment, Bernanke has cut the Fed rate, thereby dissatisfying everyone, including himself. What the USA needs, and Bernanke knows this, is lower consumption for economic rebalance.

US consumers are still spending like there will be no tomorrow. That may be their motive! In the UK, in contrast, the credit squeeze is beginning to bite.

Another “Tuesday effect”, with Abu Dhabi buying into Citigroup, does not mean a change of fortunes. Now another securities class, “auction bonds” is contributing to the loss of confidence.

Each dispersal of the fog reveals greater sub-prime losses, contagion to other markets and more reasons to expect a continually falling dollar. And bond market liquidity is again worsening.

A rebound in stock prices after several days of falls could signal a change in mood, but we doubt it as the underlying US economic problems are far from resolved.

If you thought it was "all clear" after the credit squeeze, think again. Some banks could even be in serious trouble, but they all have much less to lend.

Beyond the week-to-week developments of financial markets, a “mega-trend” is firmly underway, providing a background to individual events: the shift of economic power from the West to the East.

From Euromoney’s AsiaHedge Conference in Hong Kong, the USD and the US economy look very weak. Investors here plough on, while in the West “wait and see” rules.

Whether the USA and other countries are heading for inflation or deflation is far from obvious. Consider both sides of the argument to review likely Fed rate moves.

The UK has US-like symptoms of a housing bubble and a sub-prime mortgage market, fed by unscrupulous selling, inadequate due diligence and lax supervision. Expect changes in financial market regulation.

One of the financial market problems, bank illiquidity, is slowly being solved. However, the US economy is facing slowdown or recession. We hope the rest of the world will cope.

The Fed rate cut may have been justified, but it does not solve deep-seated problems, notably falling house prices. But at least serious rebalancing of the world's economy is underway.

Bernanke has put sticking plaster on the wound, a necessary but insufficient move. The problems of overspending and housing remain, and the immediate credit crisis has yet to be solved.

The US economy is slowing because of the sub-prime failures, but, as central banks fail to solve the bank liquidity crisis, the credit squeeze will amplify the effect. Recession?

While the Fed is focusing on solving the credit squeeze, any target rate cut this month will be to avoid a recession resulting from the bursting of the housing bubble.

A systems failure means the system must change. Consider how, and follow through the logic of the housing bubble busting, the credit squeeze and the carry trade.

Bank liquidity is the single main problem the US policy makers should focus on. Only T-Bills are wanted when banks will neither lend to each other nor trade commercial paper.

Even as financial markets almost beg Bernanke to bail them out with a cut in rates, he continues to stress inflationary fears, which seem quite justified as China’s prices rise.

A major step to world rebalancing has taken place with credit markets reflecting a more appropriate risk/reward relationship. We would see Bernanke accepting a slower US growth as desirable.

Credit markets remain more alert to dangers of CDOs and the credit squeeze than equity markets, but if the tail strikes, too, watch out! We mean carry-trade unwind.

It is right to focus on sub-prime related CDOs, but the de facto credit squeeze, with wider spreads and more severe terms for corporate loans will have even wider negative repercussions.

Systemic failure by the US financial system is tacitly admitted by the Fed “pilot scheme: on mortgage supervision, but is also apparent in the absence of market prices for CDOs.

The sub-prime/CDO crisis is not just about “knock-on effects” as risk aversion grows, but is a sign of systemic failure by the US financial system. Expect serious pressure to reform.

Sub-prime and CDO problems are just not going away, despite attempts of banks, rating agencies and regulatory authorities to pretend otherwise. Odd that the UK’s FSA should speak up, though.

Bond Outlook [by bridport & cie, June 27th 2007]

The shift of foreign purchases from US T-Bonds to other bonds and equities reflects government decisions about reserve management. Normalisation of the USD yield curve will have serious repercussions.

The USD vulnerability we expected has not happened but bonds and stocks have proven very sensitive to higher yields. We offer our explanation in terms of surplus countries’ investments.

Bond yields moving towards higher levels spells out a new environment in which good returns from bonds and shares will be hard to come by. Watch for further USD vulnerability.

Switzerland is enjoying a cheap currency, a property boom and expanding labour. We draw parallels with Spain, UK and Japan and seek a general conclusion about labourforces everywhere.

While the Fed may be worrying about excess cheap credit, the Chinese may be doing something about it as they divert some of their investments to private equity.

As if a housing bubble were not enough, a new one is inflating in junk bonds linked to LBOs. 1989s revisited? Even “toggle bonds”, a new name for “bunny bonds”.

The housing bubble deflation pushing toward a Fed rate decrease, and the tight labour conditions still threatening inflation and a Fed increase. Which will win the “race”?

An asset bubble on a global scale? What happens when it ends? How do investors prepare for its end? Seek matching risk and return while decreasing overall risk?

We keep insisting on sub-prime problems still to come. USD 75 billion may be the loss to date for buyers of opaque and illiquid US mortgage-backed bonds.

The news this week, including a still weaker USD and a politico-economic rapprochement of China and Japan, suggest global rebalancing is advancing nicely. US household consumption has yet to moderate.

Moody's Investors Service cut the credit ratings of 44 banks, including units of ABN Amro Holding NV, ING Groep NV and Fortis, as it seeks to calm protests over a new system for assessing financial institutions.

The sub-prime problems are spreading and will eventually wash through to consumer spending, but good news that a weaker USD is really helping US exports, while Europe is holding its own.

Are we wrong as equities climb and bonds are not doing much (although USD yield curve is steeping as foreseen)? The real and the financial economy seem out of synch.

Bond Outlook [by bridport & cie, March 21st 2007]

Cracks in the sub-prime mortgage market have turned into crevasses, and cracks are appearing all over the housing loan business. First reaction of the authorities? Mutual blame!

The market correction is not over, as the root causes, housing and carry-trade, remain. A slowdown in the USA means interest rates, except in Japan, at or near their peaks.

Financial markets look wonderful, but the real US economy, where goods and services are exchange, might better be described as “woeful”. When will the two align to each other?

Two root causes lie behind the loss of confidence this week: the poor results for US durable goods and sub-prime mortgages resulting from the end of the housing bubble.

What can upset the unstable structure of the world economy? A rebound in the JPY for one thing, a relentless shift away from central bank buying of T-bonds for another.

None of the longstanding problems of the US economy have been properly addressed, so we are beginning to doubt our own optimism of recent weeks. What a challenge for Bernanke!

Is the future of the CHF linked to the JPY’s and possible unwinding of the carry trade? For those expecting curve steeping in Euroland, new CMSs are available. But beware!

The CHF has weakened further and must be worrying the SNB by now. In the meantime, the Fed is trying to remove excess liquidity, but failing miserably.

Diversification in the currency mix of fixed-income portfolios is the order of the day. However, the CHF seems left out of the party as it loses safe-haven status.

Over the last week the market has espoused the view that a decline in the Fed rate is unlikely even after a few months. But there are arguments both ways.

Central Banks loath wage inflation. Whether governments want to see greater household spending or not, Central Banks will always apply brakes. Do not therefore expect a decline in interest rates.

Our optimism about a US soft landing based on lower oil prices has been encouraged by wage increases improving households’ spending power. Expect no quick change in the Fed rate.

Just two things really matter: the US housing bubble deflation and Chinese policy on the USD. If these allow a soft landing, rest of the world may escape serious problems.

The cracks in currency parities are starting to show, and it looks like they will widen further. Bernanke’s speech is not quite in line with market perceptions about interest rates.

We all remember the “Greenspan put”. Central Bankers are doing something similar with currency markets, and the consequences are similar: to delude investors into discounting risk, and delaying the inevitable.

When interest rates are moving little or predictably, it is time for fixed-interest investors to turn to thoughts of … currency. Our view is necessarily long term.

Yield curve inversion usually signals a coming recession, but, overall, the global economy looks good. Can there be another explanation for inversion linked to high global liquidity?

Will the rest of the world pick up where the USA leaves off? Opinions vary totally, but on that question hangs the future of the world economy.

The great debate goes on: will the next change in the Fed rate, some months off, be up or down? Most of the banks think "down" because the US economy will stall; most of the fund managers think "up" because inflation is still threatening. Either way the stock markets are bullish, be that because they expect lower rates, or because the economy will do so well that higher rates will be required, or, rather, justified for the right reason.

Financial markets in direct contradiction with most major banks! Who is right? Our optimism on the USA is very cautious, although quite high for the rest of the world.

The delay in the ending of mortgage equity withdrawal means it is far too early to declare the impact of the housing correction to be over as Mr Greenspan suggests.

The key issue to determine soft or hard landing – geopolitics aside – is whether US household gains from cheaper energy will compensate the return to savings as the housing bubble deflates.

If the current more-moderate oil prices persist, the fear of returning inflation is much attenuated, as is that of recession. The Fed rate can stay where it is.

Is this a commodity bubble? Are emerging markets becoming dominant? Two further key questions for all investors, beyond that of whether the Fed will raise rates again and when.

We still favour an optimistic scenario with a soft landing, but note with some concern that mortgage equity withdrawal has not yet ceased as the housing bubble deflates.

We consider four economic scenarios ranging from “Goldilocks” to “Catastrophe”, and argue for the one we favour (a fairly soft landing), while admitting a risk of something worse.

Our attempt at answering key macro questions includes Fed hikes later in the year and another hike in the UK and Euroland. It will a close thing to avoid recession.

At first sight PPI and CPI figures give hope that inflation has been beaten. We doubt it, although the markets inclines that way. Those cost-push pressures are still present.

The Fed pauses lest the slow down be too severe, but continued tightening is likely everywhere. Our old idea of a monolithic and centralised economy is in need of correction.

We still do not believe that Fed tightening to over, and present four arguments this week as to why we take that view, minority though it may be.

Bernanke saying that the economy is slowing, therefore inflation beaten, is both premature and another example of a flip-flop. The Fed will have to continue tightening to control inflation.

A look a continued inflationary pressures coming through in the US and likely effects on US Monetary Policy. Is the Middle East situation a buying opportunity?