Oct currency and bond outlook

While the fallout from hurricane Katrina continues, the second hurricane of Rita caused less damage that was expected. The price of oil is off its high, but remains at around $65 p/b. The main issue of refinery constraint rather than oil supply continues and the combination of the two hurricanes has closed refineries in New Orleans and Houston reducing US capacity by 28% - this is significant in an already tight market for petroleum products. OPEC has tried to ease the problem by releasing more crude on to the market; however the oil market is really looking for the lighter crude (rather than OPEC's largely heavier crude) and refined products. This move seems largely aimed at stopping ‘western' governments trying to blame the cartel for the high oil price. Be assured of one thing; that the US budget deficit is going to increase as they look to rebuild and have to import more oil / products.

The Federal Reserve has been transparent about their intensions for a long time and continues to be so. They raised the funds rate another ¼% in September to 3.75% and the accompanying statement mentioned their now usual phrases such as ‘accommodative' and ‘measured'. Unless the Fed makes other noises expect another rise at the next meeting and probably one in December taking the Fed Funds rate to 4.25% by year-end.

Interestingly the Institute of Supply Management (ISM) survey for August was stronger than expected at 65 (up from 60.5, when a slight drop was expected) as was the revised 2Q GDP at 3.3%, which suggests that the economy was certainly quite strong prior to the hurricane, although the consumer confidence number for September was much lower at 86.6 that August's 105.5. Consumer confidence will again be rattled in western economies by the terrorist blasts in Bali (on October 1).

While the IMF raises concerns about risks to global growth, it worries more about the global imbalances and the impact on growth of the high oil prices, the dollar has gained strength from the continuing and increasing prop of the Fed raising rates and the probability that this will continue. This is compounded by problems in three of the largest Euro-zone economies - Germany's ‘hung-parliament', which could mean a re-election, France's lame president (following the referendum defeat) and Italy's Prime Minister and his party falling in the polls with the central bank governor (Fazio) under political pressure.

The German General Election gave the markets the worst result possible, with effectively a ‘hung' parliament and now, probably weeks of wrangling as a coalition is formed. The leaders from the two main parties (Schroeder and Merkel) have both claimed victory and both staked a claim to be Chancellor, a result that could bring about a reelection.

Elsewhere in Europe, the OECD believes that some government forecasts, particularly the UK are too optimistic and they have reduced their own forecast from 2.4% to 1.9% for 2005. Even the Bank of England's forecasts are looking on the high side. While the UK (as expected) left their rate on hold in September, another cut is likely, but the BoE will want to wait for the time being to see the impact of their recent move (also see below).

The key is the inflationary impact of the rise in oil. While it might be creeping higher, if it can remain broadly contained monetary policy can still be regarded as ‘easy' (with the US moving towards neutral).

The US trade deficit (for July) was announced at a narrower level than expected at $57.9bn (expected at $60bn), which was also narrower than June's $59.5bn, mainly due to a fall in imports (oil & non-oil). The Fed will get worried if the deficit climbs over $60bn, driven by energy costs. More importantly the Philadelphia Fed index of business conditions fell to just 2.2 from 17.5 in August, which is perhaps a better indicator of the current conditions. US unit labour costs showed an increase with the unemployment rate falling to 4.9%.

The Euro-zone unemployment rate (as a whole) fell to 8.6% in June (from 8.7% July). German Industrial production rose 1.2% in July and manufacturing orders up 3.7%. Preliminary inflation figures suggest the rate is creeping up further to 2.4% (from 2.2% in August). The ECB are still suggesting no change in rates for the time being, but that the next move is up. The futures market believes the rate will not move until mid-2006. The ZEW index of economic sentiment fell sharply in early September to 38.6 from 50.0, while later the IFO index of business confidence unexpectedly climbed to 96 from 94.6. (Exports doing well to help support growth)

While in the UK industrial production fell by 1.6%in the year to July (June also declined). The UK trade deficit widened in July seeming to confirm weak growth with the rising oil & petrol price coupled with Sterling falling off, increasing the inflationary fears, which were highlighted by the August report showing the CPI rate increasing to 2.4% from 2.3% - the highest rate since the introduction of this measure in 1997. Household spending is likely to fall off further and consumer credit growth is about half that of last year. The UK economy looks certain to grow at a slower pace, more in line with OECD predictions, which means the Chancellor will struggle with tax receipts.

Prior to the government's party conference the Chancellor was coming to terms with having to accept that the UK is growing at a slower pace, marking his forecast down to slightly below trend of 2.5% from the 3-3.5% previously. The Confederation of British Industry survey showed retail sales volumes falling at their fastest rate for 22 years - High Street sales are very weak with a number of retailers going into administration in September. Overall this is quite dangerous for the UK economy with growth slowing and inflation ticking up.

The government's Labour Party conference is highlighting increased strains between the Prime Minister and the Chancellor as to when the PM will stand aside. With the PM probably wanting to stay in power longer than Margaret Thatcher, the Chancellor will have to wait at least two more years and it could be 4. If accurate this will undermine any reforms and the government's credibility.

Mr Koizumi, the Japanese PM was re-elected following his calling of a ‘snap' election. While this is in line with the polls prior to the election it is a boost for structural reform in Japan and will continue to help the currency and the stock market. Going forward there is much work to be done to take advantage of this mandate, while Mr Koizumi confirmed his intention to retire in September 2006 it is important to see how the work will be carried forward. On the economic front GDP for 2Q was 0.8% (annualised 3.3%). The trade surplus narrowed more than expected (for August), which took a little shine off the Yen, while sentiment among manufacturers has picked up over the last quarter.

Currency summary

• Undervalued:Canadian Dollar, Norwegian Kr, Swedish Krona
• Neutral: Australian Dollar, Euro €, Japanese Yen, Danish Kr, Sterling (£), Swiss Franc, New Zealand Dollar
• Overvalued: US Dollar
• Attractive smaller currencies: SA Rand, Polish Zloty, Korean Won, Mexican Peso.