Next few months are crucial for the financial markets

The original objective of fiscal and monetary policy was to even out the waves in the economic cycle. This meant building up budget surpluses and raising interest rates in good times and allowing budget deficits to mount and lowering interest rates in leaner times. On balance, however, this should have meant neutral action. This is not what happened in practice. On balance, interest rates have been kept too low and governments have virtually only had deficits. This process is now reaching all kinds of limits. There is little point in allowing budget deficits and debts to mount much further. The same applies to keeping interest rates low and continually creating extra money.

There is an extra complication in Europe, as there is hardly any more room for stimulating the economy through fiscal and monetary policy. If the EMU is to be maintained, then the northern European countries will have to dig deep into their pockets to rescue the southern countries. This is highly unpopular in the northern countries. This also applies to the southern countries, as the northern countries are setting numerous requirements.
Growth has been higher in the US recently. If this continues, then speculation of higher US interest rates will soon increase. It is also possible, however, that growth will decline again in a few months’ time. After all, various factors that are now helping growth are falling away.

Implications for the financial markets

EUR/USD has become highly oversold, so a correction of a few weeks to months to 1.35 – 1.40 would be quite normal. In view of the bad situation Europe has ended up in, we consider 1.30 – 1.35 more likely. Should the S&P 500 Index fall below 1080 and EUR/USD sink in response, then there is a good chance that both will fall further for the time being. Roughly 1.10 is the next target. The S&P 500 Index falling below 1080 and as far as below 1040 would also indicate that the outlook for the world economy is deteriorating fast. The world economy is starting to look like a rudderless ship. Finally, we think it is likely that downward pressure on interest rates will continue in the West.

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