Welcome to the first Prometheus of the year, and a prosperous 2006 to you all.

Most lead indicators are looking rather encouraging at the moment. Today Prometheus takes a look at the market which will likely make or break the year for investors – the US

Fed Policy: The end of rate hikes is in sight

There is an excellent chance that the U.S. monetary tightening cycle will end without policy having to become overtly restrictive.

The December FOMC minutes noted that most members believed that “given the information now in hand, the number of additional firming steps required probably would not be large.” Another rate hike at the end-January meeting seems likely, barring some unforeseen shock, and Chairman Bernanke may choose to flex his muscles by tightening policy at his first FOMC meeting in March. But that should be the end of the tightening, if the pace of economic growth cools as expected. FOMC members’ inflation concerns have eased, but have not disappeared. Bottom line: Expect that inflation will continue to surprise on the downside, making is easier for policymakers to move to the sidelines.

U.S. Yield Curve Inversion is a cause for concern: but it should be 'different this time'!

The inversion of the U.S. yield curve does not signal a high risk of recession in 2006 because real interest rates are still low.

The yield on U.S. 2-year government notes fell below that on 10-year notes last week for the first time in five years. As Border pointed out in their January Newsletter, historically an inverted yield curve has been a harbinger of a slumping economy. However, several factors distinguish the current situation from past periods when the yield curve inverted. These include the ongoing decline in the inflation risk premium, the global savings glut and demand at the long-end of the yield curve spurred by regulatory changes. Perhaps most importantly, real short-term interest rates remain very low—they were substantially higher in the two prior periods when the yield curve inverted.

Some comfort can also be drawn from the experience of the U.K. and Australia which have been at the forefront of the global monetary cycle and where both central banks tightening earlier than the Fed or ECB. The Bank of England (BoE) began hiking rates in the final quarter of 2003, and continued tightening for nine months. The yield curve (10-year yield minus 2-year yield) steadily flattened while the BoE was tightening and has mildly inverted in recent weeks. U.K. stocks have trended steadily higher for most of the period, on the back of good earnings and a strong global backdrop. The Australian experience has been similar. Bottom line: With core inflation contained, the Fed has no reason to crunch the economy.

Other news……..

Bird flu - an objective view

Now that most of us have digested our Christmas turkey, fears about avian influenza are making the headlines again as the number of confirmed cases in eastern Europe rises. The situation needs careful watching, but there is no need to panic yet.

The news since October has actually been relatively reassuring, in two respects: Firstly, the number of people infected in this outbreak remains low, the key point being that the casualty numbers are increasingly only slowly, and certainly not at the exponential rate that would indicate a pandemic. Secondly, there is still no evidence that the current strains of bird flu have mutated into a version that can be transmitted easily from human to human. This risk does need to be taken very seriously. Influenza has a long track record of killing large numbers of people. However, all of those affected in Turkey (as in the Asian countries) have come from poor rural communities where vulnerable people are constantly in contact with live poultry. There appears to be no risk, for example, to Western tourists.

Nonetheless, it is likely that bird flu will spread to the UK and the rest of Europe at some point. The chances of someone visiting Turkey and catching bird flu appear to be extremely small. But there is a high probability that bird flu will find its own way to the UK: the disease can be carried by migrating wildfowl which obviously do not respect national borders. This will inevitably involve some direct costs, caused for example by bird culls and restrictions on the movement of poultry. These costs may well have to be met by the government at a time when the public finances are already shaky. For comparison the cost to the Exchequer of the BSE crisis in the 1990s has been officially estimated at £3.7bn.  In addition there may be significant indirect costs, such as lost tourism revenues as potential visitors from countries like the US chose to stay at home. However, these costs should be localised and manageable: the UK economy as a whole emerged largely unscathed from the BSE crisis, and from the “foot and mouth” outbreak in 2001, despite the substantial damage to some sectors.

The much more serious problems arise if bird flu mutates into a version that can be spread to humans. The broader economic implications of a flu pandemic are likely to depend on three things: who is affected by the virus, the measures taken to control the disease, and the wider impact on confidence. One might add a fourth factor: the length of time it would take to produce an effective vaccine. In general, health problems such as HIV-AIDS which typically affect people who are active in the workforce tend to have a much larger economic impact than those such as SARS which mainly affect the very young or the elderly. Any new form of influenza is likely (though not certain) to fall into the latter category. Nonetheless, past experience of pandemics suggests that up to a quarter of the UK population could develop flu, and 10% may have to take time off work. (HSBC is reported to have an emergency plan based on the contingency that up to 50% of its staff are affected, but this is very much a worst case scenario and not a forecast). Measures to control a pandemic might have economic implications which are much larger than the direct impact of the disease itself. Examples could include travel bans, school closures, and disruption to emergency services, all of which could have major knock-on effects on normal economic activity. These costs could prove to be much larger than the costs of measures to deal with the source of the disease, such as culls. Finally, one needs to consider the impact on confidence. Fears of infection, whether justified or not, may have a big impact on sectors such as retail spending and tourism as people opt to stay at home. That proved to be the main cost of the 2002-2003 SARS outbreak in Asia, though regional growth rebounded strongly once these fears lifted.

Overall, the economic and market implications of a flu pandemic are potentially very significant. However, at this stage there is no reason to panic. There are still none of the usual warning signs of a pandemic (such as transmission to health workers) even in the South Asian countries where bird flu has been common for many years. In the meantime, worries about bird flu have at least had the unanticipated benefit of improving the take up of vaccines against ‘ordinary’ flu, and possibly shortening the time before an effective vaccine against bird flu becomes available. Bird flu is also now less likely to reach the UK until after the worst of the winter weather; just as with ordinary flu, this means that fewer people are likely to be at risk. The key point is therefore that the mutation of the current strains of bird flu into something much more serious is still a theoretical risk rather than an actual event. A crisis of this kind is almost certain to happen eventually, as it has done before, but the evidence of an imminent threat is still limited. Bottom line: Unless there is some major new development, one should continue to focus on the downside risks to the world economy from more conventional causes!

STOP PRESS - BoE holds rates again

While the MPC's decision to leave rates on hold was no surprise, the prospect of  further weakness in activity and a fall in inflation back below the 2% target in the coming months suggests that rates will fall later this year. Admittedly, the resurgence in high street activity has decreased the chances of a near-term cut. December's BRC retail sales monitor was strong and trading updates from Next and M&S suggest that the Christmas sales period went reasonably well. But the weakness of consumer confidence suggests that this improvement may not be sustained. The January pay round is still a concern. But the earliest pay announcements have been modest and earnings growth has continued to fall. In any  case, CPI inflation looks as though it has peaked. And as the previous rises in oil prices continue to drop out, it is set to fall back below 2%. If the MPC does not cut rates further, it therefore runs the risk of presiding over a significant undershooting of the inflation target. Bottom line: UK rates could fall to 4% by around the middle of this year and stay low in 2007, suggesting that there is plenty of scope for market rate expectations to fall.

And finally…………..

A South American Scientist from Argentina, after a lengthy study, has discovered that people with insufficient sexual activity in their lives tend to read their e-mails with their hand still on the mouse.....

Don't bother taking it off now, it's too late

HAPPY NEW YEAR!

Prometheus from sources: ADM, Barclays Capital, Cazenove, Charles Stanley, HSBC, ING, SocGen, UBS.