After Katrina: the issue of high liquidity conditions remains a concern.

AS THE UNITED STATES grapples with the devastating events of Hurricane Katrina, economists, analysts and policy-makers attempt to reassess future developments in markets and the effect that reconstruction costs and rising oil prices might have in the United States and the global economy.

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With all the questions still left unanswered, certain issues remain clear. First, reconstruction spending allocated to the Southeast United States will widen an already large fiscal deficit. Second, higher oil prices will threaten long-term economic growth in the United States. As a result of these pressures on the U.S. economy, there is little room for long-term U.S. Treasury Bonds to move up, thus maintaining liquidity conditions high and rendering monetary policy unable to cap consumer spending. The issue of sustainable high liquidity conditions due to "strangely" low long-term bond yields remains a valid concern.

China's participation in the U.S. economy during the immediate aftermath of Hurricane Katrina also seems obvious. Bearing in mind that China, a country that subsidizes internal oil consumption, is the second largest official reserves holder after Japan with US$ 711 billion (excluding gold), it is sensible to expect higher, or at least stable, demand for long-dated U.S. securities in order to back their current purchase of crude oil.

Less clear, however, are the policies of the Federal Open Market Committee (FOMC) during the fallout of Hurricane Katrina. Is it prudent for the FOMC to continue with the monetary tightening cycle in spite of the financial pressures facing the American economy? I believe so. Consumer prices reached an annual inflation rate of 3.1 percent in July, while August and September reports are expected to be more negative. Some argue that the Federal Reserve will have to do something to boost the economy as they did after September 11, 2001. In that time, however, monetary conditions had already begun an easing cycle with a 50 basis point cut to the Fed Funds target rate at each meeting from 6.50 percent in January 2001.

Today, the United States is in the middle of a restrictive cycle with the intention of reaching more neutral monetary conditions; a goal that even before the disastrous events of Hurricane Katrina seemed challenging for the United States to achieve. Despite the pressures to ease conditions and stimulate the U.S. economy, following the tightening policy as implemented before would not be badly regarded. Alan Greenspan, the Fed's Chairman who retires in January, has been very strict in ascertaining that whatever course of action the U.S. Central Bank chooses, it makes a long-lasting positive effect.

In Mexico, softer economic data and record-low annual core inflation (3.28 percent year-on-year in August) have resulted in a gradual relaxation of local monetary conditions. In this context, local bond yields have dropped dramatically resulting in a negative slope of the yield curve, keeping a very optimistic view on interest rates. The Mexican Stock Market Index reached another historical peak in early September at 15,257.6, disregarding unfavorable economic data and relying on expectations of lower interest rates. For instance, construction companies with operations in the United States will see a good outcome from reconstruction of the affected areas.

At the same time, these tighter interest rate differentials between Mexico and the United States have resulted in a moderate fall of the Mexican currency against the U.S. dollar. Anticipating that the United States will continue to tighten and Mexico will continue to loosen monetary policies, the Mexican peso can be expected to fall moderately against the dollar throughout the remainder of the year. Foreign investors' vision of Mexico as an attractive, emerging market, however, will balance locals' tendency to purchase dollars in times of economic insecurity and hence, maintain a moderate, controlled depreciation of the Mexican peso.

In November, further clarification of the pace of monetary policy in the United States will be unveiled. Until then, however, capitals continue to look for returns in emerging markets within a high-liquidity context and, as a result, we are bound to see benign conditions through October. Though we have yet to witness the last of the events of Hurricane Katrina, Mexico still boasts favorable conditions for global market players.

Adrian Rizo is responsible for the development of investment strategies for local debt and foreign exchange markets at HSBC Mexico.