THERE was a little corrective activity in the middle of last week, but the story this quarter for the S&amp;P 500 has been positive: the index has notched up gains of over 11 per cent. But we shouldn&rsquo;t start getting too excited just yet. The S&amp;P&rsquo;s gains sit uncomfortably with the gloomy rhetoric that is still coming out of central banks. It is possible that the central banks are being overly cautious, but the other possibility is that the market&rsquo;s general feeling of optimism might be over-stated.<br /><br />The Federal Reserve last week published the minutes of its April 28-29 meeting, and the gloom expressed took the market by surprise, as did the dovish tone of the Bank of England Inflation Report, published earlier this month.<br /><br />Similarly, the May announcement by the ECB to start buying covered bonds (albeit conservatively) was also unexpected. While the market has hung its hat on the perception that economic conditions in the second quarter have improved, the central banks seem less willing to commit.<br /><br />Most economic data are suggesting that the pace of deterioration in the second quarter may not be as sharp as in the first. But the first quarter was utterly dismal. While it is possible that the global economy may have reached a point of inflexion, there is no economic data yet that suggests that the recovery we may see from here will be V-shaped. More likely, most countries will struggle this year to shake off the shackles of recession. This suggests the recovery will at best be U-shaped; the economic fortunes of some countries may even be W-shaped. Faced with what could be a difficult and lengthy struggle before decent levels of growth are seen again, it is possible that further easing may be seen from the Fed, the Band of England and the European Central Bank.<br /><br /><strong>UNORTHODOX POLICY</strong><br />Sterling and the American dollar have both suffered on the back of the unorthodox policy measures employed by their respective central banks. Last week, however, fiscal policy shifted back into the spotlight and the dollar and the pound again wavered, this time under the fear that the massive amount of fiscal spending used to address the financial and economic crisis in the US and the UK could lead to a downgrading of their debt ratings.<br /><br />While the pound was initially hit hard on last Thursday&rsquo;s news that S&amp;P has revised its debt rating outlook to negative to stable, it recovered relatively quickly as other agencies reaffirmed their strong ratings and as the market digested the fact that the poor outlook on the UK public finances was not new. the pound is still about 30 per cent weaker against the euro than its pre Northern Rock levels. Against the dollar it remains about 20 per cent softer than its September 2007 level. Current levels of sterling continue to reflect a significant amount of negative news. This suggests it is likely to continue to attract buyers and it will remain more sensitive to positive news than to bad news going forward.<br /><br /><strong>COMPLICATED OUTLOOK</strong><br />The outlook for the dollar is complicated by the severe US dollar funding shortage that was evident during the height of the financial crisis. Libor, which is seen by many as a barometer of the tension in the financial system, has now eased markedly. As a consequence, it seems likely that many long dollar positions built during the crisis are now being unwound.<br /><br />If confidence in the global recovery and financial system were to recover further over the summer, the dollar could see additional weakness. But investors should be wary. The cautious tone of the central banks may prove to be extreme, but it is unlikely to be misplaced. The current recession is deep enough to expect that further bad news will be seen and this could prompt further safe-haven buying interest in the dollar.<br /><br />In view of the risk that the market&rsquo;s current outlook on the global economy may be over-confident, sterling longs may prove to be more successful against the euro than against the dollar. While sterling has paid a heavy price over the past 20 months for the banking crisis and the deterioration in the national accounts, the euro has been let off fairly lightly. Yet last week Caja Madrid announced it will skip an interest payment on its bonds.<br /><br />Eurozone banks may not have been heavily exposed to US subprime debt but with unemployment in Spain forecast to reach 20 per cent next year it is hardly surprising that the level of bad debts closer to home have increased. More negative news from European banks is a risk suggesting euro-pound could claw its way back towards its year to date low at 0.8640 and potentially lower.