Sunday, March 22, 2009

The Weekly Bottom Line

HIGHLIGHTS
  • Federal Reserve buys additional $1.15tr in debt
  • Canadian retail sales and CPI see temporary pops

For a central bank with interest rates effectively at zero, the Federal Reserve still knows how to make a splash. The Fed made a historic decision this week to nearly double the size of its balance sheet, which would include the purchase of $300 billion in U.S. Treasuries. But the actions should be judged by how they moved the market. And by that account, 5- and 10-year U.S. Treasury yields have receded to their level of two months ago while LIBOR-OIS spreads - which measure the ongoing elevated costs of lending between banks - have receded to their level of mid-February. That should help reduce borrowing costs, but oil prices are back above $50 and higher than they have been in four months.

There are a lot of large numbers being thrown around these days. People are moving from vertigo to being desensitized by the day, and could be excused in wondering whether google is just a company, or the soon-to-be level of their national debt. But, it may be a good idea to run through some of the many staggering numbers that have been popping up in global markets in recent weeks. A bit of Economic Novocain, if you will, because we are living in the age of extreme volatility and big numbers, and they are only going to get bigger.

$1.15 trillion: New Fed purchases of debt over the next six months. $850bn of this is mortgage-related debt while $300bn will be U.S. Treasuries, especially between the 2- to 10-year maturities. Buying $300bn over the next six months is a lot, but the Treasury will be issuing more than that over the next three months. So this is much more the Fed dipping their toe into the water rather than a waterfall of cash into the economy. While the Fed's balance sheet had begun to shrink to close to $1.8tr (see graph on next page), this action, if fully carried out, would take it near $3tr.

$40 billion: The amount of net new cash in circulation due to the Fed's actions to date. In the decade prior to the September 2008, currency in circulation in the U.S. tended to grow by about $660mn per week, or $34bn per year, like clockwork. In the 25 weeks since then, it has grown by $2.3bn per week. This comes out to $1.6bn in net new currency each week, or $40bn in total, over the usual pace. So by increasing their balance sheet by up to $1.5tr over the last six months (before this week's decision), the Fed managed to get an extra $40bn in net new currency - a little over a year's worth - circulating in the economy. But with rising unemployment, financial uncertainties, and cash constrained banks, cash just doesn't circulate like it used to. So maybe that still isn't enough.

40 basis points: $300bn in Treasury purchases would be very roughly equivalent to a 40bps reduction in the Fed Funds Rate. From October to December, the Fed cut the Fed Funds Rate by 187.5bps (to the midpoint of the current 0-0.25% range). Over the same period, 5- and 10- year Treasury yields fell by about 150bps. So given that 5- and 10-year yields fell by about 50bps following the Fed decision this week, that translates to about 40bps of implied easing from the Fed. It helps, but it hardly seems a game changer. Especially when we consider that Taylor Rule estimates - a benchmark economists use to determine where interest rates should be given the divergence of the economy and inflation from desired levels - suggest the Fed Funds Rate should currently be at -2.40%. In other words, if $300bn in Treasury purchases was the equivalent of 40bps, this benchmark says the Fed needs to buy another $1.5tr to reduce benchmark borrowing costs for households and businesses.

$15.7 trillion: The total amount the Fed may need to buy given mental math from the Bank of England (BoE). The Fed's decision seems to have been influenced by the success the BoE had in beginning similar purchases of government bonds earlier this month. The BoE meeting minutes released this week showed that their range of £75- 150bn in government debt to purchase was the result of figuring that nominal GDP had grown by about 5% annually over the last decade and inflation had on average been near target over that period, as well. So given their forecasts for nominal GDP growth in 2009 and 2010, the difference from a 5% growth rate came out to about £100bn. Assuming the same dynamics in the U.S., this would imply the Fed would need to buy $15.7tr in government debt. One problem here is there is less than $7tr even in public hands at present. This illustrates two points. First, when it comes to quantitative easing, there are no rulebooks or best practices to follow. And second, for the Federal Reserve, there is likely trillions to go before they sleep.

$1.8 trillion: Applying the same BoE math to the Canadian economy, the amount of government debt the Bank of Canada would need to buy. But once again, that's more than the existing level of debt. Our own preliminary assessment is the BoC may need to venture in with about $60bn in purchases, evenly split between government and corporate debt, but the risks certainly seem skewed to the upside.

-94.8%: 3-month annualized pace of contraction of Canadian auto production in January. That means that were the same pace maintained throughout 2009, auto production in Canada would virtually cease to exist by New Years. Rather than an average of 171,000 cars per month, Canada would produce just 3,850 cars in January 2010. Now we admit this is a bit of hyperbole for effects sake. For one, preliminary data suggests production statistics to be reported next week will likely show some rebound in February. But this provides the prism through which we must look at this morning's Canadian retail sales for January, that showed a 1.9% m/m rise in spending - the first gain since September. This is short-term volatility in a trend that is still heading lower.

-$73.95: The average reduction in monthly spending by each Canadian man, women and child relative to September. Now that may not sound like a lot, but across the economy, that comes out to nearly a 7% fall in spending over four months (or $10bn less in cumulative spending). Now over that same period, prices fell 1.3%, so some of that reduction in spending reflects cheaper prices. But with the trend in consumer spending likely to continue to move lower, and production levels to remain very low, the trend in inflation will continue to moderate, as well.

UPCOMING KEY ECONOMIC RELEASES

U.S. Durable Goods Orders - February

Release Date: March 25/09 January Result: total -5.2% M/M; ex-transportation -2.5% M/M TD Forecast: total -2.5% M/M; ex-transportation -2.0% M/M Consensus: total -2.0% M/M; ex-transportation -2.0% M/M

There hasn't been any good news coming from the U.S. manufacturing sector lately, and with U.S. consumer and business sentiment continuing to falter, we are unlikely to see things turn around in the sector any time soon. Indeed, with the economy continuing to contract at a very alarming rate and access to credit remaining difficult, U.S. businesses are cutting back on capital investments in a dramatic fashion. The resultant weakness in manufacturing sector activity can be seen in a wide cross-section of regional manufacturing indicators that have all been hovering in contraction territory. For February, we expect the unprecedented weakness in durable goods orders to continue for the seventh straight month, with a further 2.5% M/M drop. Boeing aircraft orders, a key component of There hasn't been any good news coming from the U.S. manufacturing sector lately, and with U.S. consumer and business sentiment continuing to falter, we are unlikely to see things turn around in the sector any time soon. Indeed, with the economy continuing to contract at a very alarming rate and access to credit remaining difficult, U.S. businesses are cutting back on capital investments in a dramatic fashion. The resultant weakness in manufacturing sector activity can be seen in a wide cross-section of regional manufacturing indicators that have all been hovering in contraction territory. For February, we expect the unprecedented weakness in durable goods orders to continue for the seventh straight month, with a further 2.5% M/M drop. Boeing aircraft orders, a key component of the headline index, was also weaker on the month and should be a main drag on the headline number. As such, excluding transportation equipment, the decline should be a more modest 2.0% M/M. In the coming months, we should see new orders fall even further as the impact of the continuing U.S. economic recession takes hold.

U.S. Personal Income & Spending - February

Release Date: March 27/09 January Result: income 0.4% M/M, spending 0.6% M/M; core PCE deflator 0.1% M/M, 1.6% Y/Y TD Forecast: income 0.0% M/M; spending 0.3% M/M; core PCE deflator 0.2% M/M, 1.7% Y/Y Consensus: income -0.1% M/M; spending 0.3% M/M; core PCE deflator 0.1% M/M, 1.6% Y/Y

U.S. households continue to be squeezed at all ends, as mounting job losses, plunging equity values, declining home prices and tight credit conditions have conspired to create the perfect storm for consumers. The worsening labour market conditions have been particularly harsh, with well over 4 million jobs being lost since the beginning of last years, and well over 600K positions being eliminated in February alone. As such, we expect personal income to remain flat in February, after falling in 3 of the 4 prior months while spending is expected to rise for the second straight month, climbing by 0.3% M/M. The modest rise in spending, however, should not be viewed as part of the turnaround in personal expenditures, but instead is the combination of base-effects and consumers taking advantage of available bargains, as was already on display in the retail sales report. In terms of prices, the core PCE deflator is expected to rise by its largest margin since September, climbing by 0.2% M/M. As a result, the annual pace of core PCE inflation is expected to pop back up to 1.7% Y/ Y, from 1.6% Y/Y. This will be the first increase in this indicator in six months. In the months ahead, we expect personal income and spending to remain soft, though the impending stimulus cheques should breathe some temporary life into both indicators.

TD Bank Financial Group

The information contained in this report has been prepared for the information of our customers by TD Bank Financial Group. The information has been drawn from sources believed to be reliable, but the accuracy or completeness of the information is not guaranteed, nor in providing it does TD Bank Financial Group assume any responsibility or liability.