Sunday, April 26, 2009

The Weekly Bottom Line


  • Bank of Canada cuts overnight rate to 0.25% (effective lower bound) and commits to leave rate on hold until mid-2010 .
  • Monetary Policy Report underwhelms markets as BoC fails to commit to quantitative or credit easing.
  • But U.S. housing market vulnerabilities could yet force monetary policy into this unchartered territory.

Canada's monetary policy was the main event this week, with advance speculation of a dive into the unchartered territory of Quantitative Easing/Credit Easing (QE/CE). But prudence is the banker's mantra and the Bank of Canada held to that credo - particularly on the QE/CE front. Anticipating fireworks, one might overlook the subtle boldness of this week's actions: in just a week the Bank broke new ground with its conditional commitment to maintain the current overnight rate for over a year, substantial tweaking of the payments system, extension of repo duration, and principles for undertaking QE/ CE. Even though we didn't get a dollar allocation or a pledge to buying specific products, we better understand how the bank views QE/CE and under what circumstances it would deploy this yet-untested tool.

In recent weeks, there was growing speculation that the Bank would proceed immediately with non-traditional monetary policy. Despite all of the Bank's measures, markets were disappointed in the lack of QE/CE specifics, and the bond curve steepened. Nonethless, conditions for Canadian financial markets still remain much improved, with corporate spreads easing on the week.

QE/CE: The Final Frontier?

On Tuesday, the Bank cut its overnight target by 25 basis points, bringing it to the 0.25% effective lower bound. While a 0% rate is so technically problematic that it is infeasible, there are perils to even a 0.25% rate. With the overnight target as a reference rate, the latest 25 bps cut has adverse effects on bank margins and money markets. Nonetheless, by bringing rates to their lower bound, attention is now on non-traditional measures. With unprecedented openness, the Bank made a conditional commitment to hold these rates steady until Q2/2010. Since the Bank cannot ease the yield curve by further cuts to shortterm rates, it has used a promise to hold them low longer to cement rate expectations and influence yields at longer durations. They also waded further out along the yield curve by extending the duration of Purchase and Resale Agreements to six- and twelve-month terms at rates corresponding to the overnight target. In order to counteract low rate perils, the Bank narrowed the operating band so that banks received 0.25% on their settlement reserves rather than 0%. As well, the Bank expanded the amount available for settlement balances in its Large Value Transfer System (LVTS) from a typical $25 million to $3 billion, increasing banks' short-term liquidity backstop. While the Bank didn't say so, this still looks to us a possible means to expand the money supply: if banks bite, has the potential to expand the monetary base by nearly 4%.

Tuesday's announcement whet appetite for the Bank's Monetary Policy Report (MPR). The Bank issues an MPR four times annually in order to communicate its outlook and explain its policy. In this MPR, the Bank observed the deepening and synchronized recession, worsening its forecast for 2009 contraction and cutting its forecast for a 2010 rebound. It also halved its forecast for potential growth from 2.4% to 1.2%, observing that the external shock and consequent restructuring will cleave much of Canada's productive capacity. Lower potential growth points to a less severe output gap and less risk of acute disinflationary pressures.

Given the move to the lower bound, this MPR had to be a tandem act: In its March rate announcement, the Bank had committed to "outline" a framework "to provide additional monetary stimulus, if required, through credit and quantitative easing". The Bank had to acknowledge the elephant in the room that few tools remained once overnight rate cuts were exhausted. However, markets expected specifics (and even perhaps an immediate move to QE). Instead, the Bank laid out in general terms the three ways in which it would provide additional stimulus: 1) Additional statements about future interest rates; 2) QE through purchases of assets; and 3) CE in certain impaired credit markets to reduce risk premiums and improve liquidity. Clearly viewing QE as an untested tool, the use of which is fraught with unintended consequences, the Bank's core message was "QE if necessary; but not necessarily QE". Governor Carney also emphasized that any QE would be in response to a substantial deterioration against the Bank's baseline scenario and would be undertaken with a wellformulated "exit strategy". As well, QE and CE are regarded as potentially complementary but fundamentally separate. On the CE side, the measure is clearly regarded as a less preferable option and the Bank set a very high bar for both the scenarios and approach under which CE would be undertaken. The Bank hinted at its preference for "sterilizing" any such interventions (injecting funds in particular markets while withdrawing money elsewhere).

The Bank faces a slight conundrum that economic conditions call for continued stimulus, but the worsened and synchronized global recession is outside Canada's making - let alone our control. Price stability remains the Bank's primary mandate and it is rightly reticent to abuse its wellearned credibility. That inflation expectations remained anchored commends its prudence. The crystal ball remains very cloudy, but the Bank has clearly articulated its baseline scenario and committed to appropriate actions should conditions deteriorate further.

But U.S. Housing still on "Red Alert"

The potential source of downside risks is obvious: the U.S. financial system remains volatile and the root problems in the housing market have yet to resolve. Markets anxiously await the Treasury's "stress test" announcement on May 4th, and Geithner's statement that the "vast majority" of banks have passed still leaves much unknown. While the "toxic assets" are the centerpiece, "good" mortgage assets will be increasingly strained. While the initial round of mortgage distress owed to bad practices, the mounting foreclosures are now linked to rising unemployment, fuelling a vicious downward spiral in housing prices. U.S. house sales data for March out this week, showing a 3% M/M tumble, confirms the ongoing bleakness. We estimate that the under-water" mortgages could double if prices fall another 10% and argue that breaking this interaction between unemployment, underwater mortgages and foreclosures remains the lynchpin of housing market stability (see "U.S. Housing Market - Searching for the Bottom," April 23). While buoyed by signs of a turning "second derivative," the seas remain choppy.


U.S. Real GDP - Q1/09

Release Date: April 29/09 Q4 Result: -6.3% Q/Q ann. TD Forecast: -5.3% Q/Q Consensus: -5.0% Q/Q

After a stunning pace of decline in the final quarter of 2008, the U.S. economy continued to sink like a stone at the outset of 2009. A dramatic drop-off in world trade likely resulted in both exports and imports falling by close to 35% (annualized) - their biggest declines in forty years. Given the larger size of imports, net-trade will likely be a small positive contributor to growth but more than anything reflects the impact of several quarters of weakened U.S. domestic demand. Excess capacity in the business sector likely led to a dramatic pullback in business investment as firms cut back on all types of expenditures from equipment and software to construction to inventories. Moreover, a rising inventory-to-sales ratio saw firms scaling back production in order to draw down excess inventories. Smaller defense outlays suggest that the government sector will also subtract from growth in the first quarter. Perhaps the one glimmer of hope amidst all the grey is that after two quarters of dramatically reigning in spending, U.S. consumers look to have rebounded slightly in the first quarter. Nonetheless, the fall in retail sales in March and continued labour market deterioration suggests this could be a short lived phenomenon.

U.S. FOMC Interest Rate Decision

Release Date: April 29/09 Current Rate: 0.00% to 0.25% TD Forecast: 0.00% to 0.25% Consensus: 0.00% to 0.25%

The next instalment of the Federal Open Market Committee (FOMC) interest rate decision will be delivered on April 29. However, as has been the case in the past few months, with the Fed explicitly committing itself to keeping interest rates "exceptionally low" for an extended period of time, the actual interest rate announcement is unlikely to attract much attention. Instead, the focus will undoubtedly be on the tone and content of the statement. Of particular interest will be whether the Fed increases the size of its balance sheet to bolster its current quantitative easing programs. On this front, given that the Fed took the plunge into quantitative easing at its last interest rates meeting with the decision to expand its balance sheet by up to $1.15T, we believe that the risks of a further expansion of the balance sheet at this meeting are low. However, the Fed may use the opportunity to offer some insights on their relative effectiveness. In terms of the economic and inflation outlook, with the U.S. economy continuing to weaken, we expect the economic assessment to remain quite bleak, and the tone very dovish, though possibly reflecting the modest improvements in condition recently. We also believe the Fed will repeat its concerns about price inflation persisting below levels consistent with price stability, and reaffirm its commitment to employing "all available tools to promote economic recovery and to preserve price stability." The bottom line is that little is expected to change relative to the last statement.

U.S. Personal Income & Spending - March

Release Date: April 30/09 February Result: income -0.2% M/M, spending 0.2% M/M; core PCE deflator 0.2% M/M, 1.8% Y/Y TD Forecast: income -0.2% M/M; spending -0.1% M/M; core PCE deflator 0.1% M/M, 1.8% Y/Y Consensus: income -0.2% M/M; spending -0.1% M/M; core PCE deflator 0.1% M/M, 1.8% Y/Y

The squeeze on U.S. households' balance sheets appears to have gathered steam in recent months as the dramatic turn in U.S. labour market conditions and accelerating home price depreciation have meant that the problems facing U.S. consumers have intensified. And even though equity markets have recovered since mid-March, consumer confidence has continued to languish in depressed territory on account of the elevated level of economic anxiety. Despite the weight of this combustible mix, personal spending advanced in the first two months of this year, ending six consecutive monthly declines, though personal income has risen in only one of the last five months. The outlook for both indicators, however, is not so favourable. Our call is for personal income to fall by a further 0.2% M/M in March, with spending expected to fall by a more modest 0.1% M/M. Indeed, with the backdrop for U.S. consumers continuing to remain grim, we expect both personal income and spending to remain weak in the near term, with the impact of the fiscal stimulus likely to bolster both indicators later this year. In terms of prices, despite the underlying economic weakness, the core PCE deflator is expected to rise for the third straight month, gaining a further 0.1% M/M in March. The annual pace of core PCE inflation, however, is expected remain flat at 1.8% Y/Y. In the months ahead, we expect the core PCE deflator to start easing as the growing economic slack dampens core price pressures.

Canadian Real GDP - February

Release Date: April 30/09 January Result: -0.7% M/M TD Forecast: 0.1% M/M Consensus: -0.2% M/M

The new calendar year has not been particularly kind to the Canadian economy, as the domestic economic recession appears to have intensified dramatically in the first quarter. Much of the intensification in the economic crisis is due in large part to the firming up of the global economic recession, which has sent Canadian export demand into a freefall. Indeed, despite the massive monetary and fiscal stimuli that have been administered to the ailing Canadian economy, things appear to have gone from bad to worse. And with the impact of the ongoing global financial crisis continuing to seep into the real economy there is little hope that the weakness in economic activity will go away any time soon. Despite this dire prognosis, economic activity appears to have ticked-up slightly in February on the back of strong export demand, and the resurgence in the Canadian manufacturing sector and housing activity during the month. The gains in these sectors, however, are likely to be offset by weak retail sales activity. As such, our call is for the Canadian economy to post a meagre 0.1% M/M gain in February, following the brutal 0.7% M/M drop the month before. Notwithstanding this respite in February, Canadian economic fundamentals remain very weak, and we expect the downward trajectory in Canadian GDP to return in very short order and continue for at least several months to come.

U.S. ISM Manufacturing Report - April

Release Date: May 1/09 March Result: 36.3 TD Forecast: 39.0 Consensus: 38.0

Despite the weakening domestic economy, there have been a number of recent encouraging signs indicating that the pace of decline in U.S. manufacturing sector activity may be abating. This much has become clear in the actual ISM headline index, which has risen in the last three months, after reaching a cyclical low of 32.9 in December. Moreover, with the regional manufacturing sector indicators also pointing to further improvement (even though all of the indices remain in contractionary territory), we expect the ISM index to post its fourth consecutive monthly gain in April, climbing to 39.0. Adding to the sense of an upward momentum in the index are the recent strong gains in new orders, which reached a historic low in January. However, this improvement in the index should not be construed a an improvement in U.S. manufacturing activity, as the state of the U.S. manufacturing sector remains extremely weak and output has continued to decline. Moreover, with the economic backdrop for U.S. goods producers remaining very dire, we expect manufacturing activity to remain weak for some time, even though the pace of decline should continue to ease.

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.