Saturday, May 23, 2009

The Weekly Bottom Line


  • U.S. housing starts fall, but single-family starts rise signaling housing construction may bottom
  • Canadian retail sales grow in March on auto sales

There were further signs of short-run stabilization in the global economy and financial markets this week. Largest among them was the ongoing rapid improvement in US LIBOR rates - the cost of interbank lending. The U.S. 3-month LIBOR rate is now at 0.45%, its lowest level since February 4, 2008, and is now at or below Canadian LIBOR for the first time since January of this year (for more see our Daily Indictors of Financial Stress here: Other short-term costs have likewise improved, most notably ABCP, which is now at its lowest level since March 2007, and at 0.27% is just 0.07% above its average over the 2002-2006 period.

The Future's So Bright, I've Gotta Downgrade

The economic recovery will not come cheap, though. Recognizing this, the focus of financial markets has started to turn to the long run costs, with equities having a bit of a pullback. Standard and Poor's on Thursday reduced the outlook on U.K. government debt to negative from stable. This sent shivers through the U.S. bond market, which pondered whether the U.S. would be next. Yields on longterm U.S. debt rose sharply to reflect a heightened chance that U.S. debt could eventually be downgraded and become more risky. Along the same vein, U.S. bond markets continued to increase their bets that government borrowing and Fed asset purchases will eventually stoke inflation. FOMC minutes showed that the Fed has little concern on inflation, and neither do we, as they even discussed increasing their asset purchases. The fears even bled into Canada, whose debt levels are nowhere close to warranting similar concerns. This does provide us with a perfect chance to discuss yet another structural change - the high fiscal burden in a number of countries - which is likely to drive a shallow economic recovery.

Every Claim You Stake, I'll Be Watching You

In making its decision to put the U.K. on the negative watch list, S&P noted that “even assuming additional fiscal tightening, the net general government debt burden could approach 100% of GDP and remain near that level in the medium term.” So S&P's concerns revolve both around the high level of debt - which would be a doubling over four years - as well as the ability to reduce it over time. Canada and Japan both saw their debt ratings downgraded in the mid-1990s when their gross debt levels rose above 110%, as well, so the risks of a downgrade rise as debt levels get to the 100% of GDP level. Historically, about one-third of countries whose ratings are put on the negative watch list eventually have their rating downgraded at some point over the following two years. So it is not a conclusion that the U.K. will see an actual downgrade. And short of any new surprises, S&P stated that any further revision to the U.K.'s outlook or rating is unlikely to come before new general elections are completed by mid-2010, to give the next government a chance to produce a plan for fiscal consolidation.

I Walk the Line

But how close is the U.S. to meeting these above criteria? According to the most recent OMB estimates, U.S. federal debt held by the public is expected to nearly double, as in the U.K. but rise from 37% of GDP in 2007 to 70% in 2011. From that point, it is expected to stabilize, though not recede. Gross U.S. government debt is expected to rise to above 100% of GDP, but about one-third of this is intergovernmental holdings of its own debt. Theee are obligations of the government to itself well in the future - such as when the Social Security Trust Fund begins to get drawn down after 2016 - and would be excluded from ratings decisions for now. So U.S. debt levels do not appear to reach the absolute size needed to trigger a rating change. Our own estimates suggest the underlying economic assumptions in the OMB projections are woefully optimistic, particularly the impact the deterioration of the economy will have on tax revenues, so our own forecast suggests debt levels are likely to be 5-10% of GDP higher by 2011 than the current OMB projections.

But where our concerns lie for the U.S. fiscal position is beyond 2011. There are only three ways to deal with debt and deficits - decrease spending, increase taxes, or increase economic growth. It is cheap for the U.S. government to borrow right now given the Fed has brought interest rates down to zero. The issue is that as the economic recovery takes hold and interest rates rise, the interest costs on the debt are likely to rise to about 3-4% of GDP per year from 2012 and beyond. The U.S. would need to run a surplus of 3-4% of GDP before interest payments - as it did over the 1998-2000 period - just to keep the level of debt in dollar terms constant. This would require some significant belt tightening, but this pain can be offset by the fact that as long as U.S. debt in dollar terms is growing slower than GDP, the level of U.S. debt as a percent of GDP will fall. With our expectation that U.S. economic growth will average about 3% over the next decade, the U.S. could run a deficit of about 3% of GDP (including rising interest costs) and still stabilize the debt levels. We think it will be very hard for the U.S. to keep its overall deficit below 3%. Therefore, our own forecasts show that current policies would take U.S. publicly-held debt to the 100% debt-to-GDP level within about 10 years. This is not simply the cost of repairing the banks, but the current U.S. fiscal position is unsustainable with huge medical and retirement costs on the horizon which will require compromises on spending and tax policies to rebalance.

Time is on My Side

And what of Canada? Not even close. While the change to the U.K.'s outlook prompted questions on the Canadian debt position, the level and trajectory of debt is no where close to warranting a red flag from rating agencies. In fact, the only mention Canada's debt position is likely to get from international rating agencies is to commend it on having the best fiscal position of any major country in the world right now. Our most recent update (http:/ / sees Canadian federal debt levels rising from 29% in the 2008/ 09 fiscal year to a peak around 35% of GDP by 2010/11, and would be hard-pressed to exceed 40%. The nearterm costs for Canada have been far less than any other G-7 economy with no bailout money needed for the financial sector and relatively moderate stimulus spending. Canadian retail trade data for March confirmed that while consumers are not going gangbusters, there is certainly more strength in Canadian consumers than elsewhere. With the shock to trade and businesses retrenching, it now looks like Canadian GDP will print at slightly worse than a 6% annualized contraction in the first quarter, but even this would be one of the best results relative to the G-7. In may not be pretty, but in the relative economic race, Canada is the mudder that is shining on a very messy track.


U.S. Durable Goods Orders - April

  • Release Date: May 28/09
  • March Result: total -0.8% M/M; ex-transportation -0.6% M/M
  • TD Forecast: total 0.5% M/M; ex-transportation -0.3% M/M
  • Consensus: total 0.5% M/M; ex-transportation -0.3% M/M

The deep retrenchment in the U.S. manufacturing sector appears to be abating somewhat given the recent flow of regional manufacturing sector surveys. Despite this, U.S. businesses have continued to hold-back on major capital expenditures, resulting in durable goods orders declining in 7 of the last 8 months. In April, however, durable goods orders should post a modest 0.5% M/M gain. This advance is expected to be on account of the strong Boeing orders on the month. Excluding transportation, orders are expected to ease 0.3% M/M. In the coming months, we should see new orders remaining soft despite the encouraging signs coming from the manufacturing sector surveys.

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.