Sunday, July 26, 2009



  • U.S. existing home sales up for the third straight month in June (+3.6%), signalling a trough in housing is forming.
  • Ben Bernanke delivers his semi-annual testimony to Congress, explaining the Fed exit-strategy and stressing the importance of Federal Reserve independence.
  • Bank of Canada (BoC) leaves overnight rate at 0.25% and reiterates its commitment, conditional on the inflation outlook, to stand pat until July 2010.
  • BoC upgrades real GDP outlook for 2009-10, and forecasts that inflation will return to the 2% target one quarter earlier (Q2-2011) than forecast in April.
  • Canadian wholesale (-0.3% M/M) and retail (+1.2% M/M) trade in May were significantly better than expected.
  • British Columbia to present a new Budget on Sept. 1, 2009 and move to harmonize sales tax (HST) on July 1, 2010.

In week fairly light on economic data, the U.S. existing home sales report made waves, giving one of the clearest signals yet that a trough is forming in the U.S. housing market. Existing home sales beat expectations and rose by 3.6% in June, the third straight month to see an increase. The year-over-year decline in sales is now only 0.2%, the best reading since 2005. In terms of leading indicators of recovery, rising existing home sales rank high, signaling that demand is returning to the housing market and helping to pull down inventories of unsold homes, key to limiting further price declines. Along with data on U.S. housing starts, this is as clear a sign as any that a recovery in the housing market and the economy may be close at hand.

The week was also marked by Federal Reserve Chairman Benjamin Bernanke's semiannual Policy Report to Congress. Bernanke's testimony to Congress comes at a pivotal time for the Fed chief, who has been under mounting pressure to explain both the Fed's exit-strategy as well as to defend the independence of the Federal Reserve in setting monetary policy. The Fed chief used his testimony to cover both bases. With regards to the exit strategy, Bernanke walked the tight rope of stressing that current economic conditions continue to warrant stimulative monetary policy "for an extended period", while at the same time explaining how - when the time comes - they will unwind the stimulus in an age of non-traditional monetary policy.

The main area of concern in terms of exit-strategy is the size of the Federal Reserve's balance sheet, which has grown by over 100% in the last year. In order to fund their liquidity injections and longer-term bond purchases, the Fed has effectively printed money by crediting the reserve accounts of banks. This has created the risk that as financial conditions normalize, banks sitting on piles of excess reserves will lend these out. But, if banks start lending out all these excess reserves it threatens to drastically overheat the economy and result in rampant inflation - the Fed needs a way to prevent this. Bernanke, in his testimony, explained that the Federal Reserve's ability to pay interest on excess reserves enables them to prevent the expanded balance sheet from causing rampant inflation. Put simply, since a payment by the Fed is risk free, it does not make sense to lend out money at below the rate the Fed is paying you to keep it in reserve. Therefore, if the Fed raises the rate it pays on excess reserves, its target rate should move up along with it.

The job of a Fed Chairman is never easy, least when an economic crisis such as the one we have experienced takes place. Equally important in Bernanke's testimony was his insistence that the Federal Reserve maintain its independence in setting monetary policy. A loss of Fed independence would most likely imply a much more volatile path both for inflation and interest rates in the future. Federal Reserve independence from the political sphere is necessary because controlling inflation requires actions that can be politically unpopular - raising interest rates when the unemployment rate is still historically high for example. As history shows, re-anchoring inflation expectations once they have become unhinged is a painful process that everyone would like to avoid.

The Fed chief also commented on policy initiatives aimed at avoiding crises in the future, indicating that a move towards macroprudential regulation that goes above and beyond individual institutions to focus on the stability of the entire financial system is essential to future regulatory efforts. Finally, Bernanke gave time to fiscal policy. While he has supported fiscal stimulus measures in the past, Bernanke stressed that government deficits, if not reigned in, are also a threat to economic stability. Sustained deficits imply higher-long term interest rates that crowd out private investment, which is the key driver of future prosperity growth.


Attention was squarely focused on the Bank of Canada's (BoC) words, rather than actions, this week. Consistent with a conditional commitment made in April, which was reiterated, the BoC left its overnight rate unchanged at 0.25%. A noticeably more upbeat tone was adopted in recent statements, however, from which we take away the following.

First, Quantitative/Credit Easing is all but dead and buried before it was ever born. To begin with, the BoC had set a high bar as to what cataclysm would need to happen - a new seizing up of credit markets, for instance - for this non-traditional form of monetary policy to be deployed. Thankfully, nothing of the sort has happened, and financial and credit conditions have been on the mend. At this point, the BoC is simply paying lip service to this option in reiterating that it is ready and available if need be.

On the plus side, stimulative monetary and fiscal policy, improved financial conditions, firmer commodity prices, and a rebound in business and consumer confidence will support more domestic growth than anticipated in its April MPR. In the minus column, a higher Canadian dollar and ongoing restructuring in key industries will weigh on growth. All said, the BoC thinks positive real GDP growth will resume in the current quarter (Q3), thereby technically ending the recession. If this unfolds, it will have been the shortest recession since 1957, albeit brutal nonetheless. Real GDP would still contract by 2.3% in 2009 - less than the 3.0% contraction forecast in April and similar to our forecast of a 2.4% contraction.

In early June, the BoC worried that "if the unprecedentedly rapid rise in the Canadian dollar [...] proves persistent, it could fully offset these positive factors". From late April to early June, the CAD had gained 12% against the USD. After retracing somewhat, the CAD remains 12% stronger than in April, so it remains unclear to us why a softer tone on the currency was adopted precisely when a risk noted in June is crystallizing. In 2010, the BoC expects a real GDP expansion of 3.0%, more than the 2.5% forecast in April. The gap between this forecast and our own (1.4%), as well as the private-sector consensus (2.1%) is wide. What the BoC sees as a downside risk, we build into our base-case scenario: we think the CAD will reach parity by year-end and its drag on growth into next year should not be downplayed. The BoC forecast implies an unprecedented performance of the Canadian economy vis-à-vis its trading partners. The Canadian economy has historically only outperformed the U.S. economy by this order of magnitude (1.5 percentage points or more) on four occasions over the last half-decade - each time in years entering a recession and never on the initial year of recovery after a recession. While the specific composition of assumed growth channels in the U.S. (e.g. industrial production, machinery & equipment, motor vehicles) might disproportionally favour our export performance, it would still constitute a remarkable feat for Canadian economy to grow by 3.0% while the U.S. and world economies crawl at respectively 1.4% and 2.3% growth.

On the data front, wholesale and retail trade figures for May came in significantly better than expected. Wholesale trade slipped by 0.3% M/M while markets expected a larger 2.0% M/M drop. Meanwhile, retail trade expanded at a brisker pace (1.2% M/M) than anticipated (0.5% M/M). Both data reports were fodder for recovery enthusiasts. The recent data is clearly showing that the recession is in its final stages, with growth resuming in either Q3 or Q4. But we would caution against getting too optimistic about the strength of the recovery. As the BoC acknowledged, it is early days and there remain strong headwinds.


U.S. Durable Goods Orders - June

  • Release Date: July 29/09
  • May Result: total 1.8% M/M; ex-transportation 1.1% M/M
  • TD Forecast: total -1.0% M/M; ex-transportation 0.0% M/M
  • Consensus: total -0.5% M/M; ex-transportation -0.2% M/M

The recent flow of manufacturing sector reports has offered some hope that the sharp correction in the U.S. industrial complex may be nearing an end. Despite this, the lingering impact of sluggish global demand and weak domestic consumer spending will continue to push U.S. capital expenditures lower as businesses adjust their level of activity to the soft economic fundamentals. For June, we expect durable goods orders to decline for only the second time since January, with a 1.0% M/M drop. The sharp drop in Boeing aircraft and motor vehicle orders should be the key factors driving the headline number lower. As such, excluding transportation, durable goods order should be flat on the month. In the months ahead, Annualizedwe expect new orders to remain soft as the U.S. economic recession moves slowly into memory.

U.S. Real GDP - Q2/09

  • Release Date: July 31/09
  • Q1 Result: -5.5% Q/Q ann.
  • TD Forecast: -0.8% Q/Q
  • Consensus: -1.5% Q/Q

The U.S. economy likely shrunk in the second quarter of 2009 for the fourth straight quarter in a row. However, unlike the previous two quarters, the pace of decline is expected to have diminished significantly. The biggest source of downward pressure on U.S. GDP growth in the second quarter will likely be the drop in business inventories, in part due to the shut down of auto production, but also across other sectors as businesses adjusted their inventory levels to match the much slower pace of sales. Domestic demand should also continue to be a source of weakness to GDP, as both consumers and businesses cut back spending. Fiscal stimulus, in the way of social security transfers, gave support to personal income growth in the quarter but most of the checks ended up in savings and so had little impact on the level of spending. On a monthly basis real consumer spending troughed in December of 2008 and has moved pretty much sideways in the months since then. Government and net-trade were the two sectors that likely added to growth in the second quarter. In the case of government, a rebound in defense spending will be the main contributor to the gain, while on the net-export side the support will likely simply be a matter of imports falling by an even greater amount than exports - hardly something to cheer about.


Canadian Real GDP - May

  • Release Date: July 31/09
  • April Result: -0.1% M/M
  • TD Forecast: -0.2% M/M
  • Consensus: -0.3% M/M

The combination of weak domestic consumer spending and slumping export demand have continued to hamstring the Canadian economy, resulting in the longest slump in economic activity in many decades. In fact, since July last year, Canadian economic activity has contracted in every month with the value of domestic output now at levels not seen since October 2006. The pattern of weakness is expected to continue into May. Indeed, during the month we expect Canadian GDP to contract a further 0.2% M/M. Slumping manufacturing sector activity (which have declined a staggering 5.8% M/M) and weak export demand (down 4.7% M/M) should be the key sources of drag on activity. Stronger retail sales and residential investment activity, however, should add favourably to the headline number, though they will only provide a partial offset. In the coming months, we expect Canadian economic activity to begin stabilising as the significant monetary and fiscal policy stimulus administered to the Canadian economy begins to gather traction.

PDF Format

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.