Sunday, November 22, 2009

The Weekly Bottom Line

  • U.S. industrial production falls by 0.1% in October M/M but still poised for strong growth in the fourth quarter.
  • U.S. housing starts fall by 10.6% M/M in October, reversing somewhat the strong rebound seen through the third quarter.
  • U.S. headline inflation rested at -0.2% Y/Y in October, poised to turn positive again next month, while core inflation has remained stickier than the spare capacity in the economy might suggest.
  • Bernanke's speech makes rare comments about the U.S. dollar, saying that the Fed is watching it “closely” and speaking to the strong dollar that more typically is made by the U.S. Treasury.
  • As base-year effects reverse, Canadian headline CPI inflation for October rises to 0.1% Y/Y from -0.9% Y/Y. Despite economic slack, core inflation jumps to 1.8% Y/Y from 1.5% Y/Y - though a slowdown in core prices is expected in coming months.
  • Confirming expectations for output growth in September, Canadian manufacturing shipments rose 1.4% M/M in September, and the inventory-to-shipments ratio abated. However, Canada's inventory contraction continues.
  • At odds with the broader economy, Canadian existing homes sales rose a further 5.1% M/M to 45.8k units in October, following the 3.0% M/M in September, now up 41.5% Y/Y.
  • Growth in the average price of resale homes accelerated to 20.7% Y/Y in October from 13.7% Y/Y in September, and, controlling for the geography of sales, prices grew 14.0% Y/Y in October, up from 9.3% Y/Y in September.


The fourth quarter has gotten off to a slow start for the economy. Industrial production for October fell by 0.1% from September while housing starts fell by 10.6% over the same period. Given the strong growth in the industrial sector in the third quarter, the level of production in October still remains well above the third quarter level so a healthy growth rate for the overall economy in the fourth quarter remains likely. The weakness in housing, on the other hand, would suggest some retrenchment in the construction sector after a phenomenal rebound in the third quarter, but a large part of the fall in October came from the volatile multifamily starts so it's likely too early to read too much into these numbers.

In spite of the weakness in some of this data, there did seem to be some fears of inflation creeping back into markets, as even though yields fell, the curve continued to steepen. Treasury yields fell across the curve this week, with 2- and 5-years down about 13bps while 10- and 30-years were down only 6-8bps. The data and speeches from Bernankeand several other Fed members made investors a bit more accepting of the fact that the Federal Reserve will be keeping rates low for a long time. And over the last 4 weeks, the short end has fallen by more than 30bps while 10-years have fallen only 16bps and 30-year Treasuries are completely unchanged.

With the short end of the curve falling further than the long end, this may be a symptom of strong buying of short-term securities by banks looking to boost their balance sheets as we near year-end. But, this could also be one sign that financial markets are a bit more concerned that this extended stay at the zero bound could come at the risk of higher inflation down the road. The expected inflation implied in inflation-protected Treasuries (TIPS) and the inflation swap market suggests this is a concern, as well.

So what are we to make of this? We still think that fiscal deficits and improvement in the economy over the next several years could eventually lead to inflation concerns in the U.S., but over the next year or two, it's hard to see inflation pressures in the U.S., given the unemployment rate is already sitting at 10.2% and the large amount of idle manufacturing capacity. These are not conditions that are ripe for inflation.

That said, there are some red flags for the forecast of extremely subdued inflation. We did see CPI inflation come in stronger than expected in October. Headline inflation grew by 0.3% M/M and the -0.2% pace of deflation Y/Y will likely turn back into positive territory in November. Core inflation, the one the Fed will keep a much closer eye on as a better gauge of the inflation trend, also remained strong with a 0.2% M/M gain and an annual pace of 1.7%. This annual pace of core inflation is stronger than we would expect if the large amount of unemployed workers and idle capacity in the manufacturing sector were exerting as much influence on inflation as it has in the past.

Through the 1980s, the large amount of slack in the economy did exert a strong downward pressure on inflation, but the closer we move to the present, inflation expectations have increasingly anchored actual inflation close the 2% pace that the Fed likes to see. Through all this, we have generally seen the ISM index provide a decent guide as to how much influence the swings in manufacturing output - and thus the swings in idle capacity in the economy - would have on the change in the rate of inflation. According to this indicator, we should be seeing core inflation lag behind the real economy and slow much faster than it has.

This is an area of concern that we'll need to watch very closely over the next few months. Ben Bernanke reiterated this week the Fed's commitment to keep rates low for an “extended period” given “low levels of resource utilization, subdued inflation trends and stable inflation expectations.” Most economists - us included - still take it on faith that spare capacity will mute inflationary pressures, but most also still worship at the altar of inflation expectations. Headline inflation will continue to move higher as the collapse in oil prices last year makes the Y/Y increase in oil prices appear strong. But if core inflation does not weaken further, then faith in the impact of resource utilization will have to succumb to the cold hard facts.


Data from the past week confirmed our expectation that GDP advanced in the third quarter, although we now project a more modest annualized pace of quarterly growth in the 1.0% range. Canada turned the corner but growth will be “skinny” in this first quarter of rebound.

September's manufacturing data point to stronger shipments rounding out the quarter, consistent with the improving trade balance. The value of Canadian shipments rose 1.4% in September, thanks to a 1.8% boost in volumes, but this didn't fully retrace lost ground from August's 2.2% retreat. Motor vehicles were the big push to the monthly gains, with vehicles shipments rising as U.S. auto retailers restocked depleted lots and parts up from heightened production. As well, some buoyancy can nonetheless be read from the new and unfilled orders data, with improvements in demand appearing sustainable. However, inventory contractions continue and, although real inventories are now at 1999 levels, inventory-to-shipments (I/S) remains high against history, pointing to continuing draw-downs through the coming quarter.

These ongoing inventory draw-downs in the manufacturing and wholesale sectors will also detract from third quarter growth. There is certainly a shift in composition of demand towards domestic sources and trade won't be the prime propellant during recovery. Indeed, Canada's export side is still battling major headwinds and it will be up to the domestic side to do much of the heavy lifting.

Canada's pace of recovery will not be bursting from the gates, but the pace of recovery looks to pick up in the coming quarters on the strength of domestic demand - particularly durables purchases by households and heightened M&E investment by firms. With rallying stock markets and blistering housing prices, household wealth is improving, which is supportive of consumer spending. However, facing weak job markets, consumers remain cautious.

The big surprise in recent months has been the strength in housing markets. Existing housing sales for October continued at a break-neck pace, up 41.5% Y/Y. Although distorted by geography and not accounting for quality of homes sold, the Canada-wide average price rose 20.7% Y/Y.

We do expect housing to moderate into November (, but we're not certainly not seeing this yet. While strengthening borrowing by households and propelling housing-related purchases, this persisting pace of the housing market is obviously at odds with the general macroeconomic setting.

As we highlighted in a recent note ( special/ca1009_housing.pdf), the Bank of Canada will be paying increasing attention to a potential overpricing of housing if present housing strength fails to moderate into the late fall. Obviously, it's a no-go to hike interest rates when unemployment is still rising, the loonie is still appreciating and excess capacity is still wide. While the Bank has signaled its unease about potential instability from emergent asset bubbles, it prefers the “scalpel” of targeted market-specific tools, rather than the “meat cleaver” of monetary policy.

Indeed, with the picture of a gradual recovery, excess capacity will remain wide and, though core inflation has remained sticky on firmly-anchored expectations, economic slack is sure to slow core price growth over the coming quarters, supporting a go-slow approach on rate hikes.

October inflation somewhat bucked the downward pressure on price growth. As was anticipated given the base-year effects in energy prices, headline inflation returned to positive year-over-year territory after drifting negative in past months. However, more surprisingly, October experienced an advance of core inflation from 1.5% Y/Y in September to 1.8% Y/Y, but base-year effects contributed (Core CPI in October 2008 abnormally weak, again advancing in November 2008).

Looking forward, a higher dollar will cheapen imports, with pass-through likely to be more elevated than in past loonie rallies. As well, higher food prices had previously propelled core inflation and this dynamic is now reversing. Despite well-anchored expectations, core inflation should soften in months ahead, supporting the Bank of Canada maintaining low interest rates for longer.


U.S. Durable Goods Orders - October

  • Release Date: November 25/09
  • September Result: total 1.4% M/M; ex-transportation 1.2% M/M
  • TD Forecast: total 0.5% M/M; ex-transportation 1.0% M/M
  • Consensus: total 0.5% M/M; ex-transportation 0.8% M/M
As the U.S. economy slowly pulls itself from the deep economic recession, favourable support is expected to come from business spending and export demand. And with durable goods orders rising in 4 of the last 6 months, the support from business capital expenditures has been quite evident. In October, we expect the positive momentum in durable goods orders to continue, with new orders rising a further 0.5% M/M. However, with the headline number likely to be depressed by weak transportation orders, excluding transportation, durable goods orders should rise by a more respectable 1.0% M/M. In the coming months, as the economic recovery gathers further traction, we expect orders to stay in positive territory as U.S. businesses replenish their depleted capital stock in anticipation of the pick-up in demand.

U.S. Personal Income & Spending - October

  • Release Date: November 25/09
  • September Result: income 0.0% M/M, spending -0.5% M/M; core PCE deflator 0.1% M/M, 1.3% Y/Y
  • TD Forecast: income 0.1% M/M; spending 0.6% M/M; core PCE deflator 0.1% M/M, 1.4% Y/Y
  • Consensus: income 0.2% M/M; spending 0.5% M/M; core PCE deflator 0.1% M/M, 1.3% Y/Y
Despite the distressed labour market conditions and weak economy, the positive momentum in the U.S. housing market (driven in large part by stimulative monetary and fiscal policies) and the dramatic recovery in financial markets over the past few months have contributed in large part to the stabilisation in consumer confidence, and consequently personal consumption expenditures. In October, personal income is expected to track modestly higher, rising by a meagre 0.1% M/M mostly on account of higher transfer payments by the government. Personal consumption expenditures are also expected to rise, posting its fifth monthly advance in six months, with a 0.6% M/M gain. Evidence of the strength in personal consumption has been seen in the corresponding retail sales report, thereby providing an upside risk to this call. On the inflation front, the core PCE deflator is expected to rise by a modest 0.1% M/M, with the annual pace of core PCE inflation rising to 1.4% Y/Y, from 1.3% Y/Y in September. In the coming months, we expect the core PCE deflator to ease as the growing economic slack in the U.S. economy dampens core consumer price pressures.


Canadian Retail Sales - September

  • Release Date: November 23/09
  • August Result: total 0.8% M/M; ex-autos 0.5% M/M
  • TD Forecast: total 1.0% M/M; ex-autos 0.5% M/M
  • Consensus: total 0.6% M/M; ex-autos 0.4% M/M
With the Canadian economy on the verge of emerging from the brief economic recession, we expect retail sales to post its fourth monthly advance in five months with a 1.0% M/M gain. Much of the upward momentum in spending should come from motor vehicle sales, which is poised to post its second consecutive month of strong gains. Additional support should come from expenditures on housing related items, on account of the buoyancy in Canadian housing market activity. Excluding autos, retail sales are expected to rise by a more modest 0.5% M/M. Real retail sales, should also advance on the month, though it is likely to rise at a more modest pace than the headline number. In the months ahead, with Canadian labour market conditions expected to remain soft, consumer spending should be tepid.

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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.

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