Sunday, January 24, 2010


  • In just two days, most U.S. equity markets retraced a month's worth of gains on concerns that China will do more to cool its economy and proposals for stringent bank regulation in the United States.
  • Building on his plan to tax banks in the prior week, President Obama proposed a series of regulations that would cap individual bank sizes, and the amount of risk bank's can take.
  • U.S. housing starts were weaker than expected in December, falling 4.0% M/M to 557K units from 580K units. Despite the disappointing decline in starts, the surge in permit approvals suggests a future pick-up in residential building activity.
  • Bank of Canada holds overnight rate at 0.25% effective lower bound, reiterating conditional commitment to maintain present rate until Q2/2010.
  • Bank of Canada Monetary Policy Report notes that excess capacity began to be absorbed in Q4/2009, upgrades core inflation outlook, and forecasts improving growth during 2010 on the strength of domestic demand.
  • Canadian headline inflation rose to 1.3% in December, from 1.0% in November. Core inflation was unchanged at 1.5% - well below the Bank's 2.0% target but showing "stickiness" in the face of excess capacity.
  • Despite a slight decline of Canadian retail sales in December (largely attributed to warmer-than-usual weather), retail spending has still climbed in 5 of the last 6 months and sales are just shy of their pre-recession level.
  • Canadian manufacturing shipments gained in November, but U.S. demand is improving only gradually - a drag on Canada's economic recovery.

It was a light week of U.S. economic data, but there was plenty of news to rattle financial markets. In just two days, U.S. equity indices retraced a month's worth of gains. This owed to a combination of concerns that global growth will be impacted as China attempts to cool its economy and proposals outlining more stringent bank regulation in the United States. All major U.S. stock indexes fell below levels not seen since mid-December, so investors returned to the safety of Treasuries, with yields falling to a one-month low. Markets also turned to the U.S. dollar for comfort, and, after depreciating over much of January, the U.S. dollar soared against most major world currencies by week end.

This week's volatility is a reflection of how much uncertainty that continues to swirl with respect to the economic landscape and the shape that financial market regulation will take. A week earlier, President Obama proposed a Financial Responsibility Fee, in which a tax of 0.15% would be levied on Wall Street Firms with more than $50 billion in consolidated assets. This week he announced a plan to clamp down on U.S. banks and proposed a series of regulations that would cap individual bank sizes and the amount of risk bank's can take. However, these are just proposals, and will face significant hurdles in congress. There is still a question mark around what the future holds for the U.S. banking sector. Adding to investor angst this week was the notion that a global recovery could be slower than expected. With China's economic growth coming in at a booming 8.9% in 2009, markets have been looking to China to help drive a world recovery. But, officials in China are concerned about rising debt levels, high inflation and the formation of asset bubbles. As such, after raising the reserve ratio for banks last week, Chinese policy makers hinted that they may do more to curb borrowing and cool the economy in China.

As we look ahead to the coming week, there are a number of releases that will be vying for the attention of investors. In particular, they will get their first glance at fourth quarter U.S. economic growth. The U.S. economy likely grew by 5.0% in the fourth quarter of 2009 - fairly decent for postrecession growth.

However, over half of the bounce in economic activity looks to have been due to a large inventory swing, and not to sustainable economic drivers. As such, we expect quarterly real GDP growth to moderate back into the range of 2-2.5% for most of 2010 - about half the growth rate typically seen during economic recoveries. The largest challenge for the U.S. economy is the significant amount of headwinds faced by the U.S. consumer. Since consumer expenditures account for 70% of economic activity, we cannot count on a robust recovery unless the U.S. consumer is entirely engaged.

As for other data of interest, next week brings forth a slew of housing data, and investors will want some affirmation that the housing market continues to improve through rising monthly prices in the Case/Shiller index and some easing in inventories in the resale market. So, there won't be a shortage of data that could certainly inject more volatility into financial markets if it fails to meet investors' expectations


Canada's rebound continues to strengthen but indicators still point to a gradual uptake of economic slack. Strong domestic demand, supported by very accommodative monetary policy remains the push. However, as rebuilding U.S. household net worth and recapitalizing U.S. financial institutions proceeds slowly, Canada's imports will grow faster than its exports, and this trade deficit will continue to drag on Canada's growth. Fiscal stimulus will provide support to Canada's 2010 growth as the bulk of those "shovel ready" projects hit full stride, but 2011 will see give-back as stimulus ends and governments cleave spending.

These points were echoed by the Bank of Canada in its rate announcement and Monetary Policy Report (MPR) on Tuesday and Thursday, respectively. While noting the recovery is in motion, the Bank held the overnight rate at its 0.25% effective lower bound and reiterated its conditional commitment to hold on any hike until at least June 2010. The Bank noted that excess capacity began to be absorbed in Q4/2009 and projects that this pace of recovery will build during 2010. However, economic slack will be only absorbed gradually. As the graph shows, with the present size of the output gap (the difference between the economy's potential output and its actual output), analysts have been surprised by the relative resilience of core inflation. While ebbing, core inflation has sustained at a higher-than-expected pace, and the Bank attributes this "stickiness" to "the fact that wage growth had remained high relative to the underlying trend in productivity." That is, expectations of price growth remained anchored when workers and firms were setting wages, despite the dip in labour productivity and rising unemployment. With slack now being absorbed, the Bank has therefore upgraded its core inflation forecast, seeing a higher trough for core price growth in early 2010 than previously forecast.

The tone of the Bank's statements was certainly doveish on rate hikes and, owing to the size of the output gap and our softer profile for 2010 growth, we do not expect the Bank to hike rates until Q4/2010. While the Bank has flagged the pace of household borrowing and strength of housing markets in recent statements, it was fairly mute on these in the MPR. The Bank recognizes that the overnight rate is a blunt tool to use for cooling particular markets and, having communicated these issues, will look to other institutions to act on these fronts should conditions warrant.

Nonetheless, there are still significant risks to the Bank's outlook and, therefore, its interest rate policy. In the global context, Canada is a small, open economy, and, with trade the main near-term drag on growth, the Bank of Canada noted the speed of global recovery as the major risk to the outlook in the near- and medium-term. A fasterthan- expected pick-up in global trade could spur a faster Canadian recovery, and, even with the intense monetary and fiscal support, the near-term lift to U.S. consumption and exports has been surprising. However, the still-deleveraging U.S. financial system and uncertainty around regulatory reform (witnessed this week by Obama's proposed bank size limits) will certainly check the recovery in U.S. credit growth. Indeed, looking to the medium-term, rectifying "global imbalances" is a keystone of sustainable global growth and this requires a reversal of U.S. current account deficits, higher U.S. household savings, fiscal consolidation, and greenback depreciation. All of these are downsides to Canada's trade outlook.

Indeed, looking past the recovery, we forecast Canada's economy to converge with a slower pace of trend growth relative to that prior to the downturn. In his press conference remarks, Bank of Canada governor Mark Carney was questioned on this "new normal" for Canadian economic growth, a subject on which TD has previously written. Owing to slowing labour force growth, lackluster innovation performance and generally languishing productivity, the trend pace of annual Canadian output growth beyond 2012 looks to average around 2%, which is around 1% lower than that prior to the crunch. Slower trend growth has negative implications for governments looking to balance budgets and households who are borrowing today on expectations of future income.


FOMC Interest Rate Decision

  • Release Date: January 27, 2010
  • Current Rate: 0.00% to 0.25%
  • TD Forecast: 0.00% to 0.25%
  • Consensus: 0.00% to 0.25%
The Federal Open Market Committee (FOMC) will deliver its next interest rate decision on January 27, and as has been the case in recent months, markets will look beyond the actual interest rate decision and focus instead on the tone and wording of the accompanying communiqué. In this regard, we expect the overall tone of the statement to remain dovish, and expect the Fed to reaffirm the Committee's commitment to "maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period." The economic assessment is expected to remain largely intact, with the Fed reiterating the improving outlook for the U.S. economy, reflecting in part the encouraging tone in recent economic reports. The inflation outlook should also remain relatively unchanged, with the Committee reiterating that it expects inflation to remain "subdued", on account of the "substantial resource slack".

U.S. Durable Goods Orders - December

  • Release Date: January 28, 2010
  • November Result: total 0.2% M/M; ex-transportation 2.0% M/M
  • TD Forecast: total 3.0% M/M; ex-transportation 1.0% M/M
  • Consensus: total 2.0% M/M; ex-transportation 0.3% M/M
With the U.S. economic recovery appearing to have gathered considerable steam in the last quarter of 2009, capital investments by U.S. businesses have also been on the upswing, as durable goods orders have risen in 5 of the last 6 months. This momentum should continue in December, with new orders expected to rise by a robust 3.0% M/M. Strong transportation sales, bolstered in large part by the surge in aircraft orders during the month, should be the main driver of this strong advance in new orders. As such, orders excluding transportation should rise by a much more modest 1.0% M/M, reflecting a more moderate pick-up in core capital orders. In the coming months, with the economic recovery expected to gather further traction, we expect new durable goods orders to stay in positive territory as U.S. businesses replenish their depleted capital stock in anticipation of the pick-up in demand for their products.

U.S. Real GDP - Q4/09

  • Release Date: January 29, 2010
  • Q3 Result: 2.2% Q/Q ann.
  • TD Forecast: 5.0% Q/Q
  • Consensus: 4.5% Q/Q
After a rather meek reading of 2.2% Q/Q ann. for the final estimate of third quarter U.S. real GDP growth, the fourth quarter of the year should be the first to resemble anything like a post-recession bounce. Unfortunately, the rebound is not due to any new-found economic dynamism, but rather to a slowing pace of inventory liquidation after deep cuts earlier in the year. When all is said and done, more than half of the growth in real GDP in the quarter will come from the inventory swing. Growth in personal consumption slowed from the third quarter, reflecting in part a decline in motor vehicle purchases after the expiration of the cash for clunkers program. Business fixed investment remained another source of weakness, due to continued deep cuts in investments in non-residential structures. On the brighter side, businesses did spend more on equipment and software, but after declines of over 20% over the course of the recession, this is a deep hole to fill. Finally, residential investment also contributed positively to growth - for the second quarter in a row.

While housing starts stalled over the second half of the year, homebuyer tax credits and bargain mortgage rates continued to push up existing home sales. Peering into 2010, the contribution from inventories will diminish and the impact from government stimulus will wane. Growth of 5.0% will certainly be a welcome event, but is more likely to be an exception than the norm.


Canadian Real GDP - November

  • Release Date: January 29, 2010
  • October Result: 0.2% M/M
  • TD Forecast: 0.2% M/M
  • Consensus: 0.3% M/M
The recovery in the Canadian economy has been quite slow, as the combination of a strong domestic currency and weak U.S. demand continues to wreak havoc on the export-dependent Canadian economy, even in the face of strong domestic fundamentals. As such, in November, we expect the favourable support from strong housing market and wholesale sales activity to be partially offset by weak consumer spending and soft manufacturing sector activity, with GDP growing by only 0.2% M/M, following a similar gain the month before. However, notwithstanding the modest growth in recent months, the pace of economic rebound in Q4 should be well ahead of the meagre 0.4% Q/Q ann. growth attained in Q3, suggesting some pick-up in economic activity in the quarter. In the coming months, the Canadian economic recovery should remain intact, as the significant monetary and fiscal policy stimulus administered to the Canadian economy gathers traction, though the recovery is likely to remain both slow and fragile.

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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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