Monday, March 17, 2008

Bank of Canada to cut by another 50 bps in April so thinks TD/CT

Insights and highlights from TD/CT

U.S. weakness takes bite out of Canadian growth and Bank of Canada to cut by another 50 bps in April

Canada cannot escape the fallout from the U.S. economic slump was the message that rang loudly in the Bank of Canada's decision to pull the trigger on a 50 basis point cut to its overnight rate on Tuesday. In fact, in light of the increasingly "dovish" tone in the communiqué that accompanied the rate move and this week's spate of soft economic data, another rate cut in April appears a very good bet. The only question is: how much? Despite today's unexpectedly robust job report, the risks still are tilted towards another bold half-point reduction by the central bank, taking the overnight rate down to 3.00%.

Canadian growth prospects waning

This week's economic news highlighted the growing dent being placed on Canada's growth prospects from softening U.S. demand. A whopping 8.5% drop in exports was the key culprit dragging down Canadian real GDP growth to a six-year low of 0.8% (annualized) in the fourth quarter from 3% in the prior period. Offsetting the export plunge was a surge in domestic spending (+7%), spearheaded by the consumer. So, while the bite of weakening manufacturing exports to the United States is becoming more evident, domestic resilience continues to drive overall expansion – some good news there.

These trends were echoed in this morning's employment numbers – in spades! More than 40,000 net new jobs were created in Canada in February on the heels of an equally impressive gain in January and leaving the jobless rate at a 33-year low of 5.8%. Some 24,000 jobs in the export-heavy manufacturing sector were lost in the month, bringing the total losses since November to 50,000. Yet, service sector job creation powered ahead by 56,000 positions, with increases spread across public and private sectors. On a year-over-year basis, jobs in the public sector have increased at three times the pace (+6.6%) of the overall economy (+2.2%).

The blockbuster employment increase raises the question how much longer the job market can remain "decoupled" from the production side (i.e., GDP). Historical experience in Canada would argue that this divergence won't last very long. As export output and employment remain under significant pressure – which as we discuss below is very likely – there will be increasing knock-on effects to construction and services, and employment will ultimately follow suit. Governments will also respond to slower revenue growth by softening the pace of new hiring. In the meantime, the robust job market conditions continue to mitigate the risk of recession in Canada.

U.S. problems continue

With the U.S. problems leaving an increasing footprint on the Canadian landscape, this week's U.S. indicators did not provide much comfort. After being served up earlier this week with news that housing foreclosures jumped to a new high in the fourth quarter, investors received word that households are facing a rapidly-eroding employment picture. Non-farm payrolls dropped by 63,000 positions in February, chalking up the second straight monthly loss. Other indicators weren't much more heartwarming. The ISM survey of manufacturing activity slipped below 50 – the growth-contraction threshold – for the second time in the three months. On a brighter note, the export sub-index remained well above 50, indicating that a weak U.S. dollar continues to provide a boost to economic growth. The ISM non-manufacturing index rose from its depressed level of 44.6 in December, but at 49.3, remained slightly below 50.

It is the export sector – along with the stimulus from the Bush plan and Fed rate cuts – that will continue to provide key offsets to the headwinds brewing on other fronts going forward. At the same time, however, commodity prices, and notably crude oil (which rose to a new record of U$105 on Thursday) continue to rise on the back of U.S. dollar weakness. And with these elevated prices representing a tax on many U.S. consumers and businesses as well as raising inflation fears, some of the growth benefits of the currency-related weakness be increasingly eroded. In addition, the Fed will have less room to lower interest rates than otherwise would be case. Lastly, as we discuss in special report this week entitled U.S. Homeowners Not Getting Much of a Break on Mortgage Rates, the power of central banks to boost growth by rate cuts is lessened significantly when credit markets are in distress. Despite 225 basis points in Fed rate cuts, U.S. mortgage rates have barely budged.

Bank of Canada likely to go 50 again

Putting it all together, while the brisk job growth will not be lost on the Bank of Canada, we still feel that another aggressive half-point rate cut will be in the offing at the central bank's next fixed announcement date in April. By then, it will remain clear that the U.S. problems are not getting better, that the slowdown in Canada continues to broaden to the services side, and that Canada's overall economy will be hard pressed to record growth in the first quarter. Soft core inflation trends also provide credence to our call. Lastly – and importantly – we assume that the March reading on employment will better reflect the softening underlying momentum in the Canadian economy.

TD Economics releases Global Markets

This week, TD Economic released its latest installment of Global Markets, which presents quarterly forecasts for North American bond yields and international currencies. Despite the string of soft U.S. news, we still feel that too much pessimism has been priced into U.S. government debt markets, with yields likely to head moderately higher from current ultra-low levels and for the overall curve to flatten over the remaining three quarters. Canadian yields are also forecast to rise, albeit to a much lesser extent. Another key takeaway is that the US greenback will eventually find a bottom, likely by mid-year, although low U.S. rates will limit the extent of the bounce. In contrast, the Canadian dollar is likely to gravitate towards 95 US cents by year end.

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