Friday, January 19, 2007

Canadian Mortgage Interest Rates, Outlook and US Sales - Current Trends


HIGHLIGHTS Bank of Canada unlikely to change rates next week
Canadian Business Outlook Survey and international trade reports strong
US retail sales accelerate in December

Financial markets hate it when central banks throw surprise parties. Shifts in the direction of monetary policy tend to be scripted well in advance of any change in interest rates – the Bank of England’s decision this week to surprise markets for the second time in six months notwithstanding. Because of this, don’t expect any surprises when the Bank of Canada (BoC) meets next Tuesday. (For a more detailed analysis, see TD Economics Monetary Policy Monitor at http://www.td.com/economics/finances/mpm0107.pdf.)
Markets are unanimously expecting the overnight rate to remain at its current level of 4.25 percentage points. More attention will fall on the statement accompanying the decision, as well as the BoC’s Monetary Policy Report Update which will be released on Thursday. Both of these will provide the BoC a forum to signal any potential shifts in their outlook.

Canada’s economic speed limit
We believe the BoC may soften its tone next week for several reasons. Their forecast for the Canadian economy to grow by 2.8% in the fourth quarter looks likely to miss the actual outturn by at least a full percentage point. Moreover, David Dodge commented in December that the Bank’s forecasts for 2007Q1 may also turn out to be too optimistic at this stage. As the Canadian economy cooled through the second half of 2006, the BoC was able to keep interest rates unchanged by arguing that Canadian productivity growth was slowing. As such, the potential speed at which the Canadian economy could grow without fueling inflation was also diminished. The Labour Force Survey released last week showed hours worked growing at a brisk 2.9% annualized pace in Q4 – implying an outright decline in productivity. However, because Remembrance Day did not fall on a weekday this year, the seasonal adjustment done to the data is likely overstating hours worked. This means Q4 productivity is likely higher than the hours worked would suggest. The BoC will have a hard time lowering the Canadian economy’s speed limit once again to fully offset the economic weakness we’ve seen.

Where the BoC sees the risks
Discerning the tea leaves of future monetary policy then rests on exactly what the Bank will have to say on the risks to the Canadian economy. On this account, some stronger indicators in January come on the heels of a general softening trend seen over the last three months. From September to November, the pace of new home price growth in Canada was only a little more than a third of the rate seen since the start of the year. Housing starts for December also declined and came in below consensus, implying further cooling in the housing market is to come. Additionally, retail sales in Canada have been decelerating since January. This is important because the BoC has said the principal upside risk to their forecast is strong credit growth fueled by momentum in home prices and household spending. With a marked deceleration in each of these, upside risks to inflation are lessening.

On the flip side, the Bank’s press release after their December meeting stated they were worried “…that the U.S. economy could slow more sharply than expected, leading to lower Canadian exports.” This sentiment was reaffirmed by David Dodge this week. While he acknowledged that the U.S. housing slowdown does not appear to be filtering as quickly as expected into the rest of the U.S. economy, two sectors that have softened – housing and autos – are two sectors of principal importance to Canada. Canada’s merchandise trade numbers for November released this week showed the auto sector did get a reprieve with exports growing by 5.4%, but the underlying trend remains weak. With oil prices declining further this week and nearing our forecast of a low point of US$50 a barrel, the downside risks for the Canadian economy could best be described as tentative.

There is certainly nothing to suggest that the Canadian economic slowdown is anything more than temporary or mild. The Business Outlook Survey released this week showed firms’ expectations remain positive. Businesses expect sales over the next 12 months to increase at a rate slightly above that of the previous 12 months and capacity constraints remain. However, expectations for producer and consumer price inflation over the next 12 months had fallen. So while core inflation remains at 2.2% – slightly above the Bank’s 2.0% target – both expectations and the increasing economic slack suggest inflation will continue to moderate. For this reason, we forecast the BoC will lower rates twice – 25bps in April and 25bps in May – as an insurance policy against the risks surrounding the economy. As such, it may be time to break the tea leaves out of the cupboard. The BoC does not meet again until early March. If they do see the risks edging slightly toward the downside, this would be their chance to provide guidance to the market on which way they may be leaning. They will then have seven weeks of data to see how the risks unfold.

Shop till you drop – and then some
The cruel irony is that the U.S. housing slowdown is making its presence felt in the Canadian market more than it appears to be leaking into the rest of the U.S. economy. U.S. advance retail sales today defied expectations with a 0.9% gain in December and accelerated over the downwardly revised 0.6% seen in November. The housing slowdown did drag down sales at building materials stores by 1.1%, but there simply appears to be little sign that this is fazing the U.S. consumer one iota. In fact, there is a real chance that real consumer spending in the fourth quarter will actually come in above the 2.8% seen in the third quarter.

With consumer spending accounting for over two-thirds of U.S GDP, further firmness here can cover a lot of sins elsewhere. The U.S. trade gap shrank by nearly one per cent in November and may also contribute positively to growth in the fourth quarter. While the loss of housing wealth has diminished U.S. consumers’ purchasing power, lower energy prices and strong wage growth appear to be just what the doctor ordered to ensure a timely rebound in the U.S. and Canada as 2007 evolves.

Article courtesy of R. Paul Chadwick of TD Canada Trust

For more information please contact A. Mark Argentino

A. Mark Argentino Associate Broker, P.Eng.,
Specializing in Residential & Investment Real Estate
RE/MAX Realty Specialists Inc.
2691 Credit Valley Road, Suite 101, Mississauga, Ontario L5M 7A1

BUS 905-828-3434
FAX 905-828-2829
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