Tuesday, November 27, 2007

RBC believes the Bank of Canada will hold rates steady over the next while

Bank of Canada to hold rates steady; C$ strength to slow growth

Healthy job gains and escalating wage growth this year are providing strong support for consumer spending, with real retail sales running 5.3% faster, on average, than in the same period last year. However, strong jobs gains, rising wages and the strong housing market will keep the Bank of Canada worried that fast-paced household spending will push the economy further into excess demand.

The continued deterioration in the U.S. housing market and the sky-high Canadian dollar are inflating the downside risks to the outlook for Canadian exports. Canada's dollar will likely continue to appreciate into early 2008, leading to softer demand for Canadian exports and resulting in the trade sector acting as a more significant drag on growth. We expect the Bank to cut the overnight rate by 25 basis points in the first quarter of 2008 and have adjusted our forecast for Canadian interest rates downward accordingly.

Interest rates are expected to trade at the low end of their recent range, ending the year at 4.10% for two-year yields and 4.25% for 10-year yields. In early 2008, a 25 basis-point cut in the overnight rate to 4.25% is likely to see short-term rates move modestly lower.

Our expectation that the U.S. economy will reaccelerate in the second half of 2008 will likely see the U.S. dollar regain ground against its major trading partners, with the Canadian dollar likely to drift back down through parity. This will take some of the sting out of the trade sector's bite on Canadian growth and will give the Bank room to reverse its early 2008 rate cut.

We still expect interest rates in Canada to grind higher in the second half of 2008 but have trimmed back our forecast to 4.5% for two-year rates (from 5.00%) while maintaining our previous forecast of 5.05% for 10-year rates at year-end.

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A. Mark Argentino
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