Canadian interest rate forecast for July, 2012

July 5, 2012

VANCOUVER, BC, Jul 5, 2012/ Troy Media/ – European politicians and policymakers managed to avoid a looming crisis and crafted an agreement to deal with the most pressing issues of a bailout of Spain’s banks. A banking union is closer to realization as a result, while achieving a fiscal union will need more summit meetings, more compromises, and more time.

Meanwhile, Europe’s economic recession worsens which the growth pact formulated at the summit will not stem. The global economy’s slowdown will continue in the near term but lift later in 2012 and in 2013 with additional policy stimulus from the emerging economies, a steadily improving U.S. economy, and less market uncertainty.

The low interest rate environment extends well into 2013 before central bankers begin to the long road to rate normalization.

Eurozone Crisis

The EU summit made some important progress but much more remains to be negotiated and implemented.

The decision to break the connection between bank bailouts and higher sovereign debt is an important step. A single supervisory mechanism for euro area banks involving the European Central Bank (ECB) moves the euro area towards a banking union.

Bank recapitalization in Spain will come from EU bailout funds, the European Financial Stability Facility (EFSF), until the European Stability Mechanism (ESM) becomes available and then support will be transferred to the ESM without seniority.

Conditions are attached with the support, including compliance with state aid rules. The summit agreed to use the existing EFSF/ESM instruments, bond purchases in primary and secondary markets, but did not agree on ECB bond purchases.

Another agreement was a growth pact comprising more capital to the European Investment Bank, allocation of unused structural funds from the EU budget, and project bonds for infrastructure projects. These measures amount to €130 billion.

All summit decisions are to be implemented by July 9, 2012 and are designed to address immediate pressing issues such as maintaining Spain’s and Italy’s access to debt markets.

Future measures will likely include increasing the size of the bailout fund. Also, the ECB will likely be more heavily involved to alleviate future market stresses via another Long-Term Refinancing Operation (LTRO). The steps toward broader banking and fi scal integration will come at future summits and likely evolve over years.

Economy

The global economy is in a growth ‘soft patch’. Europe is in a deepening recession and pulling down exports from emerging economies while those external forces, as well as domestic issues, affect the U.S. economy. Growth prospects appear dim in the near-term though brighten later in 2012.

In the medium term, moderate growth and volatility will be the bywords. Europe’s recession is gaining momentum and spreading from south to north. German industrial production shrank in April and production is well below the levels reported in the summer of 2011. Germany’s Purchasing Manager Index (PMI) has been below 50 for four months ending June, pointing to worsening business conditions. Second quarter 2012 real GDP will likely contract or eke out a very small gain at best.

The current situation in France is similar to Germany’s but with weaker initial conditions. Recent economic growth has been barely positive and its PMI was below 50 in the latest four months. Real GDP will be negative in Q2 2012 and likely in Q3 2012 as well.

The economies of Italy and Spain remain in the recession that began last year. The recession will worsen, according to PMI manufacturing and retail indicators. Their main economic data on production, exports, employment, consumer spending and confidence, and investment are contracting. Real GDP is on track to contract in the next two quarters at a minimum.

The EU summit was more positive than most expected but its impact on the real economy is minimal and it will not lift the Euro area out of recession. The Euro area’s recession will likely end in early 2013, assuming additional policy measures are implemented such as an ECB rate cut, some fiscal growth measures, and no policy missteps.

The consensus Euro area growth forecast is 0.7 per cent in 2013 with the recession ending in Q4 2012. Growth is penciled in at 1.0 to 1.5 per cent during 2014.

The slowdown in the Chinese economy is apparent across various indicators. Industrial production, trade data, retail sales, and fixed asset investment are expanding at a slower pace in recent months. The HSBC Flash Chinese Manufacturing PMI reported a sharp decline in new export orders in June and the overall index was below the critical 50 reading. The official PMI produced by the National Statistics Bureau was just above 50 in the May report, the latest available.

Near-term prospects hold a similar growth story in Q3 2012 but stimulative policy measures should begin to bear fruit thereafter. China cut its base lending rate and reduced its reserve requirement for the third time in six months. The government is trying to ramp up infrastructure investment spending.

This policy stimulus in China and in some other emerging economies will help lift the global economy out of its growth soft patch. Lower oil prices will help as well. Growth expectations for China are higher for 2013 at above 8 per cent while 2012 is seen below 8 per cent.

In several other emerging economies, faster growth is expected in 2013 compared to 2012. A recovery in Europe and faster U.S. economic growth will contribute to their better growth outlook in 2013.

The U.S. economy is chugging along at a 2 per cent pace in the midst of the European recession and the slowdown in emerging economies. The latest manufacturing indicators suggests weaker growth though. The June ISM manufacturing reading fell 3.8 points to 49.7, its first sub-50 reading of the recovery. There was a large drop in new orders to 47.8 in June from 60.1 in May, the weakest figure since April 2009.

Production was still expanding in June at 51.0 but July could be weaker on the large drop in new orders. The inventory index remained below 50, implying no excess.

Other negative indicators include declining retail sales in May and April. Excluding autos, sales have fallen even more sharply, down 0.4 per cent in May and 0.3 per cent in April. Lower gasoline prices and some shifts in weather-related spending were in play, so overall spending may not be as weak as it appears. June retail sales could disappoint since consumer confidence took a hit in June, likely the result of stock market declines and European events and some recent labour market weakness.

Weekly jobless claims remain elevated relative to the winter months. A similar upturn occurred last spring and summer but declined thereafter. The U.S. labour market saw payroll employment increase only 69,000 in May while the previous two months were revised down. Expectations for June payroll employment are for a 90,000 gain, above April and May.

All job growth since the recession has been in the private sector. Durable goods data for May came in on the upside. Fundamentals suggest reasonable support for additional business investment, but concerns about Europe and slowing growth in China will probably hold back spending.

The housing market continues to improve gradually. Existing-home sales dipped 1.5 per cent in May but are still up 9.6 per cent from a year earlier. The FHFA Purchase-Only House Price Index added 0.8 per cent in April and is up 3 per cent from the year before. Prices increased in both March and February but are still down 18 per cent from the 2007 peak. The April S&P/Case-Shiller composite 20-city home price index was up 1.3 per cent in April from the previous month and down only 1.9 per cent from a year earlier.

Ten of the 20 cities posted annual increases in April. Construction spending for May was 0.9 per cent higher than in April and 7 per cent higher than one year ago. Private residential construction spending showed a strong monthly gain and is now higher than last year. Private non-residential construction spending also had a moderate increase, but public construction spending continues to decline.

Cheaper oil will give Americans more spending power. West Texas Intermediate (WTI) oil prices have fallen 25 per cent since early May to about $80. Prices for other cyclically sensitive commodities are also down. Lower oil prices will bring lower gas prices, which should lift household consumption.

The basket of latest economic indicators while mixed is clearly more negative than positive. The Risk of Recession index for May rose for the third consecutive month to its highest reading since November 2011. It places the probability that the U.S. will be in a recession in six months at 32 per cent.

What do the leading economic indicators say?

The Conference Board index rose 0.3 per cent in May, after falling 0.1 per cent in April and has risen in seven of the past eight months. The ECRI weekly leading index gained slightly in the latest week, but it remained below previous readings. Both series are signaling the slowdown will continue in the near term but no recession.

The consensus view has growth in the 2 to 2.5 per cent range for the rest of this year and into 2013 but sees growth at 3 per cent on average with a low range of 2.4 per cent and the high at 4 per cent.

Economic projections released by the Federal Reserve for U.S. GDP ranges from 1.9 per cent to 2.4 per cent this year, compared with 2.4 per cent to 2.9 per cent predicted in April. Growth is seen between 2.2 per cent and 2.8 per cent in 2013 and 3.0 per cent to 3.5 per cent in 2014.

Europe remains the main uncertainty despite progress made at the just completed EU summit. China’s economy will not undergo the hard landing feared by some since policymakers have considerable latitude to re-stimulate.

On the U.S. front, the main risk is the ‘fiscal cliff’ slated for the end of this year. The automatic tax hikes and spending cuts amount to more than $600 billion. Since the political cycle culminates in a presidential election this year, it is unlikely any break in Washington’s gridlock or a budget compromise occurs.

The likely scenario is for a continuing resolution, i.e., extension of the status quo, to come into effect following the election, giving some time for newly-elected officials to deal with these fiscal measures. While dependent on the election results, only some of those measures will likely take effect.

This forecast has U.S. economic growth around 2 to 2.5 per cent in Q2 and Q3-2012 rising to 3 per cent in the last quarter when China’s economy is through its soft patch and domestic demand growth revives.

The fiscal cliff will be a drop-off rather than a plunge likely around mid-2013. Private sector growth and the improving global economy will have the U.S. growing above 3 per cent annually on a trend basis during 2014.

Canada’s economic performance remains largely tied to the U.S. Canada’s growth slowdown is following the U.S., which reflects time lags. Canada’s economy is more variable than the U.S. Recent indicators point to slower growth.

Industry real GDP grew 0.3 per cent in April, after edging up 0.1 per cent in March. Most of April’s increase was due to mining and oil and gas extraction, which rebounded from maintenance and production difficulties in February and March. This volatility masks an underlying trend growth of 2 to 2.5 per cent annually.

Employment growth slowed to 7,700 jobs added in May after 140,000 jobs generated in March and April. Those out-sized gains will likely retrace with job losses in June and July. Underlying trend growth in employment is around 1.5 per cent annually or 20,000 to 25,000 per month.

Exports are vulnerable to the global slowdown and could explain their slower pace in the first quarter. April’s real merchandise exports came in below March and have declined in three of the past four months. While monthly exports are highly variable, the outlook for May to July/August exports is weak.

Domestic sectors of the economy are slowing. Inflation-adjusted retail sales are down since last December and housing construction is set to ease, since housing sales are softer in the most recent months.

The government sector continues to contract. A more positive situation is evident in non-residential building construction investment. Housing sales have slipped in the two months ending May and indications point to fewer sales in June.

Consumer confidence was hit by the European crisis, which is never positive for large consumer transactions. The federal government’s latest tightening of mortgage insurance rules coming into effect July 9 will slow future sales.

Housing prices will follow sales and rise at a slower pace. These moves intend to slow rising household indebtedness and the Toronto condominium market affects all local markets.

Second quarter 2012 real GDP growth is downgraded to 1.5 per cent from 2.0 per cent annualized with the year expected to average 2.0 per cent versus 2.2 per cent previously. A modest improvement to 2.4 per cent is expected in 2013 with another gain likely in 2014, bringing growth to 2.7 per cent on stronger a U.S. and emerging markets.

Europe’s recovery will be more widespread in 2014 and led by the core countries. The quarterly growth profile will remain variable due to political, economic, and weather-related events. Current weakness will give way to a pickup extending to the first quarter of 2013 when another deceleration phase materializes in the second half of 2013 when U.S. fiscal tightening slows that economy. Thereafter, another growth acceleration phase in 2014 is expected.

The base scenario has a 70 per cent probability while a very slow growth or an outright recession phase is 20 per cent. The remaining 10 per cent is assigned to a higher growth scenario.

Inflation

Canada’s inflation rate dropped to 1.2 per cent in May from 2.0 per cent in April on falling gasoline prices. Energy prices were 1.6 per cent below the previous May with gasoline 2.3 per cent lower. The Bank of Canada’s measure of core inflation was 1.8 per cent in May, down from 2.1 per cent in April.

June’s all-items CPI will come in higher at 1.6 per cent and the Bank’s core inflation rate will probably rise 2.1 per cent. Some of this increase over May is due to the base effect, since the CPI index declined in June 2011.

The underlying inflation rate is slightly below 2 per cent and, in the context of modest to moderate economic growth with excess capacity, inflation pressure from the domestic economy is insignificant. This will change later in 2013 with diminishing excess capacity and potentially insufficient capacity in 2014. The Bank of Canada will act a few months before the output gap closes.

Interest rates

Most Treasury bill rates and bond yields declined during June relative to May but were range-bound for most of June, with the exception of a drop and rebound around the Greek election.

Administered rates in Canada behaved oddly, especially GIC rates posted by the Bank of Canada. According to that source, the three-year GIC rate (1.13 per cent) is lower than the one-year GIC rate (1.30 per cent). This is an extremely rare outcome and raises some questions.

In response to a query, the Bank replied they use typical rates from the six major banks, not the average rate, and a semi-annual rate rather than the annual rate. Another observation is that GIC rates have been quite volatile in the past three months.

Our Economics Department surveys deposit and lending rates regularly and its latest survey reveals three-year GIC rates are higher than one-year GIC rates by 10 to 20 basis points and no lender in this survey is offering a three-year rate lower than the one-year rate.

The Bank of Canada held its target rate at 1 per cent at its June 5 meeting. The next meeting is July 17. In a speech on June 21, its Governor, Mark Carney, used the same wording on the forward-looking aspect of monetary policy tactics as in the June 5 statement. In particular, ‘. . . to the extent that the economic expansion continues and the current excess supply in the economy is gradually absorbed, some modest withdrawal of the present considerable monetary policy stimulus may become appropriate, consistent with achieving the 2 per cent inflation target over the medium term. The timing and degree of any such withdrawal will be weighed carefully against domestic and global economic developments.’

Perhaps a more notable development was the U.S. Federal Reserve extending its Operation Twist program by purchasing Treasury securities with remaining maturities of six years to 30 years through the remainder of 2012. This will hold down long-term yields and mortgages rates with downside pressure. However, it will not have a substantial impact on the economy since rates are already every low.

The Fed reiterated its intention to keep short-term interest rates near zero through late 2014.

Interest rate forecast

There is no change in the timing of the next Bank of Canada rate move from last month. Three 25 bps increases beginning mid-2013 followed by another pause is the base scenario. The yield curve will remain fairly shallow with the spread between the 10- year GoC and three-month T-bill around 1 per cent or 100 bps for another two quarters before widening or steepening on better economic prospects pushing up the long end. By the end of the two-year forecast period, the spread widens to 135 bps.

The current low yield spread is usually associated with an economy in the middle to later stages of the business cycle and with above-trend growth. However, with uncertainty running high, the safe haven and income motives are pushing down long yields and compressing the yield curve.

The futures market for three-month Bankers Acceptances is not expecting a 25 bps rate increase until after March 2014 and 50 bps in total by the end of 2014. The consensus economic forecast view has a 25 bps increase by April 2013 and 75 bps in total by the end of 2013. There is a considerable divergence in views between economists and the market.

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