Financial Markets Monthly - July 2010: Risks to the Global Economy Leave Investors Cautious

Highlights

• The combination of fiscal austerity measures in Europe and the slowing in some emerging countries has investors worried about the outlook for the global economy.
• The Fed is likely to stay on hold until mid-2011 to ensure the recovery stays on course.
• Low rates will mitigate the effect of recent financial market volatility, which has weighed on financial assets.
• U.S. economy is in recovery mode...
• ....although the high unemployment rate level means that price pressures will stay muted thereby taking pressure off the Fed to start the process of raising interest rates.
• We revised our interest rate forecasts lower to account for recent market action and the change in our view on the timing of the first Fed rate hike.
• The strength of Canada's recovery means that very low interest rates are no longer warranted.
• The Bank raised its policy rate in June and said it is factoring in both domestic and international developments in future rate decisions.
• The international outlook has been less certain although to date the effect on Canada has been limited...
• ...paving the way for more rate increases ahead.
• The RBA is upbeat on the domestic economy and is keeping a close eye on developments abroad.
• New Zealand raised its policy rate and is likely to continue to reduce policy stimulus.
• Fiscal measures in the UK are generating downside risks to the growth outlook.
• Against the backdrop of fiscal consolidation, the ECB is likely to keep policy stimulative longer than in our previous forecast.

In the past month, financial markets have been hit with a bad case of the jitters on worries that the global economy will not be able to withstand the implementation of fiscal austerity measures in Europe and slowing growth in some emerging economies. Central bankers too have assumed a more cautious tone with both the U.S. Federal Reserve Board and the Bank of Canada pointing to risks to the outlook coming from developments abroad. While we have not changed our baseline forecasts for U.S. and Canadian growth or inflation, recent events suggest that downside risks to the growth outlook have risen leading us to revise the timing and magnitude of tightening in some countries.

IMF upgrades 2010 world growth forecast, acknowledges heightened risks

The International Monetary Fund (IMF) boosted its 2010 forecast of world GDP growth by 0.4% to 4.6% leaving the 2011 forecast unchanged at 4.3%. Stronger than expected growth in the first quarter of 2010 and a solid start in the second quarter supported the forecast upgrade. The IMF said that recent data confirm steady, albeit modest, increases in advanced economies' output and strong growth in emerging economies with “encouraging signs of growth in private demand.” At the same time, the IMF assessed that financial market turbulence boosted the downside risks to the outlook.

U.S. Fed - Financial conditions “less supportive of economic growth”

U.S. data indicate that the recovery is continuing although labour market conditions are proving less robust than most expected. This situation, in combination, with significant financial market volatility and indications that the housing market recovery has stalled, weighed on consumer confidence in June heightening the risk that household spending will moderate following the surprisingly robust gain in the first quarter. In its June 23 statement, the Fed acknowledged that the recovery is underway although it indicated that financial conditions have become less supportive for the economy as developments abroad injected uncertainty into financial markets. We expect that this bout of volatility will not significantly affect global growth in the medium term because the quick action by the European Union (EU) and IMF is likely to stave off a persistent increase in the cost of capital (outside the directly affected economies) and lessened the odds of another breakdown in the global financial system. Even if this event proves to be benign compared to the 2008- 2009 financial system meltdown as we expect, the recent tightening in financial market conditions and sharp drop in financial asset values present a risk to household and business confidence, suggesting that the Fed will retain its commitment to holding rates at the current 0% to 0.25% range.

In the context of RBC's interest rate forecast, this renewed uncertainty means that the timing of the first Fed rate hike is likely to be later than we presented in our June forecast. More likely, the Fed will hold the Funds target in its current range until the second quarter of 2011 rather than hiking at the end of this year. The rationale for this change is twofold. First, the Fed does not want to see the recovery derailed, and second, keeping interest rates low will mitigate some of the downward pressure emanating from the hit to net wealth and will offset some of the rise in the cost of capital associated with widening credit spreads. With interest rates staying low, the balance of risks are tilted toward the U.S. economy weathering this bout of volatility, and we expect the greatest effect on the economy will be felt in the third quarter of 2010 with growth reaccelerating in early 2011. Our forecasts for U.S. growth are unchanged at 3.1% in 2010 and 3.4% in 2011.

More moderate recovery means stimulus to be maintained

Our baseline forecast remains that the U.S. recovery will be more moderate than in past recovery periods, resulting in a fairly slow closing of the output gap and limited improvement in the unemployment rate over the forecast horizon. This persistent slack in the labour market is keeping price pressures muted, and we forecast that the annual increase in core inflation will hold around 1% for the remainder of 2010 and gradually increase to 1.6% in 2011. Given the Fed's dual mandate of price stability and full employment, the low level of underlying inflation means that the policy can focus on supporting economic growth and boosting employment.

In line with the change to the Fed rate call, we re-benchmarked our forecast for U.S. Treasury yields in 2010 and 2011. The sharp rally in U.S. Treasury bonds in June, due to safe-haven flows, saw two-year yields fall to all-time lows while 10-year yields dropped by more than 100 basis points (bps). This lower starting point for the third quarter and subdued investor risk appetite set up for U.S. interest rates to remain low, and we have cut our year-end 2010 forecasts by 45 to 85 bps from the June projections. Our expectation that the Fed will begin the rate hiking cycle in the middle of 2011 and that even as core inflation rises it will remain low by historical standards, is consistent with interest rates staying “lower for longer,” so we accordingly cut our 2011 year-end targets. (page 5)

Strong domestic economy to hold sway in near term for BoC

The Bank of Canada finds itself in the enviable position of dealing with an economy that is within sight of returning to its pre-recession level of GDP output. As of April, the level of real GDP stood just 1.0% below its pre-recession peak and 3.6% above the recession trough. Our forecast is that the economy will continue to grow, albeit more moderately, in the quarters ahead and will be back to its pre-recession peak by September 2010. By year end, our forecast implies that the output gap will have been cut in half enroute to being completely eliminated in the second half of 2011. The labour market has recovered with employment gains accelerating sharply in the second quarter and the unemployment rate falling to its lowest level since January 2009 in June. Inflation in Canada has been running hotter than expected, especially the core rate, which stands close to the Bank's 2% target despite the economy running in an excess supply position. Our analysis (Shifting drivers of inflation, May 4, 2010) showed that movements in Canada's core inflation rate have been increasingly driven by inflation expectations since the Bank of Canada adopted its inflation-targeting policy and increasingly anchored to that target. With that said, we expect some modest downward pressure on prices from the output gap that will keep the core inflation rate a shade below the Bank's 2% target in the near term with a gradual move to the target in the latter part of 2011 as the economy returns to full capacity.

Conditions no longer require “ultra-low” interest rates

All told, conditions in Canada's domestic economy no longer require ultra-low interest rates. The external environment, however, has the potential to weigh on Canada's economy if developments damage the global economy's momentum and hurt confidence.

At the moment, Canada's financial conditions remain supportive for the economy although the degree of ease has fallen significantly since early May. In its June 1 statement, the Bank of Canada said that both the domestic economy and international events will influence the timing of reductions in monetary policy stimulus. As of early June, the Bank assessed that the effect of external events on Canada's economy was “limited” to commodity prices falling and financial conditions becoming less accommodative. Our assessment that Canada's recovery is more firmly rooted than the US's recovery and not as exposed to high levels of indebtedness in both the private and public sector gives the Bank the leeway to continue to reduce the level of monetary policy stimulus. Thus, we maintain our forecast for a steady, gradual increase in the overnight rate during the forecast horizon. The risk to this forecast is that the fallout from the European debt crisis is greater and more persistent than we assume, which causes a negative shock to Canada's terms of trade and reduces demand for Canadian exports. At this juncture, we view the more likely outcome as being a return in momentum in global growth indicators following the recent downdraft.

Canadian rate forecast lowered; overnight rate to 1.25% at yearend

In line with our downward revisions to our U.S. rates profile, we adjusted the Canadian interest rate forecast lower. Our forecast for the Bank of Canada is largely intact with a pause expected early in the fourth quarter as the Bank takes stock of the effect of earlier rate hikes. The policy rate is now forecasted to rise to 1.25% at year end rather than 1.50% as in our June forecast. Our view that Canada's recovery will continue at a decent clip in late 2010 and early 2011 sees the Bank resuming its policy of withdrawing stimulus with the policy rate forecasted to end 2011 at 2.75%, just 25 bps below our June forecast.

The combination of lower U.S. Treasury yields, a slightly slower pace of Bank tightening and the recent sharp decline in bond yields sets a course for Canadian interest rates to end 2010 and 2011 at levels that are lower than our previous forecast. This is especially true for shorter-term interest rates with the yield on the two-year bond expected to end 2010 at 2.00% (from 2.75%) and 2011 at 3.15% (from 3.90%). We cut the 10-year bond yield forecast too but by a more modest 30 bps at the end of this year and 15 bps at the end of next year. Our updated forecast sees the 10-year rate at 3.65% at year-end 2010 and 4.10% at year-end 2011.

Volatile days for the Canadian dollar

We revised our short-term forecast for the Canadian dollar (page 7) lower because global growth uncertainties are likely to prevent a rise in risk appetite in the short term and investors are likely to increase their exposure to safe-haven assets like the U.S. dollar. Longer term, however, we remain Canadian dollar bulls and see the currency strengthening toward parity in the first half 2011 if the global economy proves able to withstand the recent financial market turbulence and as the Bank continues its tightening campaign well ahead of the Fed.

Australia's central bank eyes international developments

The Bank left the cash rate unchanged at 4.50% following its July board meeting and delivered a statement that was slightly more positive than many expected. Policymakers did not signal a change in their forecast for global growth, sticking with the view that the global economy is running at a “trend pace” with Asia, in particular, growing very strongly. Their assessment of the domestic economy remained positive as well, with key commodity prices for the Australian economy remaining elevated and supporting a move in the terms of trade back toward the recent peak. Nevertheless, the Bank signalled that it is keeping a close eye on developments in Europe and global financial markets. On balance, like the Bank of Canada and U.S. Federal Reserve, the Reserve Bank of Australia is taking into account not only domestic considerations but also international developments in setting the interest rate policy. The core inflation rate stands just above the ceiling of the 2-3% target range, and given the limited capacity in both goods and labour markets, we expect it will remain elevated. Another strong labour report in June supports our baseline view that the Bank will hike again in August, although global developments will also be factor in its decision.

New Zealand's central bank gets into action

The Reserve Bank of New Zealand raised its policy rate in early June in line with market expectations. The move reflected a broadening in the base of economic activity. Faster growth in New Zealand's trading partners and rising commodity prices were also sited as positive factors supporting the decision to reduce the amount of policy stimulus; however, the recovery to date has been patchy and momentum is limited. Further rate hikes are likely, and we expect another 75 bps by year end, but the cash rate will remain on the easy side of neutral given the modest recovery and increasing downside risk to global growth.

UK's austerity budget to temper growth; BOE in holding pattern

While markets are worried about a further softening in economic activity in light of the dose of fiscal austerity that is in the pipeline, the Bank of England is showing increased concern about inflation expectations. Last month's Emergency Budget delivered on promises of draconian cuts to spending, which will account for 80% of the savings required to eliminate the structural deficit by 2014-2015. The weight of these cuts combined with slower European growth will likely temper the economy's momentum and keep the Bank on hold as long as inflation does not misbehave in the next few months. The government's decision to delay an increase in the value added tax (VAT) until January 2011 is important for the monetary policy outlook because an immediate implementation of the increase would boost the headline inflation rate further above the Bank's target, supporting concerns that inflation expectations would rise again and immediately force the Bank's hand in raising rates. Given the risks to the growth outlook, we expect the Bank to hold the policy rate at the current 0.5% until the second quarter of 2011 although recent commentary has increased the risk of an earlier move.

European economies face fiscal restraint

The cost to insure the debt of the peripheral European countries against default remains high although the Euro has recovered some ground against the US dollar. The ISM surveys of manufacturers and service providers showed a mild deterioration in sentiment in June although both are consistent with increasing activity levels. As the fiscal austerity measures bite, the pace of growth is likely to slow. In its July update, the IMF cut its 2011 Euro Area GDP forecast by 0.2% to 1.3% with growth in 2010 projected to increase by 1.0%. Against the backdrop of fiscal consolidation, monetary policy is likely to remain lax, and we pushed out the timing of the first rate hike by the European Central Bank in our forecast until late 2011 rather than in the first quarter as we pencilled in earlier.

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