Financial Markets Monthly - November 2010: As the World Turns Print
Long Term Forecasts | Written by RBC Financial Group | Nov 10 10 16:42 GMT

Financial Markets Monthly - November 2010: As the World Turns


  • QE2 is announced as the Fed works to ensure that the economy builds momentum.
  • After a subdued Q3/10 real GDP print, recent data suggest modest strengthening in Q4/10.
  • October payrolls rise more than expected although the unemployment rate held steady at 9.6%.
  • Low interest rates are forecasted to support a steady upward trend in economic output.
  • Given the significant slack, however, inflation will remain low in the near term with only modest increases likely in 2011.
  • Canada's economic data have been bouncing around with momentum staying weak in Q3/10.
  • This slowing along with a slower U.S. growth outlook resulted in downward revisions to our 2010 and 2011 forecasts, and expectations that the Bank of Canada will maintain a 1% overnight rate until the second quarter of 2011.
  • The uncertain external environment also supports the case for the Bank to stay on the sidelines in the near term.
  • U.K. Q3/10 real GDP doubled market expectations, rising a nonannualized 0.8%, and PMIs indicate continued growth in Q4/10.
  • The RBNZ held the OCR steady because recent domestic data "turned weaker than projected."
  • The RBA unexpectedly raised the cash rate to 4.75% in a preemptive strike against the medium-term inflation risks.
  • Recent data from the Eurozone have been upbeat, with PMIs pointing to continued expansion, and confidence measures surprising to the upside.

The daily swings in market sentiment continue as investors try to interpret the changing political landscape, stop-and-go central bank policy and noisy economic data. Safe-haven flows continue to trickle into global bond markets and investors are dipping their toes back into the equity markets. The MSCI World Stock Index posted a 13.5% gain in the two months ending November 1, 2010 after suffering during the summer down draft. The foreign exchange market is one that continues to trade with a clear bias toward U.S. dollar weakness with the trade-weighted dollar off 5.8% since September 1.

Changing conditions mean central banks will sit tight

The shifts in the global economic and political backdrop support the case for central banks, in many areas, to sit tight for most of 2011 and maintain aggressively easy monetary policies. The downside risks to the global economy are not as dire as they have been, but they still exist. Additionally, the slowing in momentum in U.S. growth in the middle of 2010 has put the economy on course to grow more slowly than was anticipated three-months ago. This situation means that the unemployment rate will remain elevated and that core inflation will stay abnormally low for longer. Against this backdrop, the Fed is unlikely to be in position to raise the Fed funds target next year, and we accordingly shifted out into the future the timing of the first rate increase to 2012. This change has resonated in our calls on other central banks as well with the Bank of Canada now expected to maintain a 1% overnight rate until the second quarter of 2011, the Bank of England only initializing its rate-hike cycle late in 2011 and the European Central Bank holding its policy rate steady until 2012.

Federal Reserve puts more gas in the tank

The U.S. Federal Reserve announced another round of quantitative easing, or QE2, on November 3, 2010. The decision to purchase more long-term U.S. Treasury bonds was supported by a rather sombre assessment of the state of the U.S. economy. Output and employment gains were described as "slow," and the falling trend in underlying inflation was said to have resulted in current readings being "somewhat low, relative to levels that the Committee judges to be consistent, over the longer term," with its mandate. The Fed also pointed to the elevated unemployment rate as inconsistent with its goal of achieving maximum employment. With progress toward achieving its objectives as "disappointingly slow," policymakers deemed another round of Treasury bond purchases to maintain the Funds target in the 0% to 0.25% range as necessary to ensure that the economy transitions to a firmer growth path. The Fed's statement provided policymakers with the flexibility to alter the program depending on the how inflation and the labour market perform; however, we believe that it would take a major economic shock before the Fed would make a substantive change to the program, and we anticipate that the full $600 billion of U.S. Treasury bonds will be purchased by the end of the second quarter of 2011. US economy headed out of slow growth patch?

After falling into a period of sub-par economic performance in the second and third quarters, economic reports point to the US economy emerging from this slow growth patch in the latter part of the year. The economy grew at a 2.0% annualized pace in the third quarter, only modestly quicker than the 1.7% gain recorded in the second quarter. The acceleration was largely a result of a smaller drag from net trade and continued inventory building, as growth in final sales to domestic purchasers slowed. That said, activity in housing markets appear to have found a post-tax credit floor suggesting that the third quarter's sharp decline in residential investment will not be repeated. As well, consumer spending growth improved notably, recording its fastest quarterly gain since the fourth quarter of 2006. With interest rates remaining extraordinarily low and the pace of job gains quickening, we look for the stronger consumer spending pace to continue in the final quarter of this year. This is a key support for our forecast that overall GDP growth will improve to a modestly above-trend pace through the fourth quarter of this year and into 2011 despite an expected moderation in fiscal support.

U.S. economic surprise index makes a surprising turn!

In the four weeks ended November 5, 2010, U.S. economic data beat market expectations by the largest margin since mid-September 2009. Stronger than expected reports on manufacturing and services-sector activity were followed by a larger than expected gain in U.S. private-payroll employment. These reports augur well for the economy to kick it up a notch in fourth quarter although growth is likely to be just a shade faster than the third quarter.

QE2 will result in the economy building momentum

We trimmed back our annual growth projection for U.S. GDP in 2011 following the weaker than expected growth reported so far this year. Our forecast of 2.8% is higher than the consensus projection of 2.4%, however. Additionally, our view incorporates our assessment that, with interest rates extraordinarily low, the economy's momentum will build with quarterly growth rates following a steady upward trend. Still, our projection for growth means that the U.S. economy will grow only slightly faster than its potential growth rate, so the vast amount of slack that exists in the economy will only slowly be whittled away. Against this backdrop, the unemployment rate will be very slow to decline. Given the Fed's rationale for providing additional stimulus last week, it is unlikely that, with a 9% unemployment rate, the Fed will be comfortable with boosting policy rates in 2011. More likely, the first rate increases will come in mid-2012 as the pace of growth accelerates thereby generating more substantive declines in the unemployment rate.

Bank of Canada steps to the sidelines

The Bank of Canada maintained the overnight rate at 1.00% at its October policy-setting meeting, following three consecutive hikes of 25 basis points (bps) that raised the overnight rate from its recent trough of 0.25%. The Bank's decision reflected its assessment that the global economy had slipped into a weaker growth path, and that domestic spending and inflation were slowing more than expected.

The Bank fleshed out the details of its forecast update in its October Monetary Policy Report, in which the Bank stated that the economic recovery is likely "to be more gradual than it had projected in its July" report. Specifically, the bank revised down its Canadian growth for this year and next to 3.0% and 2.3%, respectively, from the previously estimated 3.5% and 2.9% although revised up growth in 2012 to 2.6% from 2.2%. The central bank now expects the output gap to close by the end of 2012 rather than the end of 2011 to early 2012. This weaker growth profile resulted in the Bank downgrading its projection for the core inflation rate with the rate hitting the 2% target in the final quarter of 2012.

Slower global growth

Playing into the Bank's decision to maintain a 1% policy rate was its assessment that the pace of global growth has slowed. The Bank cut its forecast for U.S. real GDP growth to 2.7% in 2010 from 2.9% and more substantially to 2.3% from 3.0% in 2011. Deleveraging by households, the persistently weak labour market and renewed weakening in the housing market are resulting in a more gradual recovery in domestic demand than the Bank assumed in July 2010. The outlook for the world economy was upped in 2010 to 4.7% from 4.6%, yet this likely reflects strong growth in the first half of the year. 2011's global growth forecast was shaved to 3.5% from 3.8%.

See-saw pattern in growth numbers

Canadian economic data have proven to be volatile in recent months with July's mild contraction in GDP followed up by a healthy rebound in August. September's reports are still few and far between, but they generally show that the economy remained on a milder growth trend compared to earlier in 2010. This see-saw pattern in the data led us to revise our third-quarter GDP forecast down to 1.8% from 3.0% or just slightly slower than the second quarter's 2% pace. Core inflation also geared down in the third quarter, averaging 1.6% following the 1.8% average pace recorded in the first six months of the year. The slower growth momentum in the third quarter sets us up for a more muted rebound in the final three months of the year resulting in a downgrade to our 2010 growth projection to 3.1% from 3.3%. We also cut our forecast for 2011 with the economy likely to grow by 2.9% rather than 3.2%, which is in line with our lower forecast for the U.S. economy.

Risks to outlook balanced but are still there

Like the Bank, we see both upside and downside risks to the outlook. On the upside, a quicker emergence from the recent slow patch in both Canada and the US could generate unanticipated upward pressure on inflation. On the other hand, Canada's economy is at risk of falling under downward pressure due to a persistent strengthening in the Canadian dollar or more aggressive easing in housing market activity. Reflecting these risks to the near term outlook, we maintain our call that the Bank of Canada will keep the overnight rate at 1% in the near term. The slower growth profile in early 2011 in both countries and expectations of no Fed action until 2012 point to the Bank staying on the sidelines until the second quarter of 2011. At that point, concerns about sustainability will likely have eased sufficiently for the Bank to resume increasing the policy rate. We look for policy support to be removed very gradually and forecast a cumulative increase in the overnight rate of 100 bps in 2011 to 2.0%.

Upside data surprises in the UK nix further easing for now

The preliminary estimate for U.K. third-quarter 2010 real GDP doubled market expectations by rising a non-annualized 0.8%. Digging beyond the solid headline, much of the strength came from the construction sector. This significant boost is widely expected to be short lived as Britain's austerity plan slows public investment and the still weak housing market has builders wary of starting new projects. With that said, the services and production industries expanded solidly in the third quarter, and PMI readings were strong in October. Given these positive data points, it was not surprising that the Monetary Policy Committee (MPC) decided to stand pat at its November 4, 2010 meeting.

Going forward, policymakers will have to continue to weigh concerns surrounding two opposing risks: that the current high and volatile levels of inflation will feed into inflation expectations, or that the private sector will not be able to fill the void from fading publicsector support, thereby resulting in further spare capacity and disinflationary pressures. The minutes from October's MPC meeting seem to suggest to us that several Committee members are leaning toward the latter. The upcoming November MPC minutes should shed a little more light on policy direction, but we believe that the recent tone of rhetoric is consistent with no change in policy in the near term.

RBNZ sits tight while RBA makes a pre-emptive strike

As was unanimously expected, the Reserve Bank of New Zealand held its policy rate at 3.00% in its October 28 meeting. The central bank noted that it was appropriate to keep the OCR on hold because recent domestic data "has turned weaker than projected." Governor Bollard, however, stated that the medium-term outlook "remains broadly in line with that assumed at the time of the September Monetary Policy Statement" and that it "remains likely that further removal of monetary stimulus support will be required at some stage." This vague timeline for the resumption of policy tightening places the burden of proof for further rate changes squarely on domestic data, and recent price and activity indicators suggest that this process will not resume until March 2011.

In contrast, the Reserve Bank of Australia unexpectedly raised the cash rate by 25 bps to 4.75% at its November 2 meeting. The increase was the first move since May and was construed as a pre-emptive strike against the "risk of inflation rising over the medium term" due to the economy being "subject to a large expansionary shock from high terms of trade" and having "relatively modest amounts of spare capacity." The underlying strength of the economy supports the case for further monetary policy tightening; however, the odds favour several pauses during this next stage in the tightening cycle. We expect that the cash rate will finish 2010 at 4.75% and end 2011 at 5.50%.

European data upbeat but ECB remains cautious

Recent data from the Eurozone have been fairly upbeat, with the latest PMIs pointing to continued expansion across most of the larger economies and confidence measures continuing to surprise on the upside. While economic growth is expected to moderate in the second half of 2010, the European Central Bank noted that the "positive underlying momentum of the recovery remains in place" and expects growth to be supported by the on going global recovery, as well as "by the accommodative monetary policy stance and measures adopted to restore the functioning of the financial system." With that said, the pace of recovery will likely be dampened by "the process of balance sheet adjustments in various sectors" and risks to the outlook are "still slightly tilted to the downside, with uncertainty still prevailing." With inflation expectations remaining firmly anchored, the central bank mainitained its view that current policy rates are "appropriate" at its November meeting.

Full Report in PDF


About the Author

RBC Financial Group

The statements and statistics contained herein have been prepared by the Economics Department of RBC Financial Group based on information from sources considered to be reliable. We make no representation or warranty, express or implied, as to its accuracy or completeness. This report is for the information of investors and business persons and does not constitute an offer to sell or a solicitation to buy securities.