The Weekly Bottom Line

HIGHLIGHTS OF THE WEEK

• Post-tax credit U.S. home sales plummet by 27% in July, pushing inventories of unsold homes to a new peak of 11.3 months and renewing recovery fears.
• New orders of U.S. durable goods orders rose slighly by 0.3% in Jul. Core capital goods fell by 8.0%, pointing to a slowdown in the pace of equipment and software investment in the third quarter.
• U.S. second quarter GDP was revised down to 1.6% from a previously reported 2.4%. Revisions were in higher imports and lower inventory investment. Final domestic demand, including consumption and business inevstment where revised up.
• Fed chairman Ben Bernanke's speech in Jackson Hole discusses the ins and outs of the options available to the Fed for supporting the economic recovery and stresses that deflation seems an unlikely outcome.
• Canadian retail sales slide 0.8% in Q2, marking the worst performance since the first quarter of 2009.
• Corporate profits in Canada were down 1.8% in Q2, ending a 3-quarter string of rising profits.
• The Teranet Home Price Index showed a 13.6% Y/Y rise in existing home prices in Canada in June.
• We have scaled back our Bank of Canada interest rate forecast. We now expect the overnight rate to sit at 1.00% at the end of 2010, and 2.00% at the end of 2011.

UNITED STATES - ON MURPHY'S LAW & MONETARY POLICY

When the history books are written on the financial crisis and Great Recession you can be sure there will be entire volumes dedicated to the response of policymakers. The law of unintended consequences is not an official theorem in economics, but perhaps it should be. This paradigm was certainly on full display this week in the economic data, and was also the topic of an important speech by Fed Chair Ben Bernanke.

The homebuyer's tax credit was a well-intentioned attempt to support housing demand by giving an up to $8,000 subsidy to homebuyers. Initially it seemed that the policy was quite successful. Home sales rose through 2009 and early 2010 and inventories of unsold homes declined. Arguably, the confidence instilled in financial markets and consumers from the improvement in housing also contributed to the general rebound in economic activity and retail sales in particular, over this time. It was hoped that while the tax credit was designed to be a temporary lift, so that this initial rise in home purchases would last long enough that by the time it expired the economy would be well into the recovery and the payback would be relatively minimal.

Fast forward to July 2010. The tax credit has expired. Anyone purchasing a home is paying up to $8,000 more than they would have paid a month ago. Not surprisingly, given the close to 5% increase in the cost of the median-priced house, the number of existing home sales plummeted by 27%. The unfortunate part is that with the economic recovery in such a precarious state, the last thing needed was another injection of uncertainty from the housing market. Strike one down for Murphy's law.

On that note, conducting monetary policy while avoiding unintended negative consequences could have been the topic of Ben Bernanke's speech in Jackson Hole this week. The meat of Bernanke's speech laid out the costs and benefits of both the Fed's earlier foray into quantitative easing (QE) and any additional stimulus measures. On QE, he stressed the theory behind the move - that by decreasing the supply of securities it would push down yields on competing investments and lead to a general easing of credit conditions - as well as his belief that it had been relatively effective in accomplishing its goal. He then went on to discuss the positives and negatives of the three main options available to the Fed going forward.

Under the title "policy options for further easing," Bernanke discussed additional QE, changes to the Fed's communication strategy, and decreasing interest paid on excess reserves. This isn't the first time we've heard these options laid out, but this time Bernanke described in greater detail the potential costs and benefits associated with each choice, which in a sense gave us a clue to the Fed's preference should push come to shove. On the plus side for further QE: additional purchases could further ease financial conditions, but likely not as much as in periods of extreme illiquidity and financial stress. On the downside, it also adds uncertainty about the ability of the Fed to withdraw stimulus and could dislodge inflation expectations. On language: the Fed could be more explicit about its commitment to low interest rates by tying them to a specific timetable or outcome for inflation. Pushed through the yield curve, this should lead to lower long-term interest rates. On the downside, this could prove counterproductive since it must still "be conditional on how the economy evolves" and could unduly tie the Fed's hands. Finally, in terms of decreasing interest rates on excess reserves, the feeling is that the marginal impact would be relatively small and the consequences for maintaining liquidity in the Fed Funds market fairly significant.

Given our outlook for economic activity over the next year (an outlook which the Fed has moved much closer to over the last few months), the most likely scenario is a continuation of the current stance of monetary policy, with a gradual removal occurring only once economic growth has moved and is sustained above potential, which we don't anticipate will happen until mid next year. If things do turn south, the most likely outcome appears to be additional QE, the option, which given Bernanke's analysis, has the most upside and least costly downside.

CANADA - ECONOMIC ACTIVITY TO MODERATE, BUT RATE HIKES STILL IN THE CARDS

The sharp rebound in Canadian economic activity seen during the final quarter of 2009 and the first quarter of 2010 was stronger than any economist could have asked for. But the rate of growth in several sectors - including the housing and labour markets - was simply unsustainable, and a degree of moderation has subsequently been anticipated. Even with expectations for some payback, economic data in Canada has managed to come in weaker than expected in a number of areas.

This week, it was the retail sales report for June that disappointed markets. Not only were sales flat on the month (up by 0.05%), but May's figure was downwardly revised, suggesting that consumers - which have been a key source of strength during the recovery - have been reining in spending over the past few months. Indeed, for the second quarter as a whole, retail sales were down 0.8% following four consecutive quarters of gains, and marked the worst performance since the first quarter of 2009. On a brighter note, prices played a role in the decline, as the volume of retail sales edged up 0.9% in June. This will provide a good hand-off for the third quarter.

Also disappointing this week was the Quarterly Financial Statistics report that showed an end to a 3-quarter string of rising profits for Canadian corporations. Operating revenues were flat in the second quarter, while profits fell 1.8% (seasonally adjusted). Given the 2-3 quarter lag between profits and job growth, this certainly doesn't bode well for employment during the latter half of the year - although this is consistent with our view that job growth will be much softer going forward.

The only positive news out this week was the 13.6% Y/Y jump in the Teranet Home Price index. Unfortunately, this is mostly water under the bridge. While the repeat sales index is useful as a home value and equity metric, it typically lags the other housing market indicators (such as the CREA standard average price) in detecting turning points. And by the CREA measure, sales have dipped 30% since year-end 2009.

So what does all this mean for economic growth in Canada and the direction of monetary policy? Well, second quarter real GDP figures are due out next week, and we are expecting growth to come in at about 2.5% Q/Q (annualized). While still a decent growth rate, it is a marked deceleration from the 5-6% growth rates seen in the two quarters prior. However, the Canadian economy is still characterized by limited slack, healthy job growth and consumer and corporate credit flows. As such, the emergency low interest rate levels are no longer warranted, implying that the only direction for the overnight rate is up.

Having said that, we are mindful of the fact that other economies around the globe are struggling to maintain healthy growth rates - which could ultimately filter back into the Canadian economy, weighing on growth. This, combined with the notable moderation in economic activity seen during the second quarter of this year in Canada, has led markets to alter their views on monetary policy. In fact, markets are now placing less than 50% odds on a rate hike next month. While we continue to forecast a 25 basis point rate hike on September 8th, we have scaled back our interest rate forecast thereafter. We now expect the bank to pause after September's increase, ending this year at 1.00%. Next year, the central bank will resume its tightening cycle, but at a more measured pace. Indeed, we are calling for a gradual rise in the overnight rate, with a year-end target of 2.00%.

U.S.: UPCOMING KEY ECONOMIC RELEASES

U.S. ISM Manufacturing Report - August

• Release Date: September 1/10
• July Result: 55.5
• TD Forecast: 52.1
• Consensus: 53.0

The ISM survey for August is expected to take a fairly sizeable hit falling from 55.5 to 52.1. A host of underlying components is expected to lead the headline index lower. Production weakened last month and will do so again in August reflecting the narrowing balance in pipeline orders growth driven by new orders and inventories. Deliveries should move lower as bottlenecks are reduced, inventories which surged last month are poised to move back closer to 45, and employment looks stubbornly high relative to the recent activity data. New orders have fallen significantly over the past two months and should hold firm around the 53-55 level. In broad terms, weakness in the ISM has been telegraphed by a sharp drop in the Philadelphia index and a substantial decline in core durable goods orders at a time when export order growth has shown signs of lagging.

U.S Non Farm Payrolls - August

• Release Date: September 3/10
• July Result: -131K; unemployment rate 9.5%
• TD Forecast: -150K; unemployment rate 9.8%
• Consensus: -105K; unemployment rate 9.6%

The August employment report is expected to reflect an ongoing struggle for the economy to generate much in the way of job creation approaching anything close to that hoped by the Fed. Headline payrolls are forecast to decline by 150k owing to another 130k jobs lost from the census workforce. That would leave another 40k of census jobs slated to be lost over coming months. Private payrolls, again the focus of our attention, is forecast to rise by only 20k, a pace comfortably below the 71k last month, and the six month average gain of 95k. Therein lies the rub for policy makers because without sufficient job creation, any recovery and especially one that is characterized by massive private sector deleveraging, is prone to lose momentum. To put this dilemma in perspective, total job creation excluding census workers has averaged only 13k over the past three months. If our assumption on census jobs for August is correct, that will fall to -19k. A report such as this will lend more fodder to the view that more monetary accommodation will be necessary to ensure this trend does not deteriorate further. The unemployment rate has been and will remain stubbornly high. Over the past several months the unemployment rate has remained steady around 9.5% despite a drop in jobs on the household survey in each of the past three months. In August, we anticipate another drop in household employment. That drop is likely to exceed whatever weakness materializes in the labor force resulting in a significant gain in the official rate of unemployment to 9.8%.

CANADA: UPCOMING KEY ECONOMIC RELEASES

Canadian Current Account - Q2 /10

• Release Date: August 30/10
• Q1 Result: -$7.8B
• TD Forecast: -$10.3B
• Consensus: -$10.5B

The recent improvement in Canada's balance of payments will likely prove to be short lived, as the deficit in the current account is expected to widen to $10.3B in the second quarter. Blame for this deterioration can be laid at the feet of merchandise trade, which is expected to swing from a modest surplus in Q1 to a $1.6B deficit in Q2. While exports are still forecast to advance, their positive influence will be more than offset by a sharp increase in imports. Elsewhere, an appreciation in the trade-weighted currency over the quarter is expected to prevent a substantial narrowing in either the services or investment income deficit.

Canadian Real GDP - Q2 /10

• Release Date: August 31/10
• Q1 Result: 6.1% Q/Q ann.
• TD Forecast: 2.5% Q/Q ann.
• Consensus: 2.5.% Q/Q ann.

After two quarters of robust economic growth of 5-6% annualized, most signs are pointing to a marked deceleration in Canadian economic growth. Following the Olympics and a stimulus-fuelled surge in spending, signs that consumers are coming back to earth started to show up in the second quarter, with the weakest reading on retail sales since the first quarter of 2009. Meanwhile, residential investment was likely a modest drag on economic growth in the quarter, following two quarters of strong growth rates of 23-26%. The drop-off in residential investment was anticipated and partly related to the expiration of the Federal Renovation Tax Credit. The credit, which helped boost renovation activity significantly through the last half of 2009, expired in February 2010, but run-on projects likely helped boost renovation activity for a few additional months. As an offsetting factor to slowing household spending, strong imports in the quarter indicate a large surge in business investment in machinery and equipment and inventories. All said, monthly GDP is expected to rise by 0.2% in June, while we forecast quarterly real GDP growth of 2.5% annualized in the second quarter of 2010.

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