The Weekly Bottom Line
HIGHLIGHTS OF THE WEEK
- Market participants are clearly trading on what everyone else seems to be feeling: the recovery is back.
- But the Fed, for its part, is not yet willing to admit that the economy has entered a new, stronger phase. Though the quickening pace of job growth is a positive sign, disposable income growth is still stagnant, and the recent run-up in commodity prices threatens to erode consumer spending growth. Europe's troubles haven't gone away.
- If market sentiment get's too far ahead of itself, the Fed may be tempted to fight back with another round of asset purchases. But if rising borrowing costs are a product of a stronger recovery then the Fed should be less concerned. Increased spreads may actually be stimulative if it leads to more lending.
- Canadian existing home sales rose 1.4% in February and home prices appreciated 2.0% from yearago levels. On a trend basis, the housing market has cooled from 2009 peaks. Home sales are 7% below their post recession peak, while annual home price growth is just a tenth of the appreciation experienced at the height of the market.
- Still, policymakers should not get complacent about the potential risks forming on the housing front. While, housing activity in the most concerning market – Vancouver– appears to be softening, other markets, such as Toronto and Winnipeg, are seeing some additional strength. A continued low interest rate environment poses a risk for a further acceleration in Canadian housing, which is already moderately overpriced.
UNITED STATES - RISK ON
Statements by the Federal Open Market Committee usually move markets. This week was no exception. While the Fed signaled no material change in policy – it maintained its commitment to keep interest rates exceptionally low and announced no new asset purchases – Tuesday's statement fueled risk taking in equity markets and a corresponding sell-off in Treasuries. On Thursday, the S&P 500 closed above 1400 for the first time since June 2008. As of writing, yields on 10-year Treasury notes had risen 27 basis points since Monday, and are currently hovering around levels not seen since last October.
Market participants are clearly trading on what everyone else seems to be feeling: the recovery is back. Even the most hardened skeptics can't ignore the positive signs, especially in the labor market. Just over half a million jobs have been created so far this year, with more jobs created in January than during any other month since 2006. Initial claims for unemployment insurance have fallen over 12% since the start of the year. The unemployment rate at 8.3% is down from 9.1% just last summer.
The quickening pace of job growth is a positive sign, indeed. An improving labor market will aid the recovery in other sectors of the economy, particularly the housing market. With more people drawing an income, the pool of potential homebuyers is expanding, thus facilitating the process of clearing excess housing inventory built up during the bubble years. Tighter supply will help stabilize home prices and declining housing-related equity wealth, which ultimately will support stronger consumer spending growth. This, in turn, will spur new business investment, and still more jobs.
But the Fed, for its part, is not yet willing to admit that the economy has entered a new, stronger phase. We're inclined to share its caution. Economic data is notorious for its revisions, and there are hints that the recent string of positive employment data is not without challenge. Historical data from the oft-overlooked Job Openings and Labor Turnover Survey (JOLTS) shows that a healthy labor market should exhibit a certain degree of churn: people are more willing to leave their jobs when they are confident of their employment prospects elsewhere. But “separations” have actually fallen in recent months, and remain incredibly low relative to pre-recession trend.
Of course, there are other reasons the Fed is maintaining a cautious outlook. Disposable income growth is still stagnant. The recent run-up in commodity prices threatens to erode consumer spending growth. And despite a reprieve in Europe's troubles, which were so palpable last fall, they haven't gone away
Massive internal imbalances persist between the competitive core and the stagnant periphery countries. Until these imbalances are corrected, either through structural reforms that raise the competiveness of the periphery or a stronger fiscal transfer union, doubts over the sustainability of the currency union will linger and the global financial system will remain vulnerable.
Paradoxically, all this positive sentiment about the economy may actually complicate things for the Fed. If the recent sell-off in Treasuries is sustained, it will test the Fed's commitment to keep long-term borrowing costs low. The Fed may be tempted to fight back with another round of asset purchases, a move that entails taking on significant risks for an uncertain payoff
However, it's ultimately a matter of timing. If rising borrowing costs are a product of a stronger recovery then the Fed should be less concerned. In fact, the increased spreads may actually be stimulative if it gives banks a greater incentive to lend some of the $1.6 trillion dollars in excess reserves they currently have on deposit with the Fed. When that starts to happen, the Fed could find itself worrying not about whether employment growth is too slow, but whether inflation is getting too hot.
CANADA - HOUSING: PROCEED WITH CAUTION
Canadian housing bubble or no bubble? That seems to be the million dollar question these days. In TD Economics' opinion, the Canadian housing market is too hot, but is not headed for a U.S.-style catastrophe.
The material slowing in home price and sales growth over the latter half of 2011 early 2012 has been a key argument against a bubble in the Canadian housing market. Home sales are 7% below their late 2009 peak, while annual home price growth was just 2.0% in February – a tenth of the appreciation experienced at the height of the market. The arguments for housing trouble are the elevated home price-to-rent and home-price-to-income ratios – which are at levels seen in the U.S. just before their bubble burst. But, current Canadian home price levels are being supported by low interest rates. And, affordability remains decent.
On balance, TD Economics pegs the current overvaluation in Canadian home prices at 10-15%. However, prices remain loftier in Canada's key markets, such as Toronto and Vancouver. Still, the Canadian Real Estate Association stated this week that 60% of the housing market remains in balanced territory (measured by the sales-to-new listings ratio). Some of the overvaluation is being unwound in the most concerning market – Vancouver – where annual price growth flattened out after growing by 15-20% in mid 2011. In contrast, excesses are continuing to build in Toronto, where housing activity – especially in the condo market – has picked up steam over the last few months. Existing home prices in Toronto rose 10.5% from year-ago levels in February, entering double-digit territory for the first time since 2010. Winnipeg is another major metropolitan area where housing activity has started to accelerate following the late 2011 lull. Elsewhere, housing activity has been more subdued.
Our baseline view is that low interest rates will continue to support housing activity at relatively lofty levels through 2012 and most of 2013 and that the overvaluation will be gradually unwound once interest rates rise to more normal levels. But, as argued in a TD Economics perspective released earlier today “ Real Estate Overvaluation and Consumer Debt Pose Risks to the Economy”, policymakers should not get complacent about the risks. First, high household indebtedness is one consequence of overvalued real estate markets, making Canadian households more sensitive to higher interest rates. While Statistics Canada brought some relief this week when it reported that the debtto- income ratio edged down in the fourth quarter of 2011, the ratio remains at an excessive level of 150.6%, and is likely to resume an upward trend in the coming quarters as debt growth moderates, but still grows at a pace above income. Second, much of the wild swings in housing activity over 2010 and 2011 can be attributed to the introduction of tighter mortgage insurance rules. The initial introduction of the new rules in October of 2010 and January 2011 temporarily tempered housing activity. However, with interest rates still incredibly low – with many banks cutting their four and five year posted mortgage rates to 2.99% earlier this month – there is a risk for a further acceleration in Canadian housing in the near term. Overall, while we believe that the housing market will correct in an orderly fashion with the real economic consequences being mild, we do think policymakers should proceed with caution.
U.S.: UPCOMING KEY ECONOMIC RELEASES
U.S. Existing Home Sales - February
- Release Date: March 21, 2012
- January Result: 4.57M
- TD Forecast: 4.55M
- Consensus: 4.60M
With the labour market continuing to enjoy a period of strong growth, there is growing evidence that the housing market is finally beginning to stabilize, with home sales and building activity both improving in recent months. In February, however, we expect the pace of existing home sales to fall marginally to 4.55 million from 4.57 million, undoing some of the gains last month. This is fairly consistent with the relative mixed tone in pending home sales activity over the past few months, which showed the pace of tentative purchase agreements remaining relatively flat since November. Distressed sales should continue to account for a significant portion of sales, and despite the moderation in the level of sales activity we expect the inventory of unsold homes to dip further as the number of home available for sales remains at multi-decade lows.
In the coming months, we expect the pace of home sales to pick-up as the favourable buying conditions along with the improvement in labour market activity provide a supportive backdrop for sales activity in the coming months.
U.S. Leading Indicators - February
- Release Date: March 22, 2012
- January Result: 0.4% M/M
- TD Forecast: 0.8% M/M
- Consensus: 0.6% M/M
Driven by improvements manufacturing and labour market activity and strong gains in consumer sentiment, we expect the index of leading indicators to post a robust 0.8% m/m advance in February, adding to the positive momentum of the past four months. The improvement in financial market condition variables should also add favourably to the top line, as higher equity prices along should more than offset the declines in the real money supply and worsening in the interest rate spread. In the months ahead, we expect this indicator to rise further underscoring that the economy is continuing to build on the positive momentum of the past few months.
Looking ahead, with the pace of economic growth expected to accelerate during the remainder of the year, we expect the improvement in the LEI to be sustained.
CANADA: UPCOMING KEY ECONOMIC RELEASES
Canadian Retail Sales - January
- Release Date: March 22, 2012
- December Result: Retail Sales -0.2% M/M; Ex-autos 0.0% M/M
- TD Forecast: Retail Sales 1.8% M/M; Ex-autos 0.4% M/M
- Consensus: Retail Sales 1.8% M/M; Ex-autos 0.5% M/M
A 15% jump in new car sales are expected to have propelled overall retail sales to a healthy 1.8% monthly gain in January following a modest contraction in December. Part of this increase was attributed to resurgent inventories of several imported brands following production disruptions related to floods in Thailand. Note that this forecasted increase is somewhat smaller than what the industry data provided by Statistics Canada would imply for overall retail sales, as we are assuming that the impact of marginally higher gasoline prices, weaker employment, and a decline in home sales will have curbed spending elsewhere. This expectation is also reflected in our forecast for just a 0.4% increase in retail sales excluding autos. After taking into account rising prices, we expect retail volumes to increase *Forecast by Rates and FX Strategy Group. For further information, contact TDRates&
. in the ballpark of 1.0%. If this increase is realized, it will bode well for industry-level real GDP growth in January but we will see some retrenchment in February, as preliminary tracking for auto sales suggest a 7% contraction in sales. For the quarter as a whole, we anticipate the momentum through the end of the year will lift real GDP in Q1 to an annualized increase of 2.1%.
Canadian CPI - February
- Release Date: March 23, 2012
- January Result: CPI 0.4% M/M; Core CPI 0.2% M/M
- TD Forecast: CPI 0.4% M/M; Core CPI 0.4% M/M
- Consensus: CPI 0.5% M/M; Core CPI 0.2% M/M
Set against continued upwards momentum in commodity prices and a strong seasonal adjustment factor, we expect the all-items CPI price index to increase by 0.4% in February. This increase would be even larger if it were not for the temporary 0.1% monthly drag following the increase in provincial taxes in Quebec in the previous month. After controlling for seasonality, the underlying increase in headline prices is expected to be a far more subdued 0.1% M/M. On a year-ago basis, we expect headline inflation to pick up to 2.7% which would be the highest reading since November of last year. Assuming a modest deceleration in March - largely driven by base-year effects - we see Q1 headline inflation in the ballpark of 2.4% which is consistent with the Bank of Canada's assessment of a modest upside risk to their 2.2% forecast presented in the January MPR.
For core inflation, seasonal factors also have a large role to play, as we expect to see a 0.4% increase in February (note that there is no adjustment for provincial sales tax given that the Bank of Canada's definition of core excludes changes in indirect taxes). When the aforementioned seasonal adjustment factors are excluded from the calculation of core the increase forecast in February is a far more temperate 0.2%. On a year-ago basis, the changes expected in the monthly price series imply a year-ago measure of 2.3% for core inflation. Looking out to the quarter as a whole, we anticipate core inflation to be in line with the Bank's 2.1% forecast presented back in January.