Australian & New Zealand Weekly

Week beginning 3 March 2008

• RBA to raise rates by 0.25% - more to come.
• Australia: key issues for overseas investors.
• Bumper week for Aus data; GDP, profits, retail, approvals previewed.
• RBNZ to hold but signal strongly that rate cuts off the agenda.
• BoE and ECB still on hold for now.
• US data: ISMs, payrolls previewed.
• Key economic & financial forecasts.

Australia: RBA to Raise Rates by 0.25% - More to Come

The Reserve Bank Board meets next Tuesday March 4. We expect the Governor will announce a further 0.25% increase in the overnight cash rate at 2:30pm on the same day.

This expectation is based on the Bank's inflation forecasts which were released on February 11. These forecasts indicated that for no policy change underlying inflation would be 3½% in 2008; 3¼% in 2009; and 3% for the year to June 2010. Given that the Bank is charged with holding inflation on average through the cycle in the 2% - 3% band it is unacceptable to forecast that underlying inflation which through 2007 has already registered 3.6% will remain outside the range for a further 2 years and still not fall below the top of the range by the first half of the third year.

Policy must be changed so that on a "no policy change" basis the Bank will be able to release a more acceptable forecast on May 9. We believe that the Bank should be in a position to forecast that underlying inflation will be at least at the top of the range in 2009 and back within the range in 2010.

Given the current momentum in underlying inflation, particularly due to the rise in rents and financial services costs, we expect that such a new inflation forecast would not be credible unless there is an additional move after March in either April or May. April looks to be a more likely prospect since we expect that the Bank now accepts it genuinely does have an inflation problem and therefore does not need to await further evidence from the next quarterly read on the CPI which will be released on April 23.

Ever since this long and tentative tightening cycle began the Bank has almost exclusively favoured post CPI moves in recognition that there may be an inflation problem. That tentative approach is no longer necessary since, based on the recent forecasts, the Bank recognises that it does indeed have an urgent inflation task on its hands.

Furthermore, we cannot rule out a further follow up move, possibly in May, particularly with the prospect of a possible 1% read on underlying inflation that makes the Bank uncomfortable with forecasting a more moderate inflation profile due to the first two rate hikes.

At present we are forecasting that only two additional hikes will be forthcoming. However, we see all the risks to the upside.

The signal that the Bank has done enough will come through the real sector data. Building approvals; house prices; consumer and business confidence are obvious "candidates". More important would be employment since a sharp slowdown in employment growth would weigh on the strong growth in household disposable income increases, which are currently being supported by tax cuts and strong wages and employment growth. However we expect that employment will be quite resilient.

Our customer feedback, and our wider survey operations, continue to point to a skills shortage as the major drag on Australian businesses. Any sign of a slowdown in sales is unlikely to elicit an immediate response from the labour market. Firms are likely to hoard labour during the first stages of any slowdown in activity.

The definitive signal that the Bank expects it has done enough will be when it forecasts that on a "no policy change" basis underlying inflation will return to within the 2% - 3% band in the medium term.

Reliance on those quarterly inflation forecasts while appropriate, is likely to continue to present tactical challenges for the Bank. For example, how does it assess a "no policy change" forecast when the market has policy changes priced in? How does it assess the impact on inflation of the market's reaction to the surprise of "no change"?

From a flexibility perspective it may serve the bank well to adopt the "appropriate policy" approach of the Fed or to incorporate market pricing or a forecast "most likely path" for rates like the Bank of England or RBNZ respectively.

This note is being written while on a marketing assignment with Westpac's institutional customers in North America.

The executive summary of the key points being made to our customers is set out below.

I will be writing more extensively on the key insights of the trip relative to any prior expectation when I return. I assess that opinions are more negative on growth and credit prospects for the US economy but solidly behind our own view that the global economy will be resilient to the US weakness and play a key role in moderating the impact of the economic downturn and the credit crisis on corporate America. For the household sector prospects are generally dismal - the key is the extent of the necessary fall in house prices and, as with Australia in 2004, we have no strong basis for assessing this prospect.

Further, Australia's experience of a "soft landing" will not be a reliable guide for the US because labour income growth in Australia accelerated from 2004 as the benefit of the resources boom stimulated employment and wages while accommodating a series of generous tax cuts. US employment growth is set to slow sharply; real wages growth is weak while the "one off" fiscal stimulus is very unlikely to be repeated in 2009 effectively resulting in a significant fiscal contraction.

Bill Evans, Managing Director, Economics & Research

Key Issues for Overseas Investors

This is the Executive Summary of the presentation which has been presented to overseas North American customers.

The downturn in the US economy will affect the Australian economy and its markets in two ways. Firstly, slower growth in the US will lead to slower global growth with an associated impact on Australia's exports and the prices of its commodities. There is also likely to be a fall in both business and consumer confidence as Australia absorbs the US gloom.

The second impact will be through the global capital markets. Tightening liquidity; widening credit spreads and falling share markets are already affecting the ability of Australian companies and households to borrow money. That effect is through both price and quantity. For example, while the Reserve Bank of Australia has raised the overnight cash rate by 0.75% over the last year the 90 day bank bill rate has risen by 1.4%. Variable mortgage rates for the major banks have been increased by 0.90%.

We do not anticipate that the impact on the economy of the direct activity slowdown will be particularly significant. Australia's economic boom of recent years has been based around the surge in global growth associated with the emergence of China; India; and the commodity exporters. Only around 1 percentage point of the 4% - 5% growth rate of the world economy has been due to growth in the developed world. Further, our research indicates that domestic demand is the key driver of growth in China and India and domestic demand will be resilient to the inevitable slow down in exports.

Business confidence and consumer confidence have recently fallen but business conditions remain strong and the recent surge in household incomes will underpin solid consumer spending, albeit at a higher savings rate to reflect the more cautious consumer.

The impact of the credit crisis on the Australian economy is more difficult to assess. Australian banks, which have been responsible for around 55% of the $1.2tr (120% of GDP) explosion in gross foreign liabilities since 1995 have been challenged in raising longer term funds. That is putting upward pressure on borrowing costs and, in some circumstances, the volume of liquidity available to the household and corporate sectors. For the first time since the RBA began announcing its decisions to move interest rates the major banks actually raised mortgage rates independently of a move by the RBA. That move was "only" an average of 15 basis points but did demonstrate the direct impact the credit crisis is having on credit availability and costs for Australian households and companies. The evolution of these stresses over the course of 2008 will be critical for assessing the outlook of the Australian economy.

Meanwhile Australia's "prosperity dividend" (36% rise in the terms of trade over the last 4 years) has given the economy a huge boost, mainly through the sharp improvement in the fiscal position which has allowed a series of generous tax cuts over the last 4 years and the sharp increase in employment growth. Inflation pressures have intensified such that the Reserve Bank's February Statement on Monetary Policy included a (no policy change) forecast that underlying inflation which is currently running at 3.6% (well above the top of the 2% - 3% target range) will not return to within the band for the next 2½ years.

That forecast is clearly unacceptable and means that the RBA will need to tighten policy immediately with the cash rate likely to rise by 50 basis points over the next 2 - 3 months. Given the likely 100 basis points of cuts from the US Federal Reserve over the same period, we envisage the yield differential at the short end between Australia and the US will reach 550 basis points by June well above the previous high of 375 basis points in December 2003. Differentials between long bond spreads are likely to widen further from the current 250 basis points to at least 275 basis points and the Australian dollar should remain above USD 90¢ for the rest of 2008.

The signal for the RBA to remain on hold will come from the real economy probably through housing and consumer spending. When that becomes apparent, probably from mid year, markets will be anxious to price in an "early" rate cut. However we expect that the RBA will be firmly focussed on ongoing inflation measures that will remain too high indicating that rates will remain at these expected 12 year highs for at least 18 months. Such rate action will support the AUD for an extended period.

The early threat to this profile will come from a more brutal than expected credit crunch for the Australian economy. With our excessive reliance on foreign capital a credit strike would see a precipitous collapse in the AUD. The associated recession would see a much more aggressive RBA, cutting rates despite high current inflation measures. While current prospects for an easing of the credit crisis are discouraging we believe that the current pricing of credit is not justified by the expected performance of the underlying economies and markets will gradually recognise this and stabilise through the course of 2008. Certainly, we rate a brutal credit squeeze to Australian borrowers resulting from a strike by foreign capital to be a low probability.

Bill Evans, Managing Director, Economics & Research

Australia: Data Wrap

Q4 construction work done

• Construction activity posted a surprise fall in Q4, slipping 1% after a 2.2% rise in Q3 (revised down from 2.8%). This was against expectations of a 2.2% rise.
• A sharp pullback in non-res building after a jump in Q3 combined with an unexpected decline in residential (-0.2%qtr). Infrastructure work rose 0.7%, but this was more subdued than anticipated with an expected rebound in private infrastructure work failing to materialise (it fell another 2.1%qtr following a 2.4% decline in Q3).
• Public sector work done was the main source of strength in the quarter, rising 3.6% after a 9.6% jump in Q3.
• While there isn't a one-to-one link between work done and components in the national accounts, the soft result points to downside risk to Q4 GDP. We have shaved our estimate back from 0.9% to 0.7%qtr, 3.8%yr.
• More broadly though, the Q4 dip is unlikely to mark the end of the construction upturn, particularly for non-res and infrastructure work where the pipeline remains large.

Q4 CAPEX

• Business investment rebounded in Q4 according to the CAPEX survey, rising 5.1%qtr (vs mkt f/c 3%), after a 6.2% dip in Q3. Equipment rose 3.8% (vs Westpac f/c 3.6%).
• While the headline figure was stronger than expected, the equipment component - the only item that feeds into the GDP estimates - was in line with expectations.
• The 5th estimate for CAPEX intentions for 2007/08 was $84.8bn, revised up slightly from the 4th estimate of $84.2bn reported last quarter.
• The 1st estimate for CAPEX intentions for 2008/09 was $78.5bn. Although initial est's are often well wide of the mark this is a bullish starting point. On our calculations it implies a further rise of ~21%. Businesses may have been spooked by events in recent months but most are continuing to pencil in strong spending plans.
• Australia's business investment boom, now entering its 7th year, clearly has further to run. Strong demand - globally and domestically - tight capacity and labour shortages are all encouraging firms to expand CAPEX. Prospects look good but the risk of a hit from heightened global uncertainty remains.

Jan credit

• Credit to the private sector expanded by 16.4% through the year to January 2008, with a 1.1% rise in December. Three-month annualised growth has reaccelerated to 17.2% from 16.1% in December, the highest since August.
• The underlying trends which we expect to persist through 2008H1 are booming business credit, but subdued housing credit.
• Business credit continues to surge, supported by growing investment spending and reintermediation amidst difficulties in capital markets.
• Housing credit growth is constrained by rising interest rates and difficulties for mortgage securitisers, and should see a further modest leg down through 2008 with further rate hikes.

Round-up of local data released last week

New Zealand: The Week ahead & Economic Wrap

Help and hindrance

Data this week confirmed that parts of the NZ economy are starting to show strain. Meanwhile, the Reserve Bank's preferred measure of inflation expectations remained at 2.7 in Q1 - we remain firmly of the view that it will head onwards and upwards from here. Residential building consents lifted 3.3% in January, retracing some of December's sharp decline, leaving the level of consents down 7.3% on a year ago. Residential construction looks set for a sharp contraction this year. The trend in the volatile non-residential consents series fell during January, but we expect the non-residential sector to outperform, thanks to dairy cash, low commercial vacancy rates and a government infrastructure spend-up.

External migration had another weak month, with a net 480 people arriving in January. Annual net immigration is now under 5000 - well down on a year ago, when it was above 14,000. The slowdown is another nail in the coffin of the housing market.

January's merchandise trade data came in close to expectations continuing the broad theme in recent months of very strong dairy and oil exports. NZ's annual trade deficit is shrinking quickly, despite the strength of the NZD. We expect the annual trade balance to continue improving through much of 2008.

Next week the main focus will be the Monetary Policy Statement on Thursday.

The RBNZ faces a policy dilemma sandwiched between rampant inflation pressures and an ugly outlook for the US and European economies. The course of least resistance is inaction; we expect rates to remain on hold in March, and forecasts to imply rates remaining where they are from here.

The RBNZ has had both help and hindrance from developments since December on the inflation front. Helping them out:

• The housing market is cooling very rapidly, and the weakness will only be exacerbated by lower net immigration.
• The drought will take a bit of the shine off the impact of the record Fonterra payout this season and further dent sheep and beef incomes.
• Consensus forecasts for trading partner growth have been revised down (though growth in Asia and Australia is remaining robust so far).
• The funding premium built into market rates and increasingly retail rates has done the required work for the Reserve Bank. Fixed mortgage rates are 50-80 basis points higher than they were when back in October we called for two more rate hikes.
• The NZD is flying, helping disguise the degree of inflation pressures in the economy.

There have also been less helpful developments:

• Food and petrol prices and higher ACC levies will cause the Q3 peak in inflation to be around 3.7-3.8%, versus the December Statement's 3.5%.
• The RBNZ will need to incorporate into their forecasts the inflation implications of the Emissions Trading Scheme.
• The labour market is far tighter than the RBNZ had realised, and surveyed capacity utilisation suggests both worker and machine are at full stretch.

Overall, the balance of news since the December MPS suggests a little less medium-term inflation pressure (though still a severe medium-term inflation problem). We think that the RBNZ will still want to send a strong message that interest rate cuts are firmly off the agenda, and therefore expect a very similar hawkish tone and interest rate profile as in December, with a 90-day track largely flatlining around current levels, 8.7-8.8%.

We continue to believe that the Reserve Bank is underestimating the momentum in inflation. However, the latest round of 20 basis point increases in retail interest rates will help. Any further OCR hikes are dependent on a dissipation of the funding premium currently pushing up NZ retail interest rates as well as the petro, developing and Australian economies remaining resilient to the US slowdown.

In other data next week we have a monthly read on NZ's commodity prices on Tuesday - we expect world dairy prices to have continued drifting off their highs - wholesale trade on Wednesday (we expect a significant nominal lift from food and fuel prices), and building work put in place for Q4 on Friday. We expect that residential activity was flat, while commercial building activity gathered some momentum.

Round-up of local data released last week

Data previews

Aus Q4 company profits

Mar 3, Last: -2.1%, WBC f/c: 1.5%

Mkt f/c: 2.0%, Range: -0.5% to 4.0%

• Company profits recorded a 2.1% decline in 2007Q3 with falls in mining and manufacturing driving the result.
• The Q3 decline was mainly a price effect from lower base metal prices, down 14% in Q3, which hit both miners and basic metal manufacturers). This will again be a factor in Q4, though more moderate with prices off just 5.5%.
• Profits were strong in Q3 outside of these sectors (up 4.5%qtr). Although the high AUD and rising costs continue to make life difficult for some buoyant domestic conditions and contained wages have supported profits. Recent business surveys also suggest that while confidence may be down profits are still rising strongly.
• Overall, we are forecasting total company profits to post a partial rebound of 1.5% in Q4.

Company profits: mining off highs

Aus Q4 inventories

Mar 3, Last: 1.3%, +0.3ppts, WBC f/c: 1.1%, -0.1ppts

Mkt f/c: 1.0%, -0.2ppts, Range: 0.1% to 1.8%, -0.3ppts to +0.4ppts

• Inventories showed a bigger than expected build in Q3. A jump in mining stocks (up 8.6%qtr, 24%yr) was a key factor. With new production coming onstream and supply bottlenecks persisting, mining stocks are likely to continue rising, albeit at a more moderate pace in Q4.
• The rebuilding of inventory levels across other industries has been in line with strengthening demand through 2007. With demand holding up well in Q4, this just-in-time stocking will continue to see inventories rise.
• Overall we are forecasting another healthy 1.1% build in inventories in Q4, though not quite as strong as the Q3 increase. The net impact is expected to detract slightly from quarterly GDP growth in Q4, a contribution of -0.1ppts compared to +0.3ppts in Q3.

Inventory levels rise in line with sales

Aus Q4 current account balance, AUDbn

Mar 4, Last: -$15.6bn, WBC f/c: -$17.8bn

Mkt f/c: -$17.8bn, Range: -$18.9bn to -$15.0bn

• Monthly data showed a near flat export performance in Q4 (-0.1%qtr vs flat prev), but with import growth accelerating to 3.3%qtr (vs 1.4% prev), the trade deficit jumped $2.069bn to $6.859bn.
• Another quarter of Australian equity market outperformance (vs US) should underpin further growth in net equity income outflows. However, this should be more than offset by a fall in net debt income outflows from lower US yields, a strong 4.9% AUD/USD rise, and further falls in Australian ABCP outstanding offshore amidst global credit market turmoil. We forecast a net income deficit of $10.85bn (vs $11.1bn prev).
• This lifts the current account deficit to $17.8bn (6.4% of GDP vs 5.7% prev) from $15.6bn.

Current account deficit and components

Aus Q4 net exports contribution to GDP, ppts

Mar 4, Last: -0.1ppts, WBC f/c: -0.6ppts

Mkt f/c: -0.6ppts, Range: -1.0ppts to -0.1ppts

• While export values fell in Q4, this was driven by a 2.5%qtr fall in prices, and we expect a rise in export volumes of 0.9%qtr. While not particularly strong, this follows a 2.3% jump in Q3, lifting annual growth to 4.8%yr from 4.6%. Rural volumes remain drought constrained, but non-rural volumes are beginning to respond to several years of strong investment in capacity, albeit tempered by weather disruptions.
• However, growth in export volumes in Q4 will once again be swamped by very strong import volumes growth amidst resilience in domestic demand. We forecast import volumes to rise 3.2%qtr (vs 2.3% prev), the strongest since 2006Q4.
• This results in a worse net exports contribution to GDP growth in Q4 of -0.6ppts (lowest since 2006Q4) versus -0.1ppts prev.

Export and import volumes

Aus Jan retail sales

Mar 4, Last: 0.5%, WBC f/c: 0.4%

Mkt f/c: 0.5%, Range: -0.4% to 0.8%

• Retail turnover rose 0.5% in Dec, slightly below expectations but following solid gains over the previous five months. Annual growth continues to run at well over 8% with only a hint of a squeeze from the 25bp interest rate hikes in Oct and Nov.
• Consumer sentiment fell sharply in Jan as a market-induced rise in mortgage rates combined with fears of a follow up official rate hike in Feb and global financial turmoil. Sentiment was still just above the 100 line separating optimism from pessimism and vehicle sales remained solid in January. Retail spending also outperformed sentiment through 2007H2.
• Overall. we expect Jan to post another more subdued result with a 0.4%mth rise. However, this will still keep annual growth at a brisk 7.8%yr. At least some hangover seems like after the best Christmas for retailers since 2003.

Retail sales to moderate after bumper Xmas

Aus Q4 public spending

Mar 4, Last: 0.4%, WBC f/c: 1.7%

• Public spending, which accounts for 22% of the economy, tends to be volatile from quarter to quarter. Hence this sector always poses a risk to our GDP forecast.
• We are expect to see a solid 1.7% rise in spending in Q4 following a 0.2% gain in Q3.
• Public consumption is likely to have maintained its steady pace in the final quarter of 2007.
• Construction work done figures suggest public investment - which is less than one fifth of total public spending - rose strongly in Q4. However, total public investment has often moved in the opposite direction to public construction in past. Hence there is considerable uncertainty surrounding this part of the forecast.

Public spending: steady gains

Aus RBA policy announcement (2:30pm)

Mar 4, Last: 7.00%, WBC f/c: 7.25%

Mkt f/c: 7.25%, Range: 7.25% to 7.25%

• The RBA is unanimously expected to raise rates by 25bp following on from its move in February.
• The Banks' statement with its Feb move was unambiguously hawkish. Its MPS a week later was even more so, and included an inflation forecast that stayed above target until 2010. Minutes from the Feb meeting released a week later showed the discussion focussed not on whether to move but whether to raise by 25 or 50bp, with the final decision 'finely balanced'. This is a central bank in urgent tightening mode.
• With the inflation problem beyond doubt, the RBA is no longer in the business of waiting for CPI results to act. Demand indicators are instead of more importance and so far there have been no signs of weakness, let alone a rate-rise-induced collapse. Indeed, strong jobs data for Jan suggests the contrary.

RBA poised to hike again

Aus Q4 GDP

Mar 5, Last: 1.0%, 4.3%yr, WBC f/c: 0.7%, 3.8%yr

Mkt f/c: 0.8%, Range: 0.2% to 1.2%

• The Australian economy stepped up a gear in 2007. Robust global growth and strong demand for Australia's commodity exports combined with an ongoing investment boom and a revival in the consumer sector. Public spending and tax cuts added momentum and even the housing sector sparked back into life. All of this came in spite of the RBA's rate increases in 2006 and further rate hikes in Aug and Nov 2007.
• The final quarter is likely to have been a touch softer for the economy with GDP growth forecast to be 0.7% (pegging annual growth back to 3.8% from 4.3% in Q3). Consumer spend (1.2%) will remain a positive but lumpiness in the investment pipeline and export delays will dampen the headline figure in Q4. Inventories, public spending and trade data out this week pose risks to our forecast.

Australia's economy: charging along

Aus Jan international trade balance, AUDbn

Mar 6, Last: -$1.9bn, WBC f/c: -$2.4bn

Mkt f/c: -$2.6bn, Range: -$3.6bn to -$1.4bn

• The trade deficit narrowed $226mn in December to $1.936bn. Exports built on November's 5.3% jump with a further 1.3% rise, reinstating an uptrend. Rural exports bounced 9.1% helped by surging prices, while non-rural exports consolidated November's 7.4% volume-led surge with a 0.3% rise.
• For January, we expect rural exports to rise 2.5% (weak meat and wool vols, but resilient wheat vols, higher prices and a huge seasonal adj. boost) and non-rural exports to rise 4% (further trend volume gains, higher prices and a big seasonal adj. boost), giving a 3% rise in total exports, continuing their renewed uptrend. But merchandise imports data implies a big 6% jump (even stronger vols given AUD rose 1.2%) and we expect +5.3% for total imports. This swamps the export gain, lifting the deficit to $2.4bn.

Deficit high: X rise swamped by M surge

Aus Jan dwelling approvals

Mar 6, Last: -16.0%, WBC f/c: 6.0%

Mkt f/c: 6.0%, Range: -6.2% to 12.0%

• Approvals slumped badly in Dec, falling 16.0% after rising 8.2% in Nov. An unwinding spike in apartments combined with a sharp fall in houses - the sharpest for this segment since the post-GST slump in 2000. All states experienced declines.
• The Dec result was probably affected by the timing of Christmas in 2007, which would have seen fewer effective working days than usual, delaying the approvals process. However, 25bp rate hikes in Aug and Nov undoubtedly had a hand in the decline as well.
• Although never a perfect guide, industry figs on finance approvals showed a sharp dip in Dec followed by a rebound in Jan (in seasonally adjusted terms). As such, we are forecasting dwelling approvals to rebound 6.0% in Jan. However, the Dec result clearly means there is more risk around the result.

Dwelling approvals

NZ RBNZ Monetary Policy Statement

Mar 6, Last: 8.25%, WBC f/c: 8.25%, Mkt f/c: 8.25%

• The RBNZ is firmly on hold. Rate hikes will not be foreshadowed, but doves looking for an easing bias will be disappointed.
• Data and market developments since the December MPS on balance suggest slightly lower medium-term inflation pressures.
• The RBNZ faces a serious inflation problem but recent increases in retail interest rates will help. Further OCR hikes are dependent on the current funding premium dissipating.

NZ OCR and 90 day rate

NZ Q4 Building work put in place

Mar 7, Last: 2.1%

• The value of building work increased in 2007Q3 as a strong lift in residential activity more than offset a decline in nonresidential.
• Dwelling consents figures suggest that residential building activity weakened in Q4. We expect a flat result relative to Q3, with the risk to the downside. Certainly by Q1 we expect the real value of residential building work will turn negative on a quarterly basis.
• In contrast, commercial consents data suggest that activity gathered some momentum in Q4, after a period of weakness in the previous six months. We expect a small positive gain in the value of commercial building work in Q4.

NZ Real Building Work Put in Place

US Feb ISM factory & non-manuf surveys

Mar 3, Factory Last: 50.7 WBC f/c: 48.0

Mar 5, Non-manuf Last: 44.6 WBC f/c: 50.0

• The national ISM factory survey fell into negative territory at 48.4 in December but rose back to 50.7 in January, in contrast to sharply lower readings in the various regional factory surveys from the Fed. Those regional surveys were even more depressed in February so a lower ISM reading is in prospect, especially given the renewed weakness in Jan durable orders.
• The non-manufacturing ISM's new composite headline plunged from 53.2 to 44.6 in Jan, the weakest reading on record for this decade old survey. While the economy is slowing heading into 2008, we believe the Jan signal overstated the true extent of weakness, so expect a significant but partial bounceback to around 50 in Feb.

US ISM surveys

Bank of Canada to cut 25bp or 50bp?

Mar 4, Last: 4.0% WBC f/c: 3.75%

• The Bank of Canada has eased a total of 50bp since early December, despite acknowledging strength in the domestic sectors of the economy. However the deteriorating outlook for the US economy and its associated impact on Canada have been the key policy consideration.
• Since the Jan 22 BoC cut, the US Fed has continued to ease policy aggressively and forward looking US data has raised the probability of US recession. Canadian data points to sharply slower Q4 GDP growth (data due Mar 3), despite ongoing strength in jobs growth.
• We expect a further 25bp cut to 3.75% but it is worth noting that a large number of Canadian based analysts are forecasting a 50bp move to 3.5%.

Bank of Canada to cut again

BoE and ECB still on hold for now

Mar 6, Bank of England Last: 5.25% WBC f/c: 5.25%

Mar 6, European Central Bank Last: 4.0% WBC f/c: 4.0%

• The Bank of England has cut twice this cycle, but remains very concerned about the impact of an imminent spike in the CPI to around 3% (due to sharply higher gas bills) on inflation expectations, which are already rising. Nevertheless, economic growth is slowing, and they will cut further, but it will be a gradual process with the next move not expected till May.
• ECB chief Trichet appeared to slightly soften his hawkish tone at the Feb press conference. Mixed rather than consistently weak business surveys, 3+% inflation and still rapid money supply growth will prevent a near-term ECB rate cut, but as hard evidence of slower growth emerges later in Q2, an ECB cut should follow.

ECB & BoE official interest rates

US Feb non-farm payrolls

Mar 7, Payrolls Last: -17k WBC f/c: 70k

Mar 7, Unemployment rate Last: 4.9% WBC f/c: 5.0%

• It is absolutely clear that the US economy has slowed dramatically since late last year, and that is being reflected in weaker labour market outcomes, most notably in the steep rise in jobless claims since Jan.
• However Jan's -17k payroll decline looked excessively weak, compared to the ADP jobs measure and initial claims data for the same period. Unusual Jan job losses in prof & business services and govt might either be revised away or reversed in the Feb report. Assuming no revision, we would expect a 70k Feb bounce, with risks to the downside to the extent Jan is revised higher.
• The sharp deterioration in job market confidence in Feb is consistent with the jobless rate rising to 5% or higher.

US jobs market

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Disclaimer

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