The Weekly Bottom Line

HIGHLIGHTS

• Fed cuts rates by 75 bps and adds another lending facility to ease market worries

It was supposed to be a short week for financial markets. Instead, it came to an abrupt beginning Sunday evening with surprising action from the Federal Reserve. They announced a new tool to lend directly to non-bank brokers in a similar fashion as they currently lend to commercial banks. At the same time, the Fed announced a 25 bps reduction in the rate applicable to these transactions. They also supported a deal by JP Morgan Chase to buy Bear Stears by taking $30 billion in illiquid financial instruments held by Bear - products at the heart of the current market malfunctions - and swapping them for more liquid assets. And all of this was just two days before their regularly scheduled meeting. Concerns in financial markets continued to swirl all week with the question of what is the next Bruno Magli to drop?

Plop Plop, Fizz Fizz

Oh, what a relief it is to have yet another large cut from the Federal Reserve. The Fed cut the Fed Funds Rate by 75 bps - less than the market's expectation for 100 bps - issued a statement mentioning the elevated and uncertain inflation environment, and included two dissenters who wanted less - not more - of a cut. Nevertheless, stock markets sustained a rally on Tuesday in the face of a fragile financial system. One reason was the feeling the Fed grabbed hold of a situation that risked imminently spiraling out of control. But the statement also shifted the focus from the previous "risks to economic activity" resulting from the financial and housing market problems to an assessment that "the outlook for economic activity has weakened further." With labour markets contracting and consumer spending slowing, the Fed's statement gave every indication that there are still significant cuts to come, though they are unlikely to be 75 bps cuts unless there is another major market episode.

In our own assessment, job losses are likely to continue at a moderate pace through the first quarter of 2009, consumer spending is forecast to contract in four of the next five quarters, and nonresidential construction is likely to join the rest of the housing market in a slump this year. As a result, our new forecasts released on Wednesday show the U.S. economy in a recession in 2008 - although only two out of the next five quarters should see real GDP contract. But while financial market problems are very serious, some salacious characterizations of being on the brink of the next Great Depression are a bit overboard. There are certainly lessons to be learned from that experience and some broad parallels, but we would not recommend investors stock up on canned goods just yet.

The Domino Effect

The Great Depression is the tale par excellence of global systemic risk - one domino fell and cascaded through the entire system. Eerily similar between then and now is the fact that until 1929, there was no stock disclosure required for companies so there was very little information available to inform decisions about the underlying quality of the stocks you were investing in. This fed directly into the bubble and eventual stock market crash. The problem now is not transparency in the stock market broadly, but in the asset-backed securities market.

While many immediately associate the Great Depression with the stock market crash of 1929, this crash is actually now seen as an effect, not a cause of the problems of the day. Simply too little of individuals' wealth was in the stock market, and as today, equity gains have a minimal influence on consumer spending. So this event was more of a shock to confidence than anything else, just as the ongoing inability to cleanse the financial system of mortgage-backed securities and CDOs has eroded confidence.

Credit innovations revolutionized business in each episode, as well. In recent years, securitization - as well as lax standards - fed a massive growth in housing construction as lenders were able to extend a loan and then sell that mortgage off to financial markets. In the 1920s, the innovation was installment credit. Rather than having to save all the cash for increasingly more expensive autos and appliances, a payment plan was available. This fueled a boom in manufacturing to meet this enlarged consumer demand.

The devil, however, was in the details. If an individual was 30 days late for any payment, the item was repossessed and the consumer received nothing back. All cash they had paid in was lost. Moreover, individuals were forbidden from selling the item early. Within this framework, as the Fed started to tighten monetary policy, in part because it was concerned about the stock bubble, and as income and job growth started to slow, consumers didn't dare miss payments on these products - the loss from defaulting was just too high. Instead, they cut all of their other spending. And as a result, the biggest engine to U.S. growth slammed into reverse. It is true the U.S. housing market is currently going nowhere fast, but it is only 4% of the U.S. economy, and the linkages to consumer spending are small and imperfect. There is a risk for further losses should a sufficient number of homeowners be left with a negative equity position and simply walk away from their mortgages. The systemic risk of catastrophe in the financial and housing markets becoming a catastrophe for consumer spending, though, is not apparent.

The Dominos Fall Abroad

The other major difference is the strength of the global economy. In the days when the international financial system was still rebuilding from WWI and was based on the gold standard, the tightening by the Federal Reserve necessitated a tightening all over the world, even though these areas were struggling to expand. As a result, unemployment rates outside of the U.S. were high and rising well before the depression, and when the U.S. finally went, the loss of U.S. consumer spending power was coupled with a collapse in exports. Once again, systemic risks saw the system feeding on its own malaise.

While some economies around the world continue to have exchange rates pegged to the U.S. dollar, the sharp Fed cuts are stimulating, not dragging down these foreign economies. There is growing concern that a sudden flight from the U.S. dollar might be the next domino to fall; however, it may have gone unnoticed that some nontraditional U.S. dollar intervention has already begun - in the form of Dick Cheney's recent trip to the Gulf economies to convince them not to abandon their dollar pegs. It is probably a good idea for these economies to move away from their strict dollar pegs eventually, but the issue right now is timing. Until we are in an environment where the U.S. rate cuts have subsided and foreign major central banks are all cutting rates in tandem, more traditional forms of intervention in the currency markets are unlikely to be successful.

The current environment is about limiting downside risks. There is no doubt that there is fear aplenty in financial markets. Within the housing market, there is a risk of further sharp problems within that sector itself. Also, there is good evidence that there are some further systemic risks within the financial system itself which might yet be felt, such as in insurance derivatives. However, there is no evidence that the systemic tentacles of financial uncertainty have any firm grasp over consumers and the broader global economy.

UPCOMING KEY ECONOMIC RELEASES

Canadian Retail Sales - January

Release Date: March 25/08
December Result: total +0.6%; ex-autos -0.4%
TD Forecast: total +2.0%; ex-autos +0.6%
Consensus: total +0.9%; ex-autos +0.5%

We're expecting to see a big improvement in Canadian retail sales in January, with total sales gaining a big 2.0% and ex-autos sales up 0.6%. The surge in total sales is expected to come from the 8.2% increase in new motor vehicle sales during the month, as Canadians continue their spending spree on new cars and trucks. And exautos sales are expected to bounce back from their disappointing December, when nearly every major category outside of auto sales declined. With continued healthy employment growth and the strongest wage gains in over a decade, there's no good reason to see a capitulation in spending from Canadian consumers in January. Additionally, the nearly 2% increase in gas prices will help to boost the value of sales. However, as the U.S. economy continues to slow and drags the Canadian economy along with it, we expect that the latest break-neck speed of Canadian consumer spending will slow as well.

U.S. Personal Income and Spending - February

Release Date: March 28/08
January Result: income +0.3%; spending +0.4%; core PCE deflator +0.3% M/M, 2.2% Y/Y
TD Forecast: income +0.3%; spending +0.1%; core PCE deflator +0.1% M/M, 2.1% Y/Y
Consensus: income +0.3%; spending +0.2% core PCE deflator +0.1% M/M, 2.2% Y/Y

We're expecting to see U.S. income continue to grow at a reasonable pace in February with a 0.3% gain. Although nonfarm payrolls have entered negative territory, the job loss hasn't been all that deep so far, and shouldn't have a big impact on the total wage bill. Spending, on the other hand, should slow significantly with only a 0.1% M/ M gain, since retail sales declined by 0.6% during the month, and consumer confidence continues to fall. The core PCE deflator will likely only post a 0.1% M/M reading, given the weakness we saw in core CPI in the same month, slowing from the 0.3% increase in the previous month. This would bring the Y/Y rate down to 2.1% Y/Y, and would be the first time that the Y/Y reading has moved down, as opposed to up, since August 2007.

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TD Bank Financial Group

The information contained in this report has been prepared for the information of our customers by TD Bank Financial Group. The information has been drawn from sources believed to be reliable, but the accuracy or completeness of the information is not guaranteed, nor in providing it does TD Bank Financial Group assume any responsibility or liability.