The Weekly Bottom Line

HIGHLIGHTS OF THE WEEK

While no formal aid package was announced, EU leaders promised to take “determined and coordinated action” if needed to help stabilize the growing fiscal debt problems in Greece, moderating market uncertainty.
Fed Chairman Bernanke outlined possible steps the Fed could take to rein in liquidity and tighten monetary policy, but did not provide a timeframe.
Fed may use interest on reserves rather than the fed funds rate as its main tool to guide its policy stance
Fed balance sheet is unlikely to begin shrinking until monetary tightening is underway.
Retail sales in the U.S. increased 0.5% M/M in January, led by sales at non-store retailers and general merchandise.
U.S. trade deficit deteriorated in December, from $36.4B to $40.2B, as the 4.8% gain in imports exceed the still healthy 3.3% gain in exports.
Canada's trade deficit widened slightly to $246 million in December from $201 million in November, as import growth (1.8% M/M) exceeded that of exports (1.7% M/M).
Canadian new house prices rose at 0.4% M/M in December, ahead of market expectations, on higher homebuilding costs and feed-through from resale price growth.
Canadian residential construction was up strongly in January, climbing 5.8% M/M to 186.3K starts (at a seasonally-adjusted annual rate) and boosted by gains in the volatile multiple unit category.

UNITED STATES - EXIT STRATEGY IN PLACE, TIMING STILL UNCLEAR

Week after week, we continue to see evidence that the recovery in the U.S. economy is underway. Indeed, this morning's advanced retail sales report showed that consumer appetite for spending is on the mend, rising 0.5% in January. Compared to year-ago levels, sales were up 4.7% on the month. Although the rebound has not been as great as in some other areas, consumer spending should remain supportive for growth going forward as other sectors of the economy, including the labor market, begin to gain traction.

While economic conditions in the U.S. have definitely improved, they have been largely underpinned by a great deal of fiscal and monetary stimulus measures, begging the question of how and when these policies are going to be removed? The focus this week was on the latter, as Fed Chairman Bernanke provided some insight into possible approaches the central bank could take to unwind the liquidity and accommodative monetary policy measures that are currently in place. But while shedding some light on the exit strategy, the timing is still a big question mark. Nonetheless, the release of the speech shows that the Fed is trying to be more transparent in order to avoid confusion, and proving to markets that a plan for an eventual exit is underway, and will be ready when the time is appropriate.

Perhaps the most notable part of the testimony was that there could be some fundamental changes in the way monetary policy is conducted in the U.S. once the central bank's stance changes. Indeed, Bernanke indicated that the Fed may (at least temporarily) shift away from using the fed funds target rate as the main policy tool to influence short-term interest rates, towards an alternate target, such as interest on reserves in combination with targets for reserve quantities. By raising interest rates on excess reserves held at the Fed, the central bank would have more direct influence over lending, as banks would be more inclined to keep a larger amount of money at the Fed, rather than lending it out to businesses or households. This tool, which is used by some other central banks, such as the European Central Bank, could be effectively used to drain excess liquidity from the market. As well, it would help to bring up other short-term rates, including the fed funds rate which is consequently expected to sit between the discount rate and the rate of interest on reserves. Offering term deposits to depository institutions and reverse repurchase agreements (reverse repos) are other approaches that the Fed is considering to help rein in liquidity.

Reducing the balance sheet will also be a key part of the Fed's strategy, and on that front, Bernanke said he expects the balance sheet to gradually shrink towards more “historically normal” levels, and consist of mostly, if not all, Treasury securities. As well, despite maintaining the option of redeeming or selling securities, the Chairman foresees the reduction in mortgage-backed security holdings and agency debt to come largely on account of their maturity or prepayment, rather than the Fed selling its holdings. Bernanke did note, however, that should the Fed decide to sell securities in the future, it will depend on economic conditions and will not take place until after monetary tightening is underway. As well, any such sales would be clearly communicated to the market. As such, the balance sheet is unlikely to improve in the very near term.

Although the timing of the above strategies is still uncertain, Bernanke did signal one move that is likely to happen “before long”: a rise in the spread between the discount rate (the rate at which the Fed lends to banks) and the target federal funds rate. However, he cautioned that this decision is based solely on “normalizing” Fed lending terms, rather than a change in monetary stance. Indeed, Bernanke reiterated the Fed's perspective, that economic conditions will warrant exceptionally low levels of the fed funds rate for an extended period, and he expects monetary tightening to begin once the recovery matures.

CANADA - HOUSING MARKETS UNDER THE MICROSCOPE

Canadian data were sparse this week, with international events being the main market movers. In the data, although U.S. inventory restocking spurred solid Canadian export growth in December, Canada's trade deficit widened, flagging the ongoing pressures to Canada's external balance. Other data showed new house prices gaining in December and housing starts advanced by a strong 5.8% in January.

Outside of these releases, however, Canadian housing dominated media discussions. Present dynamics have spurred conjecture about whether Canadian housing is overheated, ushering in discussion as to if and what policy response might be warranted.

First, to be clear, as we identified in our resale housing outlook, we expect growth in house prices to moderate autonomously, and incipient indicators confirm easing conditions in housing markets. On a monthly basis, new listings are rising more rapidly than sales, and increased residential construction will furnish greater supply, providing a relief value. Looking ahead, while we do not forecast an outright decline in prices, these factors will depress price growth. Spring 2010 will reveal whether this cooling transpires.

Second, analysts, including the Bank of Canada, have rightly observed that it is inaccurate and premature to label present housing markets as in a “bubble”. Strictly speaking, an asset “bubble” requires not just pricing in excess of fundamentals, but a speculative component, with buyers acquiring assets to ride the anticipated appreciation, intending to hop off before the music stops. Although speculation is difficult to identify and home sales are at record levels, current homebuyers appear to be buying with long-term homeownership intentions rather than for quick “flipping”.

However, the lack of a “bubble” does not mean that house prices are not in excess of fundamentals. Over the long-term, house prices are linked to income growth and medium-term interest rates. When homebuyers determine how much they will pay for a home, they (and their mortgage lender) must examine their ability to sustain monthly payments based on their household income. At the aggregate level, unless households' preferences somehow shift in favour of more spending on housing, average resale prices are dependent on average household income. In an April 2009 report, we identified the overvaluation of Canadian real estate prior to the 2008 slowdown. Average resale prices now up 5.7% above their December 2007 peaks and, even at present interest rates, affordability has again diminished. While not a “bubble” per se, Canadian residential real estate is likely overvalued at present prices.

Policy-makers are well-attuned to the potential macroeconomic consequences of excesses in housing markets. Interest rates are low to spur economy-wide aggregate demand; not to fuel asset price appreciation. In an October 2009 observation, we discussed the Bank of Canada's attentiveness to the housing market; but, for the purpose of moderating housing, argued that the overnight rate is a “meatcleaver” where a “scalpel” would be required. Nonetheless, there is scope for limiting borrowing by those homebuyers who will be most unsteady when rates inevitably rise. For instance, near-term variable mortgage rates make current mortgage payments appear more affordable; however, since mortgages are paid off over a long period, households and lenders should assess the affordability of mortgage payments on longer-term mortgage rates. Indeed, the Bank of Canada has flagged the prospect of substantial vulnerability from debt service costs when rates rise, and Canadian insolvency rates are already at historic highs.

Since tighter monetary policy is not appropriate for the overall economy, any policy response to address excesses in Canadian housing would fall to regulation - specifically to the terms of CMHC's mortgage insurance program. There has been considerable discussion in the media about increases to minimum downpayments or reductions in maximum amortization periods for mortgages. However, given current market conditions and prospects for cooling, such policy actions would be premature until there is greater evidence of a “bubble” forming. We will publish a research note on this issue early next week.

U.S.: UPCOMING KEY ECONOMIC RELEASES

U.S. Housing Starts - January

Release Date: February 17/10
December Result: 557K
TD Forecast: 570K
Consensus: 580K

The contrasting fortunes between the existing and new home markets have been quite apparent for some time, as the new homes market has not benefitted in any meaningful way from the recovery in overall U.S. housing demand. Indeed, with monthly sales for new single-family homes declining in 4 of the last 5 months, and the inventory of unsold new homes remaining elevated at 8.1 months, U.S. homebuilders have been averse to ramping up construction activity. This is clearly reflected in the NAHB homebuilders' confidence index, which remains at the basement low of 15, well shy of the neutral 50-threshold. We expect this pattern to remain largely intact in January, when residential construction should rise only modestly to 570K, following the unexpected sharp drop the month before. All of the gains are expected to come from single-family construction, while multi-unit construction should decline. In the coming months, with the recovery in housing demand to remain fairly modest, despite the still favourable buying conditions, we expect the rebound in new residential construction to be gradual, as the overhang of unsold homes is slowly worked off.

U.S. Consumer Price Index - January

Release Date: February 19/10
December Result: core 0.1% M/M, 1.8% Y/Y; all-items 0.1% M/M, 2.7% Y/Y
TD Forecast: core 0.1% M/M, 1.7% Y/Y; all-items 0.3% M/M, 2.9% Y/Y
Consensus: core 0.2% M/M, 1.8% Y/Y; all-items 0.3% M/M, 2.8% Y/Y

In January, we expect higher food and energy prices to be the biggest factors pushing U.S. consumer prices higher, with the headline consumer prices index expected to rise 0.3% M/M, following the modest 0.1% M/M increase in December. Prices are also expected to rise sharply on an annual basis, with the pace of annual consumer price inflation accelerating to 2.9% Y/Y from 2.7% Y/Y. Despite the surge in the headline index, core consumer price pressures should remain fairly contained, with core prices rising by 0.1% M/M, on account of the weak economic backdrop for the U.S. economy. As such, the annual pace of core consumer price inflation should ease to 1.7% Y/Y from 1.8% Y/Y in December. Looking ahead, with the considerable economic slack likely to remain a key factor placing downward pressure on core consumer prices, we expect annual core inflation to begin easing.

CANADA: UPCOMING KEY ECONOMIC RELEASES

Canadian Manufacturing Shipments - December

Release Date: February 16/10
November Result: 0.1% M/M
TD Forecast: 2.0% M/M

Despite the strong domestic currency, Canadian manufacturing sector activity has risen in 5 of the last 6 months, as the pick-up in global economic activity has boosted demand for Canadian manufacturing products. This positive momentum is expected to continue in December, with manufacturing sales likely to rise a further 2.0% M/M. During the month, we expect sales of automotive products and machinery and equipment to be the main driver of the uptick in the headline number. Real manufacturing sales should also rise on the month, suggesting that manufacturing sector activity will add favourably to Canadian GDP during the month. In the months ahead, we expect the Canadian manufacturing sector to be relatively weak, as the combination of a strong domestic currency and soft U.S. demand dampen sales growth.

Canadian CPI - January

Release Date: February 18/10
December Result: core -0.3% M/M, 1.5% Y/Y; all-items -0.3% M/M, 1.3% Y/Y
TD Forecast: core -0.1% M/M, 1.8% Y/Y; all-items 0.0% M/M, 1.6% Y/Y
Consensus: core 0.0% M/M, 1.9% Y/Y; all-items 0.3% M/M, 1.9% Y/Y

Annual headline consumer price inflation in Canada is slowly beginning to track higher, as the combination of the pick up in economic activity and rising energy prices are beginning to push consumer prices higher. In January, despite the increase in energy prices, we expect headline consumer prices to remain unchanged on a non-seasonally adjusted basis, though on a seasonally-adjusted basis prices are expected to rise by 0.4% M/M. On a year ago basis, however, headline inflation is expected to rise to 1.6% Y/Y, up from 1.3% Y/Y in December. Core prices are also expected to be quite soft on a monthly basis, falling 0.1% M/M on a non-seasonally adjusted basis, while on a seasonally-adjusted basis prices are expected to rise by 0.1% M/M. Analogous to headline consumer prices, annual core inflation should rise sharply, climbing to 1.8% Y/Y in January, up from 1.5% Y/Y in December. Looking ahead, we expect core inflation to return to its downward trajectory as the weak economic backdrop continues to keep a lid on core consumer price pressures.

Canadian Retail Sales - December

Release Date: February 19/10
November Result: total -0.3% M/M; ex-autos 0.0% M/M
TD Forecast: total 0.3% M/M; ex-autos 0.2% M/M

Given the recent buoyancy in Canadian economic activity and the continued improvement in labour market conditions, we expect consumer spending to bounce back modestly in December, following the drop the month before. During the month, our call is for retail sales to rise by a modest 0.3% M/M. The pick-up in auto sales should be one factor pushing spending higher, adding to the continued positive momentum in housing related spending. On the other hand, lower gasoline prices during the month should provide a drag. In real terms, retail sales are also expected to grow modestly, with consumer expenditures providing some boost to December's GDP. Looking ahead, with the improvement in the Canadian labour market likely to gain further traction, we expect consumer spending to also gather some further positive momentum and become an important driver of Canadian economic activity.

PDF Format

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.