Financial Markets Monthly - April 2009

Pendulum swinging?

March proved to be a remarkable month with stock markets rallying and a number of U.S. data indicators sliding onto the stronger-than-expected side of the ledger. The world stock market index that we track posted a gain of close to 8% and the S&P 500 rose 8.7%. The Federal Reserve announced plans on March 18 to make purchases of US$300 billion of government securities during the next six months aimed at keeping risk-free rates low enough to stimulate economic activity. This generated the largest one-day rally in Treasury bonds on record with the 10-year yield falling 46 basis points on that day alone. While the market could not hold onto all of the gains generated by the Fed's announcement, U.S. Treasury bonds still managed to record a positive return in March. However, there remains a great deal of scepticism that the worst has passed for both financial markets and the global economy, leaving investors jittery and the outlook still uncertain.

News not so great outside the United States

The economic news wasn't so great in the other countries. In Canada, data released in March showed that the economy contracted by a hefty 0.7% in January; another 82,600 jobs were shed in February; and housing starts fell to their lowest level since 2000. Eurozone data showed confidence indicators hitting new lows in March, consistent with a bigger drop in economic output in the first quarter than the record-breaking contraction recorded late last year. Rising unemployment in the United Kingdom, falling wages and significantly weaker retail activity (although this may have been somewhat due to bad weather) were topped off with a failed 40-year gilt auction. Policymakers continued to chisel away at steadying financial markets and the economy, but with forecasts dropping faster than you can say “toxicity within the financial system”, confidence remains low.

Another set of forecast revisions

We joke that the only thing that has gone up consistently during the crisis is the number of forecast revisions and March yielded a fresh crop. Mid-month, the IMF announced that the global economy is likely to contract by one-half to one percent in 2009, a change to its January forecast calling for a one-half percentage point increase in global economic output. The agency still looks for the global economy to recover in 2010, although GDP is now only expected to increase between 1.5% and 2.5%, down from the 3% forecast earlier this year. The OECD also revised its forecast for its 30-member countries and looks for an average 4.3% contraction in output in 2009 and a 0.1% decline in 2010, both marked changes from their November forecast for a 0.4% dip in 2009 and a 1.5% rise in 2010.

U.S. economy's slide looks like it is slowing down

On the surface, the news on the U.S. housing market and consumer spending looks encouraging. Sales of both new and existing homes defied expectations and rose in February and housing starts posted the biggest one-month gain in 19 years. Consumer spending also surprised to the upside, with a surge in January being built on in February. The stronger gains caused forecasters to switch the sign on their first-quarter consumption forecasts from a negative to a positive. The manufacturing ISM index perked up a bit in March, although admittedly it remained at very depressed levels. When all is said and done, the data still point to another large contraction in the U.S. economy in early 2009, although the pace of decline likely lessened from the fourth-quarter's 6.3% annualized drop. Similarly, while the improvement in the tone in stock markets may have buoyed spirits, it has only served to dent the first-quarter's massive 11% cut in equity values.

Will April be the cruellest month this year?

To be sure, March provided a reprieve from the steady stream of bad news and another stock market rally was spurred in early April by the G-20 commitment to additional financial aid and increased regulation. On the data front, however, April started on a decidedly sour note with the release on April 3 of a report of another huge drop in U.S. payrolls in March and a rise in the unemployment rate to its highest in a quarter of a century. Speculation that at least one of the North American car companies will fall into bankruptcy added to worries. News and data releases so far in April are keeping uncertainty high and confidence low. The reports on housing and consumer spending for March to be released this month will take on added importance as investors watch to see if the prior readings signalled the beginning of the end of the U.S. housing recession or if April will live up to its reputation and provide cruel news for budding optimists.

U.S. authorities keep adding stimulus

The Fed and Treasury Department announced more policies to combat the economic and credit crisis in March. The Fed unexpectedly announced that it was allocating US$300 billion to directly purchase government securities. It also boosted the amount of other financial assets it intends to buy with an additional funds set aside to purchase agency mortgage-backed securities and a doubling of the amount of agency debt it will purchase. These initiatives will be funded by the expansion of the Fed's balance sheet. Treasury's Geithner also made significant announcements during the month, including the publicprivate investment program and a mile-long list of planned regulatory changes.

Canada's spring looks decidedly chillier

Canada's economy looks to be on a sure course to contract at a faster pace in the first quarter - January GDP was down at a 6.2% annualized pace compared to the fourth quarter's average level. Our recent forecast showed a 4.4% annualized decline in real GDP in the first quarter, but the downside risks to this estimate have been growing and we are monitoring a heftier 5.8% drop. We will incorporate February's data before we officially change our call as the pick-up in motor vehicle production following the end of the holiday-shutdown suggests that the strong declines in auto manufacturing in December and January will not be repeated. On the negative side, the sharp deterioration in the job market and sagging housing activity are keeping downside risks alive and still point to the economy contracting at a much faster pace in the first quarter than the fourth quarter's 3.4% rate. The Bank of Canada made rumblings about changing its economic forecast in its upcoming April Monetary Policy Report as Governor Carney rang the bell on downside risks to the forecast in a recent speech. While the January forecast looked for real GDP growth of 2% in the third quarter of this year, Governor Carney postulated that the “Canadian economy could continue to contract into the second half of this year.”

Bank of Canada to join the QE club?

The intensification of quarterly declines in economic output and possible lengthening of the recession will keep the Bank of Canada on course to provide monetary policy stimulus to the economy. The foray into quantitative easing (QE) by the United States and the United Kingdom, i.e., the use of central bank balance sheets to supplement more traditional methods of monetary policy easing, prompted the Bank of Canada to explore its options. Instead of cutting its already-low policy rate, we expect the main thrust of the April statement will focus on the Bank's plan for implementing a quantitative and credit easing platform. The timing of the implementation of such a policy, however, remains a question mark as Governor Carney stated in a recent speech that “outlining a framework does not necessarily imply that these policy options will be deployed.” Given the relative health of Canada's financial system and smaller peak-to-trough decline in economic output compared to both the United States and the United Kingdom, we look for the Bank to be less aggressive than their central bank colleagues, both in terms of the size and timing of its QE program with some risk that the policy will not get implemented at all.

Interest rate forecasts little changed

We have made small tweaks to our near-term interest rate forecasts but left the general tenor unchanged, with the Fed's quantitative easing program and exceptionally low Fed funds target likely to prevent rates from rising significantly. In 2010, improving economic news plus heavy supply will likely see yield levels increase, with the 10-year yield forecast to rise to 3%. Canada's overnight rate is likely to remain at 50 basis points and the spectre of a made-in-Canada quantitative easing program will keep interest rates low.

ECB decides to slow the pace of rate cuts

The ECB cut its policy rate by 25 basis points to 1.25%, defying expectations for a larger 50 basis-point slice. While not ruling out additonal easing in the policy rate, the ECB stated that it will determine if additional non-standards programs are warranted. We expect the ECB to bring rates down to 1.0% at the next meeting and to announce some form of beefed up non-standard measures, although quantitative easing in its purer U.K./ U.S . form still appears some way off. The U.K. economy remains under pressure as highlighted by the labour market data showing the ranks of the unemployed pushing through the two-million mark for the first time since 1997. The size of the economy's contraction in the fourth quarter was revised up and it is likely that the first quarter will show an even graver year-over-year decline. The Bank of England's quantitative easing program looks to be having the desired result of bringing risk-free rates lower, with the 10- year rate down 27 basis points compared to the day before the announcement and twoyear rates off 32 basis points.

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The statements and statistics contained herein have been prepared by the Economics Department of RBC Financial Group based on information from sources considered to be reliable. We make no representation or warranty, express or implied, as to its accuracy or completeness. This report is for the information of investors and business persons and does not constitute an offer to sell or a solicitation to buy securities.