Financial Markets Monthly - May 2009

Highlights

• Financial markets are anticipating that worst is over for the global economy.
• Stock market rally continues while longer-term government yields move higher.
• Short rates anchored by central banks' commitment to keeping policy accommodative.
• Economic news "less bad", pointing to the first quarter as the trough for world GDP.
• Federal Reserve gives slightly more upbeat view of economic outlook ...
• ...although first quarter's bigger-than-expected drop sets up for bigger slump in real GDP in 2009.
• Canada's economy records seventh consecutive monthly contraction.
• Bank of Canada slashes growth forecast for 2009 to -3% from January forecast of -1.2%...
• ...and implements another rate cut, leaving overnight rate at just 25 basis points with a conditional commitment to hold the rate steady until mid-2010.
• Quantitative and credit easing policies discussed, but no action yet.

Green shoots

Global financial markets appear to be viewing the green shoots of growth as viable with the MSCI world stock market index racking up another 16% in April and early May, LIBOR rates falling to record lows and credit spreads narrowing. The data on the global economy increasingly point to the first quarter of 2009 as being the low point, with leading indicators suggesting that the pace of decline is abating. It is still early days and too soon to say that the global economy is out of the woods; however, the list of upside surprises has been growing and there are inklings of upward revisions to growth forecasts. At the same time, fears of deflation are moderating as commitment to forecasts of a second-half recovery become more firmly entrenched.

For bond markets, concern about supply to fund the massive amounts of fiscal stimulus plus optimism that the worst for the economy has passed put upward pressure on longer-term yields. The 10-year Treasury yield hit a recent high of 3.34%, a staggering increase from the 2.06% low registered in late December. Similarly, the 10-year Government of Canada bond yield, at 3.24%, stands about 70 basis points above its mid-January low with the United Kingdom and Eurozone also posting sizeable increases. Short-term rates remain near-record lows as the upfront commitment by central banks to maintain low policy rates keeps them anchored.

Glass half full

The recent improvement in the tone of economic data makes it difficult to fight the rising optimism in financial markets. The list of U.S. indicators showing signs of stabilization or improving momentum is relatively broad, with housing stats showing stability after three years of decline, the ISM surveys indicating that the pace of decline in both the manufacturing and services sectors is slowing, initial claims for unemployment insurance starting to trend lower (albeit from elevated levels) and the pace of job cuts slowing from the unprecedented rate recorded in the first quarter. The improved tone in financial markets gave consumer confidence a boost in April, with indices showing a bigger-than-expected pop in the month. Finally, the April senior loan officer survey showed a moderation in the percentage of banks that reported tightening in their business lending policies, a signal of some easing in credit conditions. That being said, we still look for another moderate-sized contraction in the U.S. economy in the second quarter and negligible growth in the third.

Lion's share of forecast cut due to outsized drop in Q1 GDP

While forward-looking indicators point to the U.S. recession easing up, the first quarter's growth report was disappointing with real GDP contracting at a stronger-than-expected 6.1% annualized pace. Weakness in residential construction, business investment and government spending weighed down the growth rate, while a massive drawdown of inventories slashed 2.8 percentage points from output. Going forward, this record drop in inventories augurs well for a pick-up in production as demand increases while government spending is forecast to rebound as the fiscal stimulus measures kick in.

In spite of the improved tone in some of the data, we are maintaining our forecast for a 2.3% annualized decline in real GDP in the second quarter as the troubled auto sector weighs on growth and the deleveraging by households and businesses continues to restrain activity. We look for a marginal increase in third-quarter output as the impact of easy monetary policy and the early stages of government spending support a pick-up in activity and lay the groundwork for a more robust recovery in the final quarter of the year. Implicit in our forecasts is the assumption that the improved tone in financial markets is maintained and that the recent credit spread narrowing continues. Even though we are sticking to our second-half recovery forecast, the sharply lower-than-expected print on first-quarter GDP has resulted in a downward revision to our 2009 forecast to -2.9% from -2.4%.

Fed sees signs of recovery too!

The Fed presented a slightly more upbeat assessment of the outlook for economy on April 29 in the statement accompanying its rate announcement. The statement was a stepup from the gloomy picture policymakers painted in early March. However, the bottom line remains that the economy is weak and the Fed's commitment to a funds rate in the current 0% to ¼% range for an "extended period" with additional support from credit and quantitative easing programs is firmly intact. In a later speech, Chairman Bernanke reiterated this view, although stipulated that another bout of financial market turbulence would pose a key risk to the Fed's more upbeat assessment. The Chairman also highlighted that policy was focused on easing private-sector borrowing costs rather than targetting specific risk-free rate levels.

U.S. 10-year yields to remain range-bound in 2009, rise in 2010

Against the tentative prospective economic recovery, falling headline inflation rates and the Fed's direct purchases of Treasury bonds, we expect that the 10-year Treasury yield will trade in a range between 2.5% and 3.3% for the remainder of 2009. Our view that the economy will grow at a moderate 2.1% pace in 2010 means that longer-term rates will break out of this range, although the subdued pace of recovery will likely limit the increase. Short-term rates will remain anchored at about 1% this year and grind higher in 2010 as markets prepare for the Fed to remove some of the monetary policy stimulus.

Canada - Darkest before the dawn

Canada's February GDP report confirmed the weak state of the economy, with output falling for the seventh consecutive month. Still, the pace of decline slowed with real GDP off just 0.1%, a marked improvement from the sharp declines recorded in November through January. On balance, the data point to a very weak first quarter and we look for an annualized drop of 6.5% in real GDP, a downgrade from our previous call -4.4%. The Bank of Canada, in its Monetary Policy Report, forecasted that the economy shrank at a 7.3% annualized pace in the quarter, supporting their decision to cut the policy rate to 25 basis points and issue a conditional commitment to hold the rate steady until mid-2010.

Unlike other countries, there is a noticeable absence of green shoots in Canada's economic data. Financial markets, however, are powering along, with the TSX recording a 32% gain from its early March low and Canada's interbank funding rate falling to 44 bps. Credit spreads eased and issuance picked up, meaning that access to financing for Canadian corporations is improving. While the mending of the financial system is a positive for economy in the medium term, especially as it will be complemented by a healthy dose of fiscal stimulus, the near-term outlook remains worrying. With manufacturers still under pressure, we have downgraded our forecast and now expect the economy to print another 2.3% annualized contraction in the second quarter and a mild 0.8% annualized increase in the third. These revisions, along with the softer first quarter, resulted in our 2009 GDP forecast falling to -2.4%, a percentage point weaker than our previous call.

QE or not to QE - That is the question

The Bank gave a "conditional" commitment to keeping the policy rate at 0.25% until mid- 2010 in its April policy statement. Policymakers also outlined a framework that would enable them to add stimulus if the economy disappoints their already-weak economic assumptions and threatens to keep the inflation rate below the 2% medium-term target. By removing some of the uncertainty about the direction of interest rates during the next year, the Bank is aiming to boost the confidence of Canadian households, businesses and financial market players and lay the groundwork for recovery.

The Bank also provided a simple framework for made-in-Canada version of credit and quantitative easing programs. In the final analysis, however, the Bank suggested that implementation of these programs is not required at this point, although the need will be assessed from rate meeting to rate meeting, starting with the next one on June 4th.

Bad news for the United Kingdom; ECB provides "credit support"

The United Kingdom suffered bad news on two fronts this past month. First-quarter GDP was reported to have declined 1.9% quarter-over quarter, representing the fastest pace since 1979. Adding to the bad news was the budget announcement that forecast a peacetime record budget deficit of 12.4% of GDP. The assumption for growth in the upcoming year was revised down, broadly in line with RBC's forecast. However, the 2010 growth assumption stands significantly above our projection, risking a bigger-than-projected deficit. The expected avalanche of gilt issuance saw the 10-year yield back up, even after the announcement of an expansion of the quantitative easing program in early May.

The European Central Bank (ECB) cut its main refinancing rate by 25 basis points to 1.0%. In his press conference, President Trichet painted the risks to growth as being 'balanced,' and, in a change in rhetoric, did not to rule out further rate reductions. On the credit easing front, the ECB extended its longer-term loans and the timeframe when it would accept a wider range of collateral. The ECB also announced it would purchase covered bonds with the details to be announced at the June meeting. Trichet was emphatic that the ECB is not "embarking on a policy of quantitative easing," but, rather, providing "enhanced credit support."

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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.