Global Markets: From Stablization to Re-evaluation - Financial Markets Wake Up

HIGHLIGHTS

• Some of the key themes prevailing over the past month since our last publication include a resurgence of risk aversion, increased conjecture over U.S. dollar diversification and a general reassessment of asset prices to more closely align with the prevailing economic reality.
• The price action in the North American bond markets shows how fixed income markets have re-priced to reflect the realization that the shape of the economic recovery has yet to be determined.
• Just as fixed income markets got ahead of themselves anticipating the recovery and the risks of inflation, so too did equity and commodity markets.
• The publication also includes quarterly interest rate and exchange rate forecasts for the U.S., Canada, Australia, and New Zealand, and also offers additional exchange rate forecasts for the Japanese yen, the euro, the U.K. pound, and the Swiss franc.

Some of the key themes prevailing over the past month since our last publication include a resurgence of risk aversion, increased conjecture over U.S. dollar diversification and a general reassessment of asset prices to more closely align with the prevailing economic reality. To this end, it would seem as though global financial markets continue to conduct themselves in a reactionary mode that more closely resembles a form of interpretive dance rather than a concrete directional view. In this regard, looking back at our last Global Markets forecast our assumption that financial markets had gotten ahead of economic reality came to fruition. Further, our expectations for U.S. 10- year bonds to hit a cyclical low of 3.25% in Q4-2009 is approaching quicker than we had anticipated, with the current yield hovering closely above that target.

(Bond) Bulls on Parade

As early as last month, it seemed to be the case that the better-than-expected economic data coming out of the U.S. suggested an economy that was (finally) starting to reach bottom. The key data over the May to June timeframe included: improved retail sales, higher levels of consumer confidence, a resurgence of activity in housing starts, improving industrial production measures and a slower rate of decline in nonfarm payrolls. As a result, a sense that the tide had turned and conditions were improving impacted financial markets in North America. Energy and commodity markets rallied, equity markets followed suit, credit spreads began to tighten, and yields on sovereign debt began to backup.

Fast forward to today, and we see a sharp reversal in this line of thinking. A plethora of worse- than-expected economic data coming out of North America coupled with a general re-thinking of the likely profile of the economic recovery effectively killed the positive momentum that was beginning to creep into the markets. Some of the recent disappointing U.S. economic data include: falling consumer credit, increasing lack of upside pricing pressures, a personal income report that showed growth primarily as a result of government transfers and a much worse-than-expected jobs report. Taken together, this set the stage for the financial markets to re-evaluate its general views on the length of time it will take for the U.S. economic recovery to materialize. Moreover, given the tremendous price discovery that global markets take from the U.S., it was not a terrible surprise to see international financial markets fall in concert.

Further along the theme of re-evaluation, there has been much conjecture as of late over the timing of the first Fed rate hike. The spate of earlier better-than-expected economic data led some market participants to believe that the commitment to keeping rates low for an extended period of time was starting to look less credible. The most recent nonfarm payrolls release for June saw the unemployment rate rise to 9.5%, which is the highest level since August 1983. Our own TD Economics forecast has the U.S. unemployment rate peaking at 10.2% in Q4-2010, which is still over a year away. If history can be used as a guide, there is extremely little risk of the Fed hiking rates as far as a year in advance of the cyclical unemployment rate peaking. To this end, we maintain our forecast that the Fed funds rate will not change until Q3-2010, a far cry closer in timing to our expectation for unemployment to peak.

The Fed may be in new territory, but central bankers are notorious for being creatures of habit. This is not to say that the Fed won't remove stimulus before this timeframe. The beauty of unconventional monetary policy is that stimulus can be removed without actually changing the target fed funds rate. We have already gotten a glimpse of this in the recent announcement by the Fed that they will allow some of the emergency liquidity facilities to expire at the end of the year in addition to suspending one of the facilities altogether. These Fed programs have a natural churn rate embedded in them as improving market conditions would offset the attractiveness of the programs falling under the umbrella of the emergency 13(3) Act.

The price action in the North American bond markets shows how fixed income markets have re-priced to reflect the realization that the shape of the economic recovery has yet to be determined and that the North American economies are too weak to support higher prices of any significance in the medium-term. With an average rally during the past month of 46 basis points (bps) and 25bps across most bond maturities in U.S. and Canada respectively, it is quite evident that the market has become decidedly bullish on sovereign debt. We continue to feel that the U.S. 10-year Treasury will end 2009 at the 3.25% level, though if the data proves even worse and the rally continues in full steam, it is conceivable to see the U.S. 10-year Treasury flirt with the 3.15% level or even lower should conditions fall further to the downside. In the immediate future, if bonds rally further, we believe the risks are titled towards Canada underperforming the U.S.

Turning to Europe, while it was universally expected that the Euro zone would be a laggard in the timing of a global economic recovery, recent data does suggest that this might not be the case. The fact that the ECB provided less monetary stimulus coupled with the realization that European labour markets typically take much longer to recover from a recession than those in North America were two of the main points supporting the argument. However, there has been a strong improvement in sentiment readings coming out of Europe recently, and when one correlates that data with industrial production measures there seems to be a possibility that real GDP growth in the Euro zone could potentially reach a high of 4-5% by Q4-2009, which is strikingly higher than previously thought, though this is unlikely to spark much of a re-valuation in European bonds until after the summer. If this were to materialize, the risk obviously would be tilted towards higher yields on Euro zone sovereign debt, particularly at the long-end of the yield curve. Having said that, one upside risk to short-term interest rates in Europe would be the possibility of another (unjustified) rally in oil prices, reflecting the fact that Euro zone CPI is very oil-focussed compared to other countries. However, despite the potential near-term lift to growth, this is likely to be short lived, and the markets will come to this realization as well.

Unpleasant Truths Gain Momentum over Comforting Misrepresentations

As noted earlier, over the past month, global economic conditions have worsened considerably. Notably, the latest GDP results from the U.K and Japan were quite disappointing as were the lower than expected machine orders from Asia.

Just as fixed income markets got ahead of themselves anticipating the recovery and the risks of inflation, so too did equity and commodity markets. This can be evidenced by taking a quick look at various global equity market returns over the past month. The Dow, TSX, Nikkei and the MSCI emerging market index have all fallen roughly around 6% over the past month, which correctly articulates the extent to which investors were pricing in a quicker road to economic prosperity, globally.

A similar pattern is evident in various international energy and commodity markets over the past month. There has been a sharp pull-back in commodity and energy prices, with oil, natural gas and copper off by 13%, 8% and 6% respectively. This largely speaks to the prolonged road ahead before global economic output advances enough to justify upward pricing pressure in the aforementioned markets, though the recent influx of speculators in the game will likely keep the volatility quite high. While those who are long-the-market might not be too happy about the recent price action in the commodity and energy space, we maintain our bias that the initial run-up was overdone and unjustified given the global economic profile.

Gone Are the Days of Yesteryear?

One of the most interesting and controversial themes arising as of late is in regards to the fate of the USD as the world's primary choice as a reserve currency. The impetus behind the discussions is a building dissatisfaction with the dollar's current status, chiefly resonating on the fiscal policies focussed on stimulating the economy put forth by the Obama administration to help fight the current recession. It is mainly the BRIC nations (Brazil, Russia, India and China) that are the main proponents of dollar diversification. However, taking a look at the U.S. dollar index's performance over the past month demonstrates the tremendous uphill battle this subject will face, as the dollar index is effectively flat during the past month despite some heightened volatility. Furthermore, a very strong report released by the IMF in Q1-2009 showed that 65% of the world's allocated foreign exchange holding were held in U.S. dollars, which is the highest in almost the past two years. As such, it strikes us as unrealistic that the U.S. dollar will lose its place on the trophy shelf anytime soon. At the end of the day, the move towards a new or possibly secondary global reserve currency sounds to have more entrenched political ambitions than economic ones.

Bottom Line

The bottom line is that financial markets will be shaped by the assessment of the timing and the strength of the future economic recovery, and the bias in the near term is likely to be on the acknowledgement that conditions are still extremely weak, similar to the tune we sang in our last Global Markets outlook. North American bonds continue to be attractive given the near-term economic profile, with U.S. 10's likely to finish the year at 3.25%. The possibility of a European economic renaissance towards the end of 2009 looks increasingly likely, though the notion that the U.S. dollar will disappear as the world's chosen reserve currency looks much less probable. Don't count on Fed hikes any time in 2009, though there is the possibility we see further reductions of the various liquidity programs as the Fed might want to start taking out monetary stimulus should conditions warrant the move. The general sense of risk aversion that is beginning to creep back into the markets reflects the capital market mentality that the re-evaluation trade has more of a positive carry than the normalization trade which was so in style a month ago.

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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.