Global Markets: Moving Heaven and Earth

Over the course of recent weeks, the unravelling in U.S. and even global financial markets has been truly astonishing. Volatility expectations, as measured by the VIX index, reached five year highs, suggesting a profound risk aversion. At the same time, high borrowing costs have filtered through to the real economy and threaten global growth. Since our last Quarterly Economic Forecast publication on September 25, the economic data has only deteriorated, which raises the downside risks to near term growth prospects And while there have been numerous and creative programs put in place to ameliorate the problems in the credit market, they are but small steps in the right direction. Nonetheless, it appears as though the Fed and the U.S. Treasury, as well as other global monetary authorities are willing to move heaven and earth to stem the crisis.

Emergency Times Call for Emergency Measures

Despite the flood of liquidity that the Fed and other central banks have provided the markets recently, financial market conditions continued to deteriorate through the early part of October. LIBOR rates continued to push higher, indicating that the market was not responding to the palliatives delivered by the monetary authorities.

As such, the need to pull out the big guns became increasingly apparent as markets continued to tank. On October 8, a coordinated 50 basis point rate cut was delivered by the Federal Reserve, ECB, Bank of Canada, Bank of England, Swiss National Bank and Riksbank.

This move changes the outlook rather profoundly. It is an admission that the current turmoil cannot be solved solely through liquidity measures. It has now become apparent that the lack of liquidity has played a serious role on the real economy. Therefore, we are now looking for rate cuts from the G7, with many central banks returning to the historical lows seen in the last major easing cycle.

Draino vs. Bullets

But until the coordinated global central bank cuts, the problems were widely perceived as primarily having to do with liquidity. This perception saw a number of tools and programs developed with the intention of unclogging the credit markets. Adding to the existing alphabet soup of facilities put in place recently is the $700 billion Troubled Asset Relief Program (TARP). This provides the Treasury with exceptional powers to purchase mortgage backed securities whose value had dropped sharply. Though massive in scope, it is not a panacea for all that ails the credit markets.

Other programs put in place included the Fed paying interest on reserves, both required and excess, thereby allowing the central bank to expand its balance sheet sufficiently to continue to address liquidity concerns.

And perhaps one of the most important steps is the program to allow the Fed to purchase commercial paper from eligible issuers (both financial and non-financial). It essentially means that the Fed will be able to lend directly to companies via its special investment vehicle. In short, it provides some support to Main Street at a time when Wall Street has been hogging the spotlight. Lastly, there has been some talk within the financial markets that the Fed might even consider guaranteeing interbank lending, which would further assist in solving the problems in the short term funding market.

Fed Adds Easing to its Arsenal

The case for further easing by the Federal Reserve has been building for quite some time. Recent losses in non farm payrolls in September bring year-to-date job losses to 760K. Moreover, there are growing indications that the legs of support that were previously holding up the economy are starting the roll over. Recent ISM manufacturing data showed a precipitous drop to 43.5 in September. In the context of a slowing U.S. economy, and tumbling commodity prices, inflation risk appears to have receded quite substantially. And even while headline and core inflation currently remains a little beyond the Fed's comfort zone, the Fed has made it clear that inflation concern has been relegated to the back burner for now.

Also arguing for lower rates is the fact that recent Fed rhetoric has turned decidedly dovish. Even the noted hawks on the FOMC have sounded somewhat dovish, if only by omission of their usual hawkish bent. Most recently, Chairman Bernanke stated that "the combination of the incoming data and recent financial developments suggests that the outlook for economic growth has worsened and that the downside risks to growth have increased. At the same time, the outlook for inflation has improved somewhat, though it remains uncertain. In light of these developments, the Federal Reserve will need to consider whether the current stance of policy remains appropriate." That sounds like a rate cut just waiting to happen.

Therefore, we are now of the view that the Fed will cut rates by 50 basis points at the October 29 decision, in an attempt to further shore up market confidence, following the coordinated rate cut of October 8. This will put the fed funds rate at 1.00%. The hope is that this rate cut will work its way though the market and have some impact on the real side of the economy.

The implications for the U.S. yield curve suggest further steepening as yields at the short end fall through the balance of the year. In this regard, lower rates are good news for the banking system, which relies on a steep yield curve to make money, as it borrows short and lends long.

BoC Sets Out on an Easing Path

Amid the unrest in global financial markets, and the very real possibility for spillover to Canadian markets, the Bank of Canada has little choice but to join the global monetary easing. We are now expecting the Bank to lower rates by 50 basis points at the October 21 meeting, which will leave the overnight rate at 2.00%.

But the case for an ease based purely on macro fundamentals is a little more mixed in Canada than for the U.S. Economic growth in Canada, at least for the third quarter appears steady, thanks to an impressive 0.7% M/M gain in July GDP. Moreover, the Canadian labour market has not deteriorated significantly.

At the same time, CPI has run a little hotter than expected, with core CPI rising to 1.7% Y/Y in August. And while a cooling economy will limit further upside in headline inflation, there are still some secondary factors that need to work through the core CPI numbers.

But, the decision might not be a particularly tough one for the Bank of Canada. Global financial conditions clearly trump domestic macro economic concerns at the moment, and while Governor Carney has been quick to remind markets that Canadian banks are in a better position than US banks, he cannot turn a blind eye to the need to maintain not only liquidity but also to keep the real economy rolling along.

Therefore, the Canadian curve is expected to steepen further, as rates at the short end of the curve head lower. The steepening trend does not have as far to go as the U.S., however, as we expect the overnight rate to rest at 2.00% in the very near future.

The G7 Will Quickly Move into Action

The coordinated rate cut set the stage for additional easing by the rest of the G7. In the U.K., the government, financial services authority and the central bank has put in place a number of powerful measures to stabilize the financial system. These measures, including a recent provision of £50 billion to recapitalize the banking system, in conjunction with the 50 basis point emergency rate cut on October 8, suggest the BoE is being vigilant about the credit crisis. We are looking for another 150 basis points of easing from the current official rate of 4.50%, which will go far to diffuse the crisis.

But while we expect aggressive easing by the ECB, they have, in the past proven intractable on their inflation bias, and therefore the risks lie towards slightly fewer cuts in the near term and larger cuts in the first half of 2009. The best reference period for this style of easing is 2001, and during that time, they cut 150 basis points in seven months and in 2002-2003, they cut by 125 basis points over seven months.  As such, the ECB is not of the "cut now, ask questions later" school, which is what underpins our view that while the ECB is most certainly on a rate cutting path, they have the potential to be least aggressive about it.

Getting Through the Morass

The rate cuts are yet another step in the right direction, particularly for the U.S. and the U.K, which are the two countries most in need of further palliatives. This is a very unsteady environment, with quickly shifting parts. The call for further, and in some cases, aggressive rate cuts is warranted at his time, as policymakers pull out all the stops and do whatever it takes to get the global economy and credit markets functioning again.

By early 2010, we expect some unwinding of this easing to occur. Global monetary authorities, and especially the Federal Reserve, will surely want to show that they have learned the hard lessons from the 2003 easing, knowing the consequences of leaving rates too low for too long.

U.S. FIXED INCOME

The U.S. bond market has rallied sharply over the past month, with the U.S. 2-year yield down by 71 basis points. The 10-year sector opted out of this move, leaving the spread between the two substantially wider than it had been. But this steepening of the curve masks an interesting kink that has developed, insofar as the yield curve has actually flattened profoundly between the 10-year bond and the 30-year bond over the past month. In turn, the 10- year bond has substantially underperformed the rest of the curve.

The motivation for the overall rally in U.S. Treasuries can be clearly pinned on the latest deterioration in financial market conditions that appears to have taken U.S. economic prospects sharply downwards as well. In turn, even after the latest surprise Federal Reserve rate cut to 1.50%, the market continues to price in some modest further easing.

TD is slightly more aggressive than the market in this regard, and believes that that the fed funds rate will shortly touch 1.00% in light of the true depth of economic and financial market conditions. In addition, flight-to-safety flows should remain substantial. In turn, this translates through to Treasuries in that the U.S. 2yr yield can afford to rally further as this scenario develops.

Towards the longer-end of the curve, TD believes that - while the curve may not flatten outright - longer-dated bonds can rally quite handsomely as these economic woes transpire, as inflation fears continue to plummet (an argument we have made repeatedly over the past year and which is now gaining traction), as deleveraging occurs with possible implications on the pace of potential GDP growth, and as the bond supply implications of recent government bailouts prove to be less substantial than many fear. Furthermore, with yields so low and few viable alternate asset classes, investors will be drawn to longer-dated U.S. bonds for their yield, which should further maintain the bid tone in the product.

TD expects to see the U.S. 2-year yield bottoming out in the 1.30% range by year-end 2008 and for the 10-year yield to bottom out at around 3.40% shortly thereafter. The yield curve may still steepen slightly further in the near-term, but the bigger-picture theme is likely to be that of bond yields remaining quite low throughout 2009, with the Fed only beginning to retract stimulus in 2010.

CANADIAN FIXED INCOME

Canadian bonds rallied substantially over the past month, with the 2-year yield down by 57 basis points. Overall, Canadian bonds managed to underperform the U.S. over the month, though the market has ebbed and flowed so repeatedly that this is more a function of the particular starting and ending dates selected than of a true broader theme. What can be said with somewhat greater confidence is that - at the extreme long end - Canadian bonds did manage to sharply underperform the U.S.: The U.S. 30-year bond rallied by 20 basis points while the Canadian 30-year bond sold off by 20 basis points. It is exceedingly rare for a 40 basis point underperformance to occur across a single month in this sector.

The market's motivation for the overall bond rally is that financial market conditions have deteriorated and that this has economic implications for the U.S., which bleeds across the border into Canada. Similarly, the Bank of Canada engaged in a surprise coordinated 50 basis point rate cut, hand-in-hand with the U.S. The market prices in substantial further easing for Canada over the next six to twelve months.

TD agrees with the market view that further easing is coming, but not with the magnitude of that easing. TD looks for only another 50bp of Canadian rate cutting, which would take the overnight rate down to 2.00%. In turn, the risk is that Canadian bonds are somewhat rich at present, and that a modest selloff could be necessary at the short end (or at least an underperformance versus the U.S.).

By contrast, in the 30-year sector, TD believes that Canadian bonds have underperformed the U.S. excessively, and that the there is room for a notable outperformance here since Canada has the same diminishing upside inflation risks, and yet no bond supply concerns and steady liability-driven investment flows towards the sector.

When the market eventually does turn, even if only modestly, there is scope for Canadian bonds across the curve to outperform the U.S. somewhat, though we do not believe this turning point will come in earnest until sometime in 2009. As with the U.S., TD inserts the assumption that central bank rates must eventually begin to normalize, but that this is still some distance away - likely not until the 2010 timeframe.

U.S. DOLLAR

The USD has continued to rally over the past few weeks, to the point now that we have become concerned that the rise has become somewhat overdone. There is little fundamental justification for the scale of the USD rise, we think, as relative fundamentals have not dramatically improved in the USD's favour while short term interest rate spreads, although narrower than at the middle of year, remain generally unfavourable for the USD.

Much of the USD's strength relates to the deleveraging and position adjustment process that has been underway since August when the credit crunch began to bite; that process appears to have accelerated in the past few weeks. Investors have been dumping risky positions in foreign assets and moving those funds into the relative safe haven of short term US Treasury bills. Meanwhile, demand for USDs has been compounded by an evident scramble for USD funding over the quarter end; financial institutions and corporations that have been locked out of the dysfunctional credit markets have had to resort to repatriating overseas assets or cash holdings to finance operations or boost balance sheets, further lifting the USD.

With the Fed liable to ease interest rates again at the end of October and the US economy now showing signs of struggling mightily as consumers retrench, we think the USD is at risk of giving back some of the recent strength (assuming that the titanic efforts of the G7 governments and financial authorities to stabilize the credit markets are successful) as we move into the end of the year and into 2009. We are particularly concerned about the impact of the measures the US government has undertaken to revive the financial markets and the economy on the US' fiscal position. A significant widening in the country's fiscal deficit next year risks undermining the USD in the medium term once again

CANADIAN DOLLAR

The Canadian dollar has taken a beating over the last few days as crude oil prices have fallen below $90/bbl, and markets are increasingly worried about the risks of a global recession, and its impact on Canada's commoditydriven economy. The Bank of Canada is clearly worried about the same thing, and after taking part in the recent coordinated rate cuts with other major central banks, it's likely going to cut rates by another 50bps at its next Fixed Announcement Date on October 21. This would leave the overnight rate at only 2.0%, matching the lows that it hit in 2002 and 2004, and amongst one of the lowest policy rates in the developed world.

We think that the recent rally in the USD is looking overdone, and that USDCAD should head back toward 1.11 (USD 0.90) by the end of 2008, after recently breaking above 1.15, and that the Canadian dollar should continue appreciating against the USD through 2009. But like the USD, we expect to see CAD underperform against most of the other majors in 2009, as Canadian economic growth gets dragged down by US weakness, and weaker commodity prices chip away at Canada's current account surplus. The last few months have debunked the global "decoupling from the US" theory, and Canada is certainly one of the most vulnerable countries to a US recession.

JAPANESE YEN

The JPY has benefited from the broad process of deleveraging and position liquidation that has characterized the most recent phase of the credit crunch. The JPY has been the best performing major currency over the past month and has risen rapidly against the higher yielding currencies that had previously benefitted from investors seeking high yield (whilst shorting the JPY). The JPY was a typical financing vehicle for investors looking to exploit the carry trade and retail as well as institutional investors often leveraged these positions significantly. As the credit crisis has deepened and investors have become increasingly risk averse or have had to liquidate positions (due to margin calls or to offset losses elsewhere), covering short JPY positions has lifted the currency while the former recipients of these carry flows - high yielding currencies, commodities and equities - have all plunged.

Japan's typical status as a "safe haven" (based on high domestic savings and a steady current account surplus) has been embellished by these events. However, the slower global growth environment may start to challenge some of the structural underpinnings of this argument. Slower global growth is presenting a significant challenge for Japan's exporters at a time when the economy appears to be heading back into recession. Japan's trade balanced slipped into deficit for the first time since the 1980s in August and exports to the US dropped 21% in the year - the worst result on record. With global growth slowing and US consumers retrenching, Japan's trade performance may suffer further, especially as the recent appreciation in the JPY is likely to inflict further pain on exporters.

While the Japanese authorities may be concerned by the strength of the JPY, the current volatility in the financial markets more broadly precludes any overt Bank of Japan response in the near term and we think that JPY volatility will moderate naturally as the deleveraging process is completed.

EURO

In our September update, we suggested that the EUR had undergone a significant change in medium term direction and that we expected EUR/USD to reach USD1.37 in 2009. We got to our target quite a bit sooner than we expected and now we have to reassess the EUR's prospects. As we have outlined in the USD section, we think that much of the movement in the currency markets over the past few weeks ultimately reflects short term issues - positioning, liquidity and deleveraging. Longer term fundamental prospects should ultimately re-emerge as the driver of broader movement and, from this perspective, we suspect that the EUR may shortly start to stabilize and ultimately recover ground against the USD.

The euro zone fundamental outlook continues to deteriorate; Q2 growth was confirmed at -0.2% in the quarter and key components (investment and consumption) were weak. We think growth momentum will remain poor and we expect the European Central bank (ECB) to reduce interest rates further in the coming months. Rate reductions are liable to be measured in terms of scope and timing initially, however; the ECB's participation in the coordinated central bank easing was driven more by a desire to shore up market confidence than by a response to domestic fundamental developments after all.

Weak domestic growth and a fragile financial sector certainly suggest that the EUR is facing some very stiff challenges in the near to medium term but, after falling some 16% against the USD in the past few weeks alone, we do not think the single currency is liable to fall that much further in the next few months as the market starts to refocus on ultra-low US interest rates and the mounting US debt burden.

U.K. POUND

The GBP is another currency that has more or less reached the 2009 target against the USD that we noted in our last update (USD1.69). The Bank of England's decision to join in the coordinated rate cuts with the other major central banks this month advanced the timing of the expected rate ease by just a day after many market observers, including ourselves, concluded that the central bank's reluctance to cut rates would fold this month anyway in the face of the deterioration in the UK economic and financial situation.

We look for more rate cuts to come through in the UK in the not too distant future, with further large-scale cuts a clear risk. The BoE had already indicated that inflation was likely to fall back towards its target rate through the current policy horizon so lower rates were really just a question of timing. With the credit crunch adding to domestic pressures and the housing market still in retreat (house prices are falling as quickly as in the housing collapse of the early 1990s), there is an added incentive for the BoE to cut rates and cut rates quickly (we look for rates to trough at 3.00% by mid 2009).

Given the immense volatility in the currency markets these days, it is perhaps easier assessing relative rather than absolute prospects for the major currencies. We remain of the view (outlined above) that the USD's surge in the past few weeks is unsustainable so we do look for the GBP to recover some of that lost ground in the near to medium term. The prospect of quick and aggressive rate cuts in the UK leaves the GBP vulnerable to renewed weakness versus currencies whose interest rate regimes may be modified more slowly, however.

AUSTRALIAN DOLLAR

The AUD has been one of the major currency underperformers in the wake of the global recession fears and commodity price pull back. The 100bp interest rate cut from the RBA on 7 October added to downside momentum. Though there were good reasons for the 35% fallin the AUD over the last ten weeks, it now seems to be in a classic overshoot. While economic growth is slowing, it remains firm, wtih little fall out on the labour market. Further, the export sector continues to boom, a point that will only be enhanced with the recent AUD softness. We look a near term partial bounce in the AUD on a 1 to 3 month view. But the lack of commodity price support should keep the AUD in the US$0.60s for most of 2009.

NEW ZEALAND DOLLAR

The NZD has held up well, despite the global sell off of peripheral markets. Some slightly better readings on consumer sentiment and business confidence and a substantial loosening of fiscal policy accounts for the relative outperformance. The fact remains that the economy is in recession, house prices are falling sharply and immigration flows are weak. This weak performance is likely to undermine the NZD and if the RBNZ responds with further rate cuts, the NZD should weaken - perhaps sharply. One risk to this is a post-election infrastructure spending boom which would act in a counter cyclical way to stimulate growth and reduce the pressure on the RBNZ for aggressive interest rate cuts.

SWISS FRANC

The Swiss franc has outperformed every major currency aside from the Japanese yen over the last month, as the financial market turmoil has led to a major flight to safety. But assuming that the Herculean efforts of the G7 governments help to stabilize the financial system going forward, EURCHF should also stabilize somewhere near its current level. It looks like the Swiss economy is weakening hand in hand with the Eurozone economy, as the SNB statement following the coordinated rate cuts said that "economic growth for 2009 will be weaker than expected at the last assessment," since "the slowdown in economic activity in the US and Europe is more severe than what the SNB had forecast at its last monetary policy assessment."

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.