Financial Markets Monthly - January 2010
- Stronger than expected data see government bond yields rise and stock markets solidify gains.
- The U.S. economy will likely expanded at a 3.4% pace in the fourth quarter...
- ...and we have made a small upward adjustment to our 2010 growth forecast.
- The Fed is taking steps to reduce policy accommodation although rate increases are unlikely to come until later in the year.
- Canadian data supports our fourth-quarter forecast of real GDP growing at a 3.4% annualized rate.
- The rally, in the housing market and improving labour market, sets 2010 off to a good start.
- Inflation is not a concern yet given that the economy is operating with significant slack.
- As the recovery becomes more entrenched, the Bank will shift policy away from its current extremely accommodative stance.
forecast supports the Bank of Canada maintaining its conditional
commitment to holding the overnight rate at 0.25% until midyear.
the pace of growth accelerates, the Bank will remove stimulus with 100
basis points in rate hikes forecasted in the second half of 2010.
- New Zealand enjoyed its second consecutive positive GDP reading in the third quarter.
- The Australian job market continued to strengthen in November.
- The final quarter of 2009 should see positive economic growth in the UK, following seven quarters of decline.
- Eurozone inflation returns to positive territory.
- Survey data continue to register improvement.
The economic recovery is on
Data over the past month largely produced upside surprises relative
to market forecasts resulting in a sustained pickup in equity markets
and a relatively sharp rise in government bond yields. Since our last
publication on December 4, 2009, 10-year rates in the markets that we
cover were up as much as 16-38 basis points. Yields retraced some
ground in the first week of January but remain in the upper end of
their 2009 trading range. The world equity market index posted a 2.1%
gain during the month, managing to build on the very strong increases
in the prior five-month period.
The improved tone in the economic reports led to upward revisions
to projections for U.S. fourthquarter growth with the consensus
shifting toward the economy growing at a faster pace than the 3%
annualized quarterly rate forecasted in early December 2009. The
slowing pace of decline in U.S. nonfarm payrolls in the fourth quarter
likely helped the revival in consumer confidence for the month and, we
expect, supported another monthly increase in retail sales activity.
These reports along with improvements in the manufacturing and service
sector point to more vigourous activity in the fourth-quarter 2009 than
we previously expected. As a result, we revised up our fourthquarter
2009 U.S. real GDP forecast to 3.4% at an annualized quarterly rate
from our previous projection of 2.6%. Our 2010 forecast has been
boosted slightly, with the economy expected to grow at a 2.6% pace,
stronger than the 2.5% rise we estimated earlier. Even with households
and businesses continuing to repair their balance sheets, thereby
weighing on the pace of the recovery, the passage of the worst for the
financial crisis, the end of the housing recession and the steady
stream of fiscal support are lessening the chances of the U.S. economy
entering a double-dip recession.
On the lookout for inflation
Next week's inflation report is sure to be closely watched with the
headline inflation rate forecasted to rise to 2.7% in December 2009,
the fastest pace since October 2008. Unfavourable base effects, energy
prices tanked in December 2008 but held up in December 2009, will take
the steam out of concerns that an attack of broad-based inflation is
underway. More attention will be paid to the core measure, which has
proven to be much less volatile. RBC Economics forecasts the core rate
edged up to 1.8% in December with 2009's average annual increase at
1.7%, down from 2.3% in 2008. We expect that the core inflation rate
will continue to slide throughout 2010 as the large output gap
generated throughout the recession keeps downward pressure on prices in
the near term. The sharp increase in the unemployment rate, which
averaged 9.3% in 2009 following 2008's low 5.8%, combined with the
near-record low capacity utilization rate, highlights the amount of
excess slack in the U.S. economy. Estimates suggest that our forecast
of a 2.8% year-over-year increase in real GDP in the fourth-quarter
2010 will only trim 1.2 percentage points from the estimated 5.7
percentage point output gap, which is consistent with a limited decline
in the unemployment rate.
Given this backdrop, inflation pressures in the US will remain
muted with the core inflation rate forecasted to end 2010 at 1.0%. A
stronger 3.4% expansion in real GDP in 2011 points to a more
substantive decline in the unemployment rate, as the output gap narrows
further and is consistent with the core inflation rate rising to 1.6%.
As indicated above, the headline inflation will be volatile as the
effects of movements in commodity prices produce a near-term rise in
the headline inflation rate, which will fade out by year end. In 2011,
the headline inflation rate is projected to average 1.8%, just a shade
lower than 2010's 1.9% pace.
Fed to remove support slowly
Our economic forecast supports the case for the Fed to move slowly
away from its current level of policy accommodation. Initially, this
will come through the termination of its nontraditional policy measures
including the end of the security purchase programs. At its December
2009 meeting, the FOMC raised the possibility of expanding some of
these programs should the economy weaken or conditions in the mortgage
Our assumption that the economy will weather the termination of
these programs means that, as the pace of economic growth accelerates
and the trough in core inflation approaches, the Fed will be in
position to take more direct action, and we expect that the Fed funds
rate will be raised to 75 bps by year end. This will kick off a year of
steady increases in the funds rate, as the economy returns to trend
growth, the unemployment rate recedes and inflation rates start to
rise. We revised up our forecast for the funds rate at the end of 2011
to 3.25% from 2.75%. On the fiscal front, the improving economy will
lend support to government finances as tax revenues increase, although
debt levels will remain high. We expect U.S. government bond yields to
rise and have revised up our forecasts with twoyear bonds forecasted to
end 2010 at 2.25% from our previous 1.85% projection. 10-year rates are
also forecasted to end 2010 at a higher level of 4.5% (from 3.75%). Our
2011 forecasts now call for a 4.25% two-year yield and 4.5% 10-year
yield at year end.
Canada's economy has turned the corner ...
After the muted start to its recovery, Canada's economy showed
signs of picking up pace in the final-quarter 2009. An increase in
employment in the quarter spurred a rise in retail spending and likely
helped the strong rally in the housing market. This increase in
household activity reverberated throughout the economy with
manufacturing and wholesale activity rising as well. We expect real GDP
growth of 3.4% to be reported for the final quarter 2009 and boosted
our forecast for growth in the first half of 2010. As a result, we look
for Canada's economy to grow at a trend-like 2.8% this year
accelerating further in 2011 with growth forecasted to average 3.9%.
...and is entering 2010 on firm footing
The sharp rebound in Canada's housing market and improved labour
market conditions indicate the economy entered 2010 on firm footing. We
expect real GDP to increase at an average 3.7% in the first six months
of 2010, stronger than our previous forecast of a 3.25% average pace.
The gains in employment resulted in the unemployment rate averaging
8.5% in the fourth quarter, a shade lower than the third quarter's 8.6%
average level. Stable labour market conditions and with record-low
interest rates saw a staggering 7.4% increase in housing resales in the
first two months of the final quarter of 2009 with prices hitting an
all-time high. Robust housing sales in turn led to stronger
construction activity with housing starts hitting their fastest pace in
a year during the fourth-quarter 2009.
Core inflation rate to stay below 2% target in 2010
Our stronger growth profile for the first half of 2010 suggests
that the bottom in Canada's core inflation rate will be higher than we
previously forecasted, yet we still project it will remain in the lower
half of the Bank of Canada's 1-3% target band. Similarly, recent data
indicate that the peak in the unemployment rate will likely be lower
than our previous forecast. Even with the upward revision to our 2010
growth forecast, the pace of growth will pale compared to previous
recovery periods. This means that Canada's economy will continue to
have an output gap but it is projected to narrow to 2.2 percentage
points in 2010 from an estimated 3.5 percentage points at the end of
2009. With excess capacity still needing to be worked off, the
unemployment rate is likely to remain above 8% throughout 2010, falling
to 7.5% at the end of 2011. Canada's headline inflation rate will
exhibit the volatility associated with movements in commodity prices
but will likely retain an upward trajectory in 2011, which would be
consistent with our expectation that the output gap will close by year
No change to Bank of Canada forecast - on hold until summer 2010
While we made upward tweaks to our forecast, our updated profile
provides little incentive for us to change our call that the Bank of
Canada will honour its conditional commitment to hold the policy rate
at its current level until the end of the second-quarter 2010. Our
assessment that the recovery will build momentum throughout 2010,
however, supports the case for the Bank to initiate a program to start
to remove the extraordinary amount of monetary policy stimulus mid-year
Our baseline forecast looks for the Bank to raise the policy rate
by 100 basis points in the second-half 2010. Most likely the Bank will
hike in 50 basis point increments because there will be little value in
drawing out the process once conditions warrant less policy
accommodation. Another 225 basis points in rate hikes are expected over
2011 with the policy rate expected to settle at 3.5%.
In keeping with the changes to our U.S. forecast, we raised the
overall profile for Canadian yields with the two-year yield forecasted
to end 2010 at 2.75% (from 2.6%) and the 10-year rate at 4.25% (from
3.8%). These upward revisions are more modest than the changes to our
U.S. projections. In 2011, with the policy rate closer to its neutral
level, we look for two-year rates to end the year at 4% with the
10-year yield holding at 4.25%.
Canadian dollar riding the wave of commodity price upturn
Canada's currency gained 2.3% against the U.S. dollar for December
with the effective exchange rate, excluding the U.S. dollar, up a
larger 4.2%. Part of the currency's rally can be traced to oil prices
hitting their highest level since October 2008 while non-energy prices
recorded a 2.2% gain. Our expectation that Canada's economy will
outperform the U.S. economy and that the Bank of Canada will raise
rates sooner than the Fed means that there is still more upside for the
Canadian dollar ahead. Our forecast is that Canada's currency will
break through parity with the U.S. dollar mid-year and only start to
weaken once the Fed moves into action late this year.
New Zealand's economy continues to grow
New Zealand's economy grew in the third-quarter 2009 matching the
second quarter's modest gain. Recent data suggest that growth continued
in the fourth-quarter 2009 and into 2010 backed by the housing market
and consumer spending. RBC forecasts that New Zealand's economy will
grow by 2.6% in 2010 and further accelerate to a 3.2% pace in 2011.
Based on our forecasts for the New Zealand economy and our view that
the annual inflation rate will accelerate to 3% in the second quarter
of 2010 from 1.7% in the most recent report, we look for the RBNZ to
hike rates in the second-quarter 2010. Our forecast remains that the
OCR will rise to 4.00% by the end of 2010 with another another 150
basis points of tightening in 2011 bringing the rate to 5.50%.
Australia still steaming ahead
Australian labour markets continued to improve as November saw
31,200 net new jobs created pushing the unemployment rate down
one-tenth to 5.7%. Although third-quarter 2009 GDP fell short of
expectations, it remained in positive territory marking a nine-month
period of expansion. Indeed, while much of the world was mired in
multiple quarters of output declines, over the past two years,
Australia saw only one quarter of negative growth. With no meeting
scheduled for January 2010, we look for the RBA to deliver a 25 bp rate
hike at its next meeting in February bringing the Cash Rate to 4.00%
and 100 bps from its recent low. Our forecast looks for the Bank
raising rates to 5.00% by the end of 2010 and to 6.00% by the end of
U.K. VAT moves up in January
In January, the VAT returned to 17.5% after being temporarily cut
to 15%, which will affect the profile for growth and inflation in the
near term. The annual pace of inflation rose to 1.9% in November 2009
on increases in the price of gasoline, and we forecast January's VAT
hike to push annual CPI up to 3.1%. The BoE has said that it will look
beyond this increase focusing instead on medium-term price stability.
With respect to growth, third-quarter 2009 GDP saw a small upward
revision, although it remained in negative territory. Growth in the
fourth-quarter 2009 should enjoy a 0.5% quarterly bounce and then
decelerate to 0.3%, because consumers likely brought purchases forward
ahead of January's tax rise. Looking forward, we look for the U.K.
economy to continue to expand although growth will likely be restrained
by falling support from the government sector. The BoE is expected to
hold the policy rate steady until the final quarter of 2010 with a 50
bps hike forecasted. As the recovery takes hold in 2011, we expect
another 150 bps of tightening to bring rates to 2.50% by the end of
Eurozone data points to a continuing recovery
The month of December saw survey data continue to improve. The
German IFO survey increased with the expectations component rising to
its highest level since January 2008. After five months in negative
territory, November 2009 annual inflation posted a positive 0.5%
reading as declines in year-ago energy prices fell out of the measure;
however, it remains well below the ECB's target providing little
impetus for immediate rate hikes. We expect the ECB to support growth
by leaving its main refinancing rate unchanged until the third quarter
2010. Thereafter, we see rate hikes as the recovery becomes further
entrenched, with the policy rate reaching 1.75% at the end of 2010 and
2.75% by the end of 2011.
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RBC Financial Group