Financial Markets Monthly – The Buzz: Transitory Factors

It has been difficult to separate the wheat from the chaff in the economic data. Rising energy prices, supply chain interruptions in the auto sector, and weather-related slowdowns have affected readings on both inflation and output. Financial markets have taken these gyrations in stride with global stock markets generally maintaining recent gains and international bond markets rallying. Central bankers are wading through the data, and while there have been changes to near-term forecasts, the overall tenor of the outlook for this year and next remains the same. The global economy is weathering the recent bumps with trade volumes growing and manufacturing activity continuing to expand although the service-sector PMI showed signs of some moderation in growth after several months of running at an above-average pace.

Central bankers stress patience

Outside the European Central Bank (ECB) and the Reserve Bank of Australia (RBA), central bankers are stressing patience with respect to monetary policy normalization. Fed Chairman Bernanke, Bank of Canada (BoC) Governor Carney, and New Zealand Governor Bollard have all gone to great lengths to indicate that policy will remain accommodative in the near term. The Monetary Policy Committee (MPC) at the Bank of England remains divided on the timing of the first rate hike. The flat economic performance in late 2010 to early 2011 suggests that the MPC will patiently watch for the dust to settle before it increases the policy rate in November. The ECB has been the outlier in terms of making policy rate changes having upped the rate by 25 basis points (bp) in April. The ECB maintained its hawkish tone at this week’s press conference citing persistent upward pressure on inflation and positive economic growth momentum.

Federal Reserve stays the course on policy outlook

The late April Federal Open Market Committee (FOMC) rate decision heralded few surprises with no changes to the Funds target or the Treasury bond buying program. The statement maintained that the current exceptionally stimulative monetary policy stance will likely be needed for an “extended period.” There was little to suggest that recent hawkish inflation talk by some of the committee members had any traction. The Fed updated the forecast for real GDP growth and incorporated the run-up in energy prices into its inflation projections. At the end of the day, the tone of the outlook was little changed—the economy will continue to grow at an above-potential pace over the forecast horizon with 2011′s increase trimmed back to reflect the one-off factors that depressed activity in the first quarter of 2011. The economy will build faster momentum next year although the large output gap will take a long time to close, and this will limit the threat of a surge in inflation.

Chairman Bernanke breezes through press conference

The FOMC’s decision to provide reporters with access to the chairman following the rate announcement four times a year proved to be a non-event for markets. Chairman Bernanke was very careful to anchor his comments to the Fed’s dual mandate of full employment and price stability pointing to the typical lag in the effect of monetary policy actions on the economy as being one to two years. He also said that the Fed’s forecasts were predicated on medium-term inflation expectations remaining stable (See chart page 9) with the recent commodity price increases not generating second round effects. He provided no clues regarding the timing of a shift in policy stance, saying the Fed will remove policy accommodation when economic conditions warrant such a step.

U.S. economy slowed in Q1/11, Q2/11 will be better

The first read on the economy’s performance in the first quarter showed a slightly greater than expected slowing in real GDP growth to a 1.8% annualized rate from 3.1% in the final quarter of last year. While this initial print was mildly disappointing, we see a number of areas where the weakness is unlikely to persist including the decline in government defence spending, the dampening effect that the particularly bad winter weather had on construction activity, and some components of household spending. We expect consumer spending will get a stronger boost from the payroll tax cuts introduced at the start of the year especially given the improving trend in private payroll employment. The April employment data showed private nonfarm payrolls posted the largest monthly gain since 2006 supporting our forecast that the economy’s growth rate will accelerate to 4.1% in the second quarter of 2011 and maintain this stronger pace for the second half of the year.

Fed sees no urgency to unwind stimulus yet

Our expectation that the slowing in the first quarter of 2011 will prove to be short lived and that the economy’s pace will accelerate sets up the Fed to pare back the extraordinarily policy stimulus in the second half of this year. Currently, the high unemployment rate is limiting the urgency to do so as suggested by the Fed chairman in his press conference. In fact, arguably the plan to complete the asset purchase program, the so called QE2, at the end of the current quarter means that the Fed is continuing to supply stimulus to the economy. The chairman indicated that the size of the Fed’s balance sheet is likely to be maintained in the near term meaning that maturing assets will continue to be replaced. With the economy expected to reaccelerate in the second quarter of 2011 after a mediocre first three months, the stage will be set for policymakers to begin the process of removing the current extraordinary stimulus. The newly minted press conferences will provide the chairman with an ongoing opportunity to discuss how the Fed sees the withdrawal of policy stimulus unfolding. Our assumption is that the end of QE2 will be the marker of the transition in Fed policy. The removal of the “extended period” clause from the statement is a likely next step followed by the end of the reinvestment of the proceeds of maturing debt as the Fed begins to reduce the size of its balance sheet. The process of draining reserves will be the next step. This sets up for the Fed to be in position to raise the Federal Funds rate target in the second quarter of 2012. (See Fed timeline page 9)

Canada’s economy is in good shape

Real GDP output contracted slightly in February although this followed two very strong monthly gains and was not enough to derail the economy from posting a solid gain in the first quarter of 2011. We maintain our forecast for an increase of 3.7% at an annualized rate, even stronger than the fourth quarter of 2010′s 3.3% rise. We lowered our forecast for growth in the second quarter of 2011 although notably we still expect the economy to expand at an above-potential pace of 2.8% and boosted our third quarter forecast to make up for this near-term slowing. This change reflects our assessment that supply disruptions in the delivery of Japanese autos and parts will dampen manufacturing activity in March and April, which will hamper the economy’s ability to grow at a pace that is faster than the first quarter. The return to more normal activity levels, (either by domestic production of parts or increased supply from Japan) sets up for a rebound in the third quarter with the economy likely to grow at a greater than 4% pace.

Inflation rates jump reflecting temporary factors

Canada’s headline inflation jumped to 3.3% in March led by surging gasoline prices and a bump up in food costs. The core inflation rate was also unexpectedly high in March coming in at 1.7%, almost double February’s record low of 0.9%. In the first quarter of the year, core inflation recorded an average gain of 1.3%, and our forecast assumes that this will mark the low for the cycle given the solid upward momentum in the pace of economic growth established late last year. Despite the elevated level of headline inflation and steady drift higher in inflation expectations, as measured by real return bonds (see chart page 9), concerns about the risk that the strong currency will seep into lower import prices and dampen demand for Canadian exports, kept the Bank of Canada from signalling that it is prepared to restart raising the policy rate in the near term. Our assessment is that the risks associated with keeping financial conditions in Canada “exceptionally stimulative” (see chart page 9) are to the upside for the inflation outlook and outweigh the downside risks associated with currency strength, potential housing market weakness, or a sharp drop in consumer spending activity. We suspect some of the jump in the March inflation rate will be reversed in the months ahead although the higher starting point will likely result in the second quarter’s average core inflation rate running hotter than the Bank of Canada’s forecast.

This combination sets up for July rate hike

Confirmation that the economy is bearing up well will be needed to convince the Bank that the risks to the inflation outlook are skewed to the upside making a rate hike at the end of May unlikely. We maintain our call that the Bank will have the ammunition to raise the policy rate in July and expect that the overnight rate will end 2011 at 2.0%, 100bp higher than today. Key to the timing of the resumption of rate hikes is the ability of the economy to deliver solid growth after transitory factors are taken into account. The April Labour Report showed 58,000 new jobs were created and that unemployment rate slid to 7.6%. Further employment growth coupled with firm global demand and persistent business investment are the underpinnings of our view that Canada’s economy will grow by 3.2% this year. The Bank of Canada upgraded its growth forecast for 2011 to 2.9% from 2.4% in its April Monetary Policy Report and now expects both the headline and core inflation rates to hit the 2% target in the middle of 2012. This is a change from the previous forecast that these inflation rates would return to the target by the end of 2012 meaning that the window for the rate to hit the target will close sooner than previously thought. This means that the Bank will have to reduce monetary policy stimulus if policy is going to counter the upside risks to the inflation outlook.

ECB to “monitor very closely” upside inflation risks

Economic developments within the aggregated euro area have unfolded broadly as expected since the beginning on the year. Recent activity and survey data indicate that euro area growth continued to strengthen through the first quarter of 2011, and the upward momentum has been carried into the second quarter. The regional PMI came in at very robust levels for April, which, when taken in isolation, are consistent with quarterly real GDP growth of a nonannualized 0.9% in each of first and second quarters of 2011. Although we believe that the PMI are likely overstating the true pace of recovery within the Eurozone, the latest set of data suggests that there is upside risk to our forecasts of 0.6% and 0.4% growth in first and second quarters, respectively. Price pressures continue to receive the lion’s share of attention, and the flash estimate of April’s annual HICP inflation rate increased to 2.8%, its highest in 30- months. The Governing Council opted to leave key policy rates unchanged at its May meeting following the 25bp increase in April. In the subsequent press conference, President Trichet noted that energy and commodity prices have been the key driver of overall inflationary pressures and that “risks to the medium-term outlook for price developments remain on the upside.” As a result, the ECB will “continue to monitor very closely all developments with respect to upside risks to price stability.” This wording (instead of inflation warranting “strong vigilance”) indicates that a June rate hike is likely off the table, and we continue to expect that the next move will come in July, followed by incremental rate increases of 25bp in the following quarters.

Uncooperative data continue to be a royal headache in the UK

The preliminary estimate of U.K. real GDP growth in the first quarter of 2011 met expectations of a 0.5% non-annualized increase, reversing the 0.5% contraction seen in the final quarter of 2010. This means that real GDP has returned to its third-quarter 2010 level, or alternatively, output has been flat for the past six months, hardly an encouraging development. While the composition of growth provides evidence in favour of the much desired rebalancing of the U.K. economy toward private investment and exports, the data lack any clear indication of underlying momentum. Moreover, the near-term data will likely not provide the much needed clarity as the additional bank holiday for the royal wedding, and its proximity to the Easter holiday will likely distort economic indicators, make it difficult to gauge underlying trends, and arrive at a short-term forecast with any significant degree of confidence. It is against this backdrop of uncertainty that the MPC left monetary policy unchanged at its May meeting. The minutes to the April meeting indicate that the committee views that there is a significant risk that inflation will exceed 5% in the near term (we expect inflation to hit 5.0% in the third quarter of 2011); however, we believe that the majority of the MPC will wait for clear signs that the economy is coping with fiscal austerity before beginning the policy normalization process and maintain our forecast for the first rate hike to come this November. We acknowledge, however, that there is a risk of an earlier move if economic growth proves to be stronger than expected or if upside inflation risks come to fruition.

RBA likely to exercise tightening bias in coming months

The cash rate was left unchanged at 4.75% at the RBA May rate meeting, and the board of governors delivered a more balanced statement than the market was expecting. The stronger than expected first-quarter 2011 inflation reading was noted to “show the effects of production losses” due to the run of natural disasters in Australia, and once these temporary shocks fade, “inflation will be close to target over the year ahead.” Governor Stevens, however, pointed out that while the exchange rate should help to suppress consumer prices in the near term, “longer term inflation can be expected to increase somewhat if economic conditions evolve broadly as expected.” The tightening bias suggested by this outlook was confirmed with the subsequent release of the detailed quarterly Statement on Monetary Policy, which concluded that “further tightening of monetary policy is likely to be required at some point.” This statement hints at a move is likely to come sooner rather than later. Accordingly, we have brought forward our call for a rate hike from the fourth quarter of 2011 to August. At this stage we still expect that there will be only one hike in the second half of 2011 given the current state of the consumer and housing market, followed by two moves next year to bring the cash rate to 5.50% by the end of 2012.

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