Canadian Interest Rate Forecast Sept. 2013

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VANCOUVER, BC, Sep 5, 2013/ Troy Media/ – Signs of faster global economic growth emerged in August and raised market expectations. However, the near-term prospect of Quantitative Easing (QE) tapering in the U.S. remained top-of-mind in bond markets.

Geo-political concerns re-ignited with the prospect of U.S. military intervention in Syria contributing to higher oil prices.

The all clear to an uninterrupted upward economic growth trajectory cannot be issued because several substantial economic and political issues and key monetary policy decisions lie in waiting.

On the political front, the Syrian situation will bring more uncertainty and could result in a negative external shock. There is a key election in Germany during September, which has policy implications for the Eurozone. The U.S. debt ceiling issue is about to resurface, needing a resolution for October along with on-going federal government funding.

On the economic front, the rise in oil prices, if sustained, would cut into global growth and the run up in bond yields represents tighter financial conditions. However, in both instances, if those increases stem from rising underlying demand and not to special factors, then it would offset their drag on growth.

In Europe, high sovereign and private debt, tight credit conditions and vulnerable banks, combined with high unemployment will keep its recovery weak and hesitant. Japan’s policy turnaround needs further development and extension into structural issues before its temporary growth upturn becomes sustainable growth.

The possible commencement of the Fed tapering its asset purchase program in September is a huge uncertainty for the market. Should tapering occur in September, the uptrend in bond yields would extend but if tapering occurred in December or later, bond yields would temporarily decline. U.S. economic growth accelerated more sharply in the second quarter, according to the BEA’s (Bureau of Economic Analysis) second estimate. Real GDP growth was pegged at 2.5 per cent annualized, up from 1.1 per cent in the first quarter and from the 1.7 per cent growth in the first estimate.

There were faster gains in non-residential investment and exports. Residential investment was an ongoing growth contributor with government the largest drag. The inventory accumulation is a likely future drag. The recent data flow was generally positive. Payroll employment increased by 162,000 in July, the smallest gain in four months, but it was close to the 12-month average. Housing activity gained momentum with sales of existing homes up 6.5 per cent in July, the median existing-home price rose 13.7 per cent year over year, and housing starts advanced 5.9 per cent in July from an upward revised June figure.

The ISM manufacturing index edged slightly higher in August. The Conference Board index of leading indicators rose 0.6 per cent in July. The ECRI weekly leading index rose for the week ending August 23. Both measures signal further growth and no recession from economic fundamentals on the horizon. A recession may occur in the next six months, but it would be due to a shock event.

Third quarter growth is projected at around 2.0 per cent, and for 2013, real GDP growth will be in the 2.0 to 2.5 per cent range. Prospects for 2014 and 2015 are brighter due to pent-up consumer demand and less fiscal drag. Real GDP growth accelerates to between 2.5 to 3.0 per cent in 2014 and tops 3 per cent in 2015.

China’s manufacturing sector is strengthening following a two-quarter slowdown. The official Purchasing Managers’ Index (PMI) rose to 51.0 in August, its highest reading in more than one year. The HSBC China Manufacturing PMI also gained and posted its first reading above 50, indicating expansion since April.

Growth in 2013 is predicted at 7.5 per cent, the government’s target and the slowest pace since the recession. This growth downshift signifies a long-term slowdown due to a number of factors including a less robust trade sector, rising domestic costs, and unfavourable demographics. Nonetheless, absolute growth will remain impressive in the second largest economy in the world.

The substantial turnaround in the Japanese economy has lifted prospects in the Asia-Pacific region. Manufacturers recorded a solid improvement in business conditions in August, as output and new order growth accelerated. The PMI rose to 52.2 in August from 50.7 in July, the second highest recorded in the current six-month run of growth.

Japan’s unemployment rate fell for a second consecutive month as the recovery in the broader economy is spilling over into the labour market. The consensus forecast for Japan’s economy in 2013 is 1.9 per cent and 1.5 per cent in 2014. The monetary and fiscal reforms introduced by the new prime minister will continue to be bolstering the economy but the concern is that it will prove temporary without follow-up with structural reforms.

The European economy may be out of recession but it is too early say definitively. Eurozone GDP expanded in the second quarter for the first time in seven quarters with provisional real GDP growing 0.3 per cent following a revised contraction of 0.3 per cent in the first quarter. Further bolstering the recovery view was the manufacturing sector PMI for August at 51.4 for the fourth successive monthly gain and the second above the expansionary 50 reading. The economic sentiment index rose in August but remained below its long-term average.

Europe is not out of the woods yet with several deep-seated problems remaining unsolved. Forecasters are upgrading their expectations and the best one can expect is a slow growth, below-average recovery phase similar to the U.S. Tight credit conditions and high debt loads are not the makings for robust economic growth.

Canada’s economy slowed in the second quarter with real GDP rose at 1.7 per cent annualized, down from a downward revised 2.2 per cent in the prior quarter. Monthly industry GDP was quite strong growth in April and May but was offset by a 0.5 per cent decline in industry output in June due to flooding in southern Alberta and a construction strike in Quebec. Household consumption growth accelerated as did government spending with residential investment rebounding. Business investment spending fell in the second quarter, as did government fixed investment. Net exports subtracted from overall growth.


Erratic movements in the Labour Force Survey continued in July, with a 39,400 drop in total employment compared to the unusually strong 95,000 spike in May. Volatility aside, the short-term underlying trend is around 10,000 to 15,000 per month increases.

Housing sales held up in July, as did housing starts and prices gained. August data are not yet available but early indications and expectations point to a gain in seasonally adjusted sales. The recent increase in mortgage rates continues to spur prospective buyers into action. Before too long, the number of pre-approved buyers will temporarily dwindle, pulling down sales later this year until prospective low-equity homeowners can adjust to higher financing costs.

The Canadian economy will continue growing at a moderate pace through the rest of the year before accelerating in 2014 as the pace of U.S. growth increases. Real GDP growth in the third quarter is forecast at 2.0 per cent annualized, far less than the Bank of Canada’s 3.8 per cent forecast, which no doubt will be revised down. Growth for 2013 is put at 1.7 per cent increasing to 2.3 per cent in 2014 and 2.7 per cent in 2015.

Inflation
Consumer price inflation edged up to 1.3 per cent in July, from 1.2 per cent in June, led by higher gasoline costs. The Bank of Canada’s measure of core inflation was 1.4 per cent in July, compared with 1.3 per cent in June. Gasoline prices in July were up 6.1 per cent from a year earlier, compared with a 4.6 per cent the previous month. Inflation pressures from the labour and product markets are mostly nonexistent which will extend well into 2014 and until the economy is operating closer to full capacity.

Interest rates
Bond yields rose to two-year highs in August resulting, in a 50 to 100 basis points (bps) rise, depending on maturity, since the early May 2013 lows. This run-up in domestic yields is not due to a change in economic fundamentals in Canada – inflation and inflation expectations are low and the economy is expanding at a moderate pace. The primary impetus emanates from the U.S. and Canada is along for the ride.

U.S. bond yields began rising following Fed Chairman Ben Bernanke’s comments in May regarding the end of QE or tapering as it is commonly called. The recent improvement in the global economic data flow also contributed to some of this increase.

Bond yields eased in the second half of August when geo-political concerns surfaced and oil prices rose. The current QE, or asset purchase program, amounts to $85 billion per month comprised of $45 billion U.S. treasuries and $40 billion mortgage-backed securities (MBS). A reduction in these purchases leading to an eventual cessation will contribute to higher yields but the market’s reaction seems an overreaction. The Fed’s monthly purchases are insignificant in actuality though hugely significant for market expectations.

The run up in bond yields is pushing mortgage rates higher. Discounted or special offer mortgage rates are up 40 to 60 bps since May. The posted three-year and five-year posted mortgage rates were largely unchanged until recently when the three and five-year rate were increased 20 bps at the end of August.

Monetary policy
The Bank of Canada’s rate Sept. 4 announcement left its policy rate unchanged and contained no surprises or changes to its forward-looking closing message. The Bank’s current economic and inflation outlook, which will be updated at the next rate announcement, implies a rate increase in the second half of 2014. Nonetheless, the cost of credit has risen due to the run-up in bond yields.

The Federal Reserve meeting on Sept. 17 is will be very telling as to whether it will start reducing its asset purchases. Uncertainties surrounding the Syrian situation and the upcoming political wrangling around the U.S. debt ceiling and funding could unsettle markets and economic agents. August employment data will also influence the Fed’s decision. A majority of U.S. economic forecasters expects the Fed to begin tapering in September and to end its buying in the second quarter of 2014.

Another uncertainty surrounding Fed policymaking is the replacement of Chairman Bernanke and several Governors. The current Chairman’s term expires at the end of 2013 and a new Chairman and Board of Governors may take a different tack and place a different emphasis on the Fed’s dual mandate of containing inflation and promoting growth. New Fed governance will likely not deviate significantly from its current policy stance.

Interest rate forecast
The market is moving rates before the central bank and consequently the commencement of its first policy rate increase is less significant for the shorter term outlook. A steepening of the yield curve will continue until the central bank raises its policy rate and T-bill rates are able to increase.

Longer term mortgage rates will rise in tandem with the increase in lenders’ cost of funds. Deposit rate increases will lag lending rates. In the very short term, should the Fed begin scaling back its asset purchases in September, markets will likely send up yields. However, should the Fed delay QE tapering until later this year, bond yields would decline, at least temporarily.

There is no change to the forecast of the first Bank of Canada, which remains at Jan. 2015. Realistically, this forecast should be viewed as a mid-point estimate in a range from Sep. 2014 to May 2015. The eventual timing of the first policy rate increase will depend on the data flow, on economic prospects, and on geo-political developments. The futures market for three-month BAs is pricing in the Bank’s first 25 bps increase approximately around September 2014 and a 100 bps increase by October 2015.

The futures market for three-month BAs is pricing in the Bank’s fi rst 25 bps increase approximately around September 2014 and a 100 bps increase by October 2015.

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