Canadian Interest Rate Forecast Nov. 2013

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The Bank of Canada's first policy rate increase will not occur until mid- 2015

VANCOUVER BC, Nov 7, 2013/ Troy Media/ – The U.S. political dilemma on government spending and the debt ceiling was partially defused in October only to be revisited in three months. This less than ideal solution avoided a crisis but set the stage for more policy uncertainty, financial market volatility, and eroded confidence for chances of a ‘grand bargain’.

It is likely the next round of negotiations will result in another short-term deal extending through the 2014 mid-term elections. The current deal funds the government until January 15 and allows some furloughed federal government employees to return to work. The debt ceiling was suspended allowing the U.S. Treasury to borrow until February 7, which can be extended a couple of weeks by the use emergency measures.

In addition, negotiations to reduce the budget deficit must be completed by December 13 and a deal must be approved by Congress and the Senate. The sequestration cuts that began in March remain in effect with the next round of cuts due to take effect in January when temporary spending measures end. In the near term, this policy uncertainty will weigh consumer and investor confidence negatively impacting spending decisions.

Economy
On the economic front, the U.S. private sector continues to grind away at a modest pace and the global economy appears to have held onto its recent momentum gains in October.
The flash PMIs on global manufacturing showed a broad based upturn in the three major economies. Growth rates were still weak in the euro zone and China while the U.S. slowed considerably, possibly due to the disruption and uncertainty caused by the 17-day government shutdown.

In the U.S., the manufacturing PMI fell to 51.1 in October from 52.8 in September and points to a soft industrial production growth in October. The ISM manufacturing production index corroborated the PMI result with a decline in October from September – still expanding but at a slower pace. September’s above-average 0.6 per cent gain in industrial production was due to a large increase in utility output while manufacturing posted a smaller gain.

Headline retail sales declined 0.1 per cent in September due to a 2.2 per cent drop in motor vehicle and parts sales. However, excluding autos, retail sales increased 0.4 per cent and are now up 2.6 per cent over the past year. Consumer spending is chugging along at around a 2 per cent pace.

Job growth was 148,000 in September but August payrolls were revised higher to 193,000 though partially offset by a downward revision to July to 89,000. Stepping back for the monthly swings, non-farm payroll growth has moderated from the first half of the year. It is likely that October will be lower because of the government shutdown and various disruptions.

Sales of existing homes fell to 5.29 million Saar units in September from 5.39 million units in both July and August. With the recent 100 bps run up in mortgage interest rates some pullback was not surprising. Housing prices held up in September and were well above year ago levels. This sales soft patch will likely extend for another three to five months and turn higher when there is more clarity on economic prospects and from the retreat in mortgage rates.

Third quarter real GDP will grow between 1.5 per cent and 2.0 per cent annualized, similar to the average growth of 1.8 per cent in the first half and to the underlying trend coming out of the recession. Fourth quarter growth looks to come in below trend owing to the partial government shutdown. Beyond this temporary dip, growth in 2014 and 2015 is set to upshift towards 3 per cent on less fiscal drag, more consumer demand, a shrinking trade deficit, and more spending on residential and business investment.

However, there is downside risk to the outlook stemming from fiscal policy uncertainty and a possible setback in Europe’s emerging recovery. Economic growth could remain stuck around 2 per cent longer than expected if consumer demand does not grow more rapidly, business investment falters, or exports stagnate because of weak demand from its trading partners.
China’s October PMI rose to 51.4 from 51.1 in September with most of the gain from higher output. This was the fourth consecutive monthly gain and the highest level in more than one year. Supporting evidence of the growth reacceleration was GDP growing 7.8 per cent year over year in the third quarter, which was the fastest rate since late 2012. More telling was the 2.2 per cent quarter over quarter seasonally adjusted gain.

China’s economy has reaccelerated modestly and this momentum will probably carry into the fourth quarter, given October’s PMI. Some government stimulus measures such as increased rail and utilities investment are providing a modest boost. The IMF’s recent outlook put China’s growth at 7.6 per cent in 2013, 7.3 per cent in 2014, and 7.0 per cent in 2015.

The October PMI indicated Japan’s manufacturing upturn continued for the third month in a row with output growing at the fastest rate since December 2009 and new orders rising at the best pace in four years while the order backlog grew again. Japanese industrial production grew 1.5 per cent in September, up some 4.8 per cent on a year ago and the fastest rate in more than a year. Policy stimulus under the new prime minister appears to be having a positive effect as well as China’s growth reacceleration.

However, the expectation is for a temporary growth boost to about 2 per cent in 2013 before falling back to around 1 per cent annual growth in the following two years. In Europe, the manufacturing PMI rose to 51.3 in October from 51.1 in September and the fourth successive monthly gain. A negative indicator came from the retail PMI showing a steep drop in sales during October.

The euro zone’s unemployment rate was at a record high of 12.2 per cent in September for the second month in a row. Credit conditions remained tight in the three quarter and the demand for loans continued to decline. However, commercial banks expect to ease the criteria for lending to businesses in the fourth quarter for the first time since the fourth quarter of 2009.
Europe’s recovery will struggle under high debt and unemployment, tight credit, and ongoing structural issues. Recovery prospects look weak and the economy could possibly retrench into recession once more.

The current recovery is not broadly based, mainly driven by Germany. The IMF forecast calls for 1 per cent growth in 2014 and 1.6 per cent in 2015 with the latter appearing optimistic.
August monthly industry GDP for Canada increased 0.3 per cent after a 0.6 per cent rise in July possibly due to some spillover from flooding in southern Alberta and construction strike in Quebec. In addition, oil and natural gas production rebounded following a weak second quarter. Based on industry GDP, third quarter real GDP is tracking 2.3 per cent annualized and would be an improvement over the second quarter’s 1.7 per cent. However, it is not a trend pickup given the special factors at play.

Net job growth in September was 11,900 down from August’s outsized 59, 200 gain. Trend employment is growing at around 15,000 to 20,000 per month. The September unemployment rate declined because the labour force shrunk.

Retail sales rose 0.2 per cent in August and excluding motor vehicle and parts dealers, sales increased 0.4 per cent. After price inflation, sales rose for the fifth time in six months.

Seasonally adjusted housing sales in October will decline for the first time in several months. The pool of pre-approved buyers has probably shrunk following the increase in mortgage rates earlier this year. Sales will be up year-over-year in October and will close out 2013 with a small gain over last year. This unfolding sales ‘soft patch’ looks to extend into 2014. Housing construction is already down about 15 per cent from last year and is biting into overall GDP growth.

The Bank of Canada released its October Monetary Policy Report and downgraded its forecast across the board. It was one of the more significant shifts by the Bank. Real GDP in the third quarter was cut to 1.8 per cent from 3.8 per cent in the July report. The Bank pared back growth in 2013 to 1.6 per cent from 1.8 per cent, in 2014 to 2.3 per cent from 2.7 per cent, and in 2015 to 2.36 per cent from 2.7 per cent. The Bank’s growth forecasts are now more in line with the consensus view.

The Bank stuck to its long-standing practice of generating a forecast that results in the output at or near zero causing core CPI to be at or near 2 per cent at the end of its projection period.
Though the Bank reduced its growth forecasts, the projected output gap is closed in the fourth quarter of 2015 because it also reduced potential GDP. Canada’s economy will grow at a moderate pace into 2014. The fourth quarter could be sideswiped by a U.S. growth dip. Growth for 2013 is still seen at 1.7 per cent and rising to 2.3 per cent in 2014 and 2.7 per cent in 2015 contingent on a more robust U.S. growth and further slippage in the loonie.

Inflation
Headline consumer price inflation held steady at 1.1 per cent in September while core inflation was 1.3 per cent, also unchanged from August. Inflation pressures remain muted and are likely to remain so into 2014 and as long as there is considerable slack in the economy. A declining loonie will tend to raise imported goods prices.

Interest rates
The downdraft in the bond market continued through October sending yields down about 20 bps by month end. Since the Fed’s decision in mid-September to not taper, bond yields dropped about 40bps at the long end and 10 bps at the short end of the yield curve. A shallower yield prevails. There was no change in administered lending or deposit rates.

Monetary policy
The Bank of Canada left the overnight interest rate at 1 per cent given the uncertainties emanating from the U.S. and the tepid U.S. recovery. The Canadian economy has been growing at a slower rate over the past year and inflation will likely remain muted. The Bank’s forward guidance was more restrained reflecting its downshift in growth expectations.
The Federal Open Market Committee stood pat at its October meeting and left its asset purchases at $85 billion monthly. Uncertainty surrounding fiscal policy and the recent softness in economic data played the major role in the Fed’s decision. There were no hints about the timing of a reduction in asset purchases. The timing of the first taper of QE3 will be data dependent and when economic data stabilizes following the disruption from the government shutdown and fiscal policy is more certain. A likely commencement of tapering is sometime around April 2014, though possibly June. Tapering is the first step toward the normalization of interest rates.

Interest rate forecast
In light of recent events and economic data, a change to the rate forecast is necessary. The entire yield curve is cutback especially in the near term with no significant increases until mid-2014. When QE3 tapering begins in the U.S. sometime around April, bond yields will begin rising once again, and, assuming no major external setback, will continue rising with the U.S. economic recovery cycle.

The Bank of Canada’s first policy rate increase is pushed back to mid-2015 from early-2015. The futures market has similarly reduced expectations for the first rate hike this time to about April 2015 from January 2015. The market expects another 25 bps increase in September 2015 and another by the end of 2015. The recent decline in bond yields and the cost of funds should lead to a cut in mortgage rates in the near future. A cut of 20 to 25 bps for a five-year fixed rate is likely. Not only has the cost of funds declined but the demand for funds will also slow because of fewer housing sales. Competitive in a shrinking market will prompt a rate cut, even in an oligopolistic market setting. No imminent change in deposit rates is foreseen.

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