Much has changed since early spring when the Fed was delivering monetary stimulus at a fast and furious pace. Though the U.S. economic data continues to point to broad based weakness, there have been some signs of improvement in the credit markets. It is against this backdrop that the Federal Reserve recently delivered a 25 basis point rate cut on April 30, lowering the fed funds rate to 2.0%.

The economic assessment was not quite as bad as feared. According to the Fed’s last monetary policy statement, there is still a good deal of softness in the U.S. economy, with household and business spending remaining “subdued.” In addition, labour markets “have softened further.” Moreover, the Fed mentioned that “financial markets remain under considerable stress,” which comes as little surprise. The housing contraction is also presumed to remain a drag on economic growth going forward. But the Fed was not nearly as clear as in the past about its intentions for the future. By leaving out the statement regarding downside risk to the economy, the Fed effectively created a neutral bias.

Even before the Fed delivered the rate cut, expectations for easing at the April 30 meeting had been scaled back. And with the statement that accompanied the decision, there are now indications that the Fed is not as worried about downside growth risks as it was just six weeks ago. What has shifted?

Not much, quite frankly, when assessing economic fundamentals. In fact, the U.S. economy seems to be decelerating at an accelerating pace. The labour market is clearly in contraction, though the damage in April was not nearly as bad as feared. In April nonfarm payrolls shrank by 20K, which was better than the expected 75K loss. And the unemployment rate actually fell modestly to 5.0% from 5.1% in February. Recent job losses have become increasingly broad based, as losses are now obvious in not only construction and manufacturing, but also retail and wholesale trade. Since January, the labour market has lost a total of 260K jobs and we think that the correction in the labour market is closer to the beginning than the end.

From the first quarter GDP data, it is also obvious that the economy is in the slow lane. In the first quarter, U.S. real GDP grew by 0.6% Q/Q (annualized). On the surface this may seem not nearly as bad as it could have been. But much of the gain in the first quarter was the result of a private nonfarm inventory build, which added 0.93 percentage points to GDP, and those inventories must ultimately be liquidated. This suggests downside in the second quarter. Moreover, final sales to domestic purchasers, which purely reflects domestic demand, fell 0.4% Q/Q annualized and points to a good deal of underlying weakness. For context, this was the first decline since the fourth quarter of 1991, which was the last comparable recession characterized by a housing market correction.

Credit Markets On the (Slow) Mend

Thanks in large part to the extended facilities that the Fed put in place over the last quarter, there have been incipient signs of repair in the credit markets. Credit spreads for a wide array of products have narrowed, though they remain wide by historical standards. Nevertheless, spreads for A and BBB versus Treasuries, as well as for emerging market bonds, are generally back to levels last seen in January, suggesting that investors have become a bit more comfortable with risk after numerous liquidity injections by the Fed. However, in the short term money market, spreads have not enjoyed the same narrowing as other securities and remain wide by historical standards, as measured by the spread between the 3-monthT-bill yields versus Libor.

The narrowing in corporate spreads has been a welcome change of pace, considering the rocky first quarter. April earned the distinction of being a record month for corporate issuance in the U.S. At $113.9 billion, corporate bond issuance was up 180% compared to last April, even as spreads remain wide by historical comparisons. The underlying reasoning is that the markets have absorbed much of the bad news and it has become clear that, despite the bottlenecks in the banking system, widespread bankruptcies are unlikely. Therefore, with some modicum of assurances that default risk is limited, U.S. corporations are taking the opportunity to get back into the market and issue debt. This is encouraging.

Against this backdrop, it is obvious the economy is not out of the woods yet, and although there are heartening signs of improvement in the credit market, it too, has much work still to do. The U.S. economic slowdown in this cycle is expected to be worse than that in 2001, and on this condition alone one can justify further Fed easing to address the situation. We continue to expect another 75 basis points of rate cuts based on our expectation that economic conditions will get much worse before staging a convincing and sustained turnaround.

Bank of Canada to Stay the Course

The Canadian economy has started to show signs of strain, due to the headwinds from the U.S. economy creating a substantial drag on Canadian exports. Canadian real GDP is, therefore, on track to disappoint the Bank of Canada’s forecast for a 1% pace of growth in the first quarter.

At their last meeting, the Bank of Canada delivered a 50 basis point rate cut and issued a fairly dovish statement detailing worries about “a deeper and more protracted slowdown in the U.S. economy” as well as “tightening credit conditions and softening sentiment.” Against this backdrop, the Bank left the door open for further rate cuts noting that the “timing of any further monetary stimulus will depend on the evolution of the global economy and domestic demand, and their impact on inflation in Canada.”

And if their new downwardly revised forecasts that were issued in the last Monetary Policy Report come to fruition, the scope for further rate cuts remains wide open. The Bank is expecting to see growth come in at 1.4% in 2008 (versus our forecast of 1.1%) and 2.4% in 2009 (versus our forecast of 1.8%), before picking up to 3.3% in 2010. This is a fairly substantial downward revision, but necessary given that the U.S. slowdown appears to be gaining some traction and has definite knock-on effects for Canada, given its trade exposure.

On the inflation front, the Bank sees core CPI inflation picking up a bit through the second half of 2008 and into 2009, although does not expect it to hit the 2.0% target again until the beginning of 2010. The combination of little upside for growth and few imminently concerning price pressures makes a good recipe for further rate cuts. And as a result we continue to expect two more 50 basis point rate cuts by the Bank of Canada, which ultimately leaves rates at a cyclical nadir of 2.0%.

Charmaine Buskas, Senior Economics Strategist
416-982-3297