Over the course of recent weeks, the unravelling in U.S. and even global financial markets has been truly astonishing. Volatility expectations, as measured by the VIX index, reached five year highs, suggesting a profound risk aversion. At the same time, high borrowing costs have filtered through to the real economy and threaten global growth. Since our last Quarterly Economic Forecast publication on September 25, the economic data has only deteriorated, which raises the downside risks to near term growth prospects And while there have been numerous and creative programs put in place to ameliorate the problems in the credit market, they are but small steps in the right direction. Nonetheless, it appears as though the Fed and the U.S. Treasury, as well as other global monetary authorities are willing to move heaven and earth to stem the crisis.

Emergency Times Call for Emergency Measures

Despite the flood of liquidity that the Fed and other central banks have provided the markets recently, financial market conditions continued to deteriorate through the early part of October. LIBOR rates continued to push higher, indicating that the market was not responding to the palliatives delivered by the monetary authorities.

As such, the need to pull out the big guns became increasingly apparent as markets continued to tank. On October 8, a coordinated 50 basis point rate cut was delivered by the Federal Reserve, ECB, Bank of Canada, Bank of England, Swiss National Bank and Riksbank.

This move changes the outlook rather profoundly. It is an admission that the current turmoil cannot be solved solely through liquidity measures. It has now become apparent that the lack of liquidity has played a serious role on the real economy. Therefore, we are now looking for rate cuts from the G7, with many central banks returning to the historical lows seen in the last major easing cycle.

Draino vs. Bullets

But until the coordinated global central bank cuts, the problems were widely perceived as primarily having to do with liquidity. This perception saw a number of tools and programs developed with the intention of unclogging the credit markets. Adding to the existing alphabet soup of facilities put in place recently is the $700 billion Troubled Asset Relief Program (TARP). This provides the Treasury with exceptional powers to purchase mortgage backed securities whose value had dropped sharply. Though massive in scope, it is not a panacea for all that ails the credit markets.

Other programs put in place included the Fed paying interest on reserves, both required and excess, thereby allowing the central bank to expand its balance sheet sufficiently to continue to address liquidity concerns.

And perhaps one of the most important steps is the program to allow the Fed to purchase commercial paper from eligible issuers (both financial and non-financial). It essentially means that the Fed will be able to lend directly to companies via its special investment vehicle. In short, it provides some support to Main Street at a time when Wall Street has been hogging the spotlight. Lastly, there has been some talk within the financial markets that the Fed might even consider guaranteeing interbank lending, which would further assist in solving the problems in the short term funding market.

Fed Adds Easing to its Arsenal

The case for further easing by the Federal Reserve has been building for quite some time. Recent losses in non farm payrolls in September bring year-to-date job losses to 760K. Moreover, there are growing indications that the legs of support that were previously holding up the economy are starting the roll over. Recent ISM manufacturing data showed a precipitous drop to 43.5 in September. In the context of a slowing U.S. economy, and tumbling commodity prices, inflation risk appears to have receded quite substantially. And even while headline and core inflation currently remains a little beyond the Fed’s comfort zone, the Fed has made it clear that inflation concern has been relegated to the back burner for now.

Also arguing for lower rates is the fact that recent Fed rhetoric has turned decidedly dovish. Even the noted hawks on the FOMC have sounded somewhat dovish, if only by omission of their usual hawkish bent. Most recently, Chairman Bernanke stated that “the combination of the incoming data and recent financial developments suggests that the outlook for economic growth has worsened and that the downside risks to growth have increased. At the same time, the outlook for inflation has improved somewhat, though it remains uncertain. In light of these developments, the Federal Reserve will need to consider whether the current stance of policy remains appropriate.” That sounds like a rate cut just waiting to happen.

Therefore, we are now of the view that the Fed will cut rates by 50 basis points at the October 29 decision, in an attempt to further shore up market confidence, following the coordinated rate cut of October 8. This will put the fed funds rate at 1.00%. The hope is that this rate cut will work its way though the market and have some impact on the real side of the economy.

The implications for the U.S. yield curve suggest further steepening as yields at the short end fall through the balance of the year. In this regard, lower rates are good news for the banking system, which relies on a steep yield curve to make money, as it borrows short and lends long.

BoC Sets Out on an Easing Path

Amid the unrest in global financial markets, and the very real possibility for spillover to Canadian markets, the Bank of Canada has little choice but to join the global monetary easing. We are now expecting the Bank to lower rates by 50 basis points at the October 21 meeting, which will leave the overnight rate at 2.00%.

But the case for an ease based purely on macro fundamentals is a little more mixed in Canada than for the U.S. Economic growth in Canada, at least for the third quarter appears steady, thanks to an impressive 0.7% M/M gain in July GDP. Moreover, the Canadian labour market has not deteriorated significantly.

At the same time, CPI has run a little hotter than expected, with core CPI rising to 1.7% Y/Y in August. And while a cooling economy will limit further upside in headline inflation, there are still some secondary factors that need to work through the core CPI numbers.

But, the decision might not be a particularly tough one for the Bank of Canada. Global financial conditions clearly trump domestic macro economic concerns at the moment, and while Governor Carney has been quick to remind markets that Canadian banks are in a better position than US banks, he cannot turn a blind eye to the need to maintain not only liquidity but also to keep the real economy rolling along.

Therefore, the Canadian curve is expected to steepen further, as rates at the short end of the curve head lower. The steepening trend does not have as far to go as the U.S., however, as we expect the overnight rate to rest at 2.00% in the very near future.

The G7 Will Quickly Move into Action

The coordinated rate cut set the stage for additional easing by the rest of the G7. In the U.K., the government, financial services authority and the central bank has put in place a number of powerful measures to stabilize the financial system. These measures, including a recent provision of £50 billion to recapitalize the banking system, in conjunction with the 50 basis point emergency rate cut on October 8, suggest the BoE is being vigilant about the credit crisis. We are looking for another 150 basis points of easing from the current official rate of 4.50%, which will go far to diffuse the crisis.

But while we expect aggressive easing by the ECB, they have, in the past proven intractable on their inflation bias, and therefore the risks lie towards slightly fewer cuts in the near term and larger cuts in the first half of 2009. The best reference period for this style of easing is 2001, and during that time, they cut 150 basis points in seven months and in 2002-2003, they cut by 125 basis points over seven months.  As such, the ECB is not of the “cut now, ask questions later” school, which is what underpins our view that while the ECB is most certainly on a rate cutting path, they have the potential to be least aggressive about it.

Getting Through the Morass

The rate cuts are yet another step in the right direction, particularly for the U.S. and the U.K, which are the two countries most in need of further palliatives. This is a very unsteady environment, with quickly shifting parts. The call for further, and in some cases, aggressive rate cuts is warranted at his time, as policymakers pull out all the stops and do whatever it takes to get the global economy and credit markets functioning again.

By early 2010, we expect some unwinding of this easing to occur. Global monetary authorities, and especially the Federal Reserve, will surely want to show that they have learned the hard lessons from the 2003 easing, knowing the consequences of leaving rates too low for too long.

Charmaine Buskas
Senior Economics Strategist
416-982-3297