The blistering fever in financial markets appears to have broken. The exceptional measures that global monetary and financial authorities have put in place now seem to have some traction and have consequently begun to placate credit markets. Not only have credit spreads started to narrow, but volatility indices are lower, with the VIX index now hovering around the 60-mark, which is down significantly from a recent peak of 80. Not to put too fine a point on things, funding costs of course remain stubbornly high.

But this is still an uneasy calm. G10 central banks continue to slash rates in response to the weakened economic conditions and unresolved credit market dislocations. Not one G10 central bank has left rates unchanged at their latest meeting. Perhaps the most aggressive rate cut to date is by the Bank of England, which just cut its official benchmark rate by 150bps in a single go to 3.00%. The magnitude of that cut speaks to the scope of the problems in the U.K. Most other central banks have opted for a 50 basis point rate cut, which in any other circumstances would be aggressive indeed. However, in the current environment, it seems that 50 is the new 25 in central banking.

The Federal Reserve has continued to flood the market with liquidity and added even more stimulus via a lower fed funds rate. Now at 1.00%, the Fed has once again returned the fed funds rate to the historical low that occurred in 2003-2004 which at the time created a lush breeding ground for the massive credit expansion that the U.S. and global economy is paying for today.

At the October 29 decision, the FOMC kept the door open for further rate cuts, but made no promises. The communiqué noted that “downside risks remain” and that the committee “will monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability.” That is a fairly transparent nod towards a strong case for further cutting. The next question is what they do next. The economic data and how the credit market takes to the new backstops and regulatory environment will determine how quickly the patient gets out of the intensive care unit.

Grim, Grimmer, Grimace

A grim third quarter GDP report in the U.S. set up a very weak backdrop for what is to come. U.S. GDP contracted by 0.3% Q/Q annualized in the third quarter, which, while better then expected, was certainly not good in absolute terms.

Consumption was the biggest drag on growth, as it fell by 3.1% Q/Q annualized and shaved off 2.25 percentage points from GDP. These data set up a very weak backdrop going forward, as headwinds for the consumer have only continued to gather force. All the channels that support consumption have broken down. The housing market has not found a bottom which has closed the doors on the consumer’s primary cash machine—mortgage equity withdrawal. The latest statistics show that on a year ago basis, active mortgage equity withdrawal was down 69% in the second quarter, and house prices have deteriorated further since then.

Moreover, credit standards for consumers are as tight as a drum. The Fed’s Senior Loan Officer Survey showed that 58.8% of respondents have tightened lending standards for credit cards. So even with good FICO scores, consumers are finding it increasingly difficult to access loans. This is not good for an economy that derives about 70% of its growth from consumption.

Third, income growth has also retrenched alongside the job market. The U.S. economy has lost 1.18 million jobs since January 2008 which obviously has taken income growth along with it. The unemployment rate shot up to 6.5% in October, which exceeds the peak of the last downturn in 2003, but is still a couple percentage points away from the real nasty peak of 7.8% in 1992. Moreover, such bleak prospects in the job market have left the consumer with little, if any hope. Consumer confidence is at its lowest point on record.

Fourth, consumers have seen their portfolio wealth evaporate as global equity markets have entered a bear market. Very roughly, there has been about a $2 trillion loss in household wealth due to the 27% decline in the S&P 500 since the end of the second quarter. And in an economy where the savings rate has been notoriously low, that means there is no cushion for a rainy day.

Zooming in on the Zero Bound?

In our view, U.S. rates will go lower still. The two prevailing concerns—the economy and the credit market—are still undergoing massive transitions. Admittedly, there have been tentative signs of improvement in the credit market, but the market is nowhere near full and robust health. As such, we are looking for the Fed to cut rates another 50bps, in two consecutive 25 bps instalments, leaving the fed funds rate at 0.50%. Of course, the Fed could deliver a 50bps cut all at once instead. But in this fluid environment, all options are on the table and one must not neglect the possibility that the Fed could have to do more than what we have priced in, which raises a number of questions about the implications of a zero percent fed funds rate. Still, we favour the odds of a 50bps floor in the fed funds rate at present.

Although this would normally translate into a steeper yield curve, diminishing inflation fears could simply send bond yields lower right across the curve.

Canada’s immunity to the nasty global virus is waning. The Bank of Canada was part of the 50 bps rate cut on October 8 rate coordinated by the G7. The statement revealed that “the recent intensification of the financial crisis has augmented the downside risks to growth and thus has diminished further the upside risks to price stability.” The subsequent 25bps rate cut that the Bank of Canada delivered on October 21 topped up the stimulus pipeline.

The Bank of Canada’s revised forecasts are a good deal gloomier than in July. GDP growth is expected to be a slight 0.6% in 2008 and 2009 and it is not expected to return to potential until 2010. TD’s view is even weaker than that and there is a non-trivial downside risk to even our pessimistic outlook.

And thus far, the economic data has largely conformed to expectations, though there have been a few surprises along the way. On the upside, the labour market has managed to retain some resilience, and in October, 9.5K jobs were added in Canada and the unemployment rate edged higher to 6.2% as new workers entered the labour force. But signals from the manufacturing sector suggest exports will once again be Canada’s Achilles heel in the downturn. Commodity prices are off their peaks as global demand wanes, and that is bad news for the commodity exporters. And while usually a weaker Canadian dollar would be helpful for manufacturers, the implosion of demand for manufactured goods bodes poorly for durable goods exports.

Aside from the downturn, though, Canada’s banking system remains one of the best in the world, according to a recent study by the World Economic Outlook and so the deterioration in credit markets should remain less severe in Canada than elsewhere.

Nevertheless, the Bank of Canada, in our view, is likely to cut rates another 50bps at the December meeting. This will leave the Bank’s overnight rate at 1.75%, which is a historical low. As with the U.S., the bond market implication is that we could see lower yields across the curve, while the Canadian dollar has further room to decline.

Charmaine Buskas
Senior Economics Strategist
416-982-3297