TD The Weekly Bottom Line
July 8, 2005
Any recap of this week's major economic and financial events would be incomplete without a reference to the terrible and tragic bombings in London on Thursday, which sent financial markets on a wild ride. However, commenting on such an event is always difficult, as the factual analysis of the longer-term implications sits awkwardly beside the immediate suffering of those most directly affected. Nevertheless, given the considerable number of requests we have received for an assessment of the economic and financial market impact of the terrorist strike, we cannot avoid the issue.
In the final analysis, it is impossible to be precise about the magnitude of the economic fallout, since much of it will ultimately be determined by the psychological response of individuals, corporations and governments. In addition to the direct impact and the disruption to economic activity in the city of London, there could be some ripple effects globally. The reminder that the war against terrorism is far from over and that the battlefield is much wider than just Afghanistan and Iraq may dampen tourism to some degree. The insurance industry could also be adversely affected, particularly if there is increased speculation about additional terrorists attacks in the future. Governments in many countries may step up their expenditures on security, which could put further strain on already stretched fiscal balances. And, consumer spending and business investment might be dented if confidence were weakened significantly, although the experience following the terrorist attacks in the United States in 2001 and Madrid in 2004 suggests that this is unlikely.
Despite these risks, we expect the economic impact to be minimal. And, even though economic conditions in Europe are far from robust, the terrorist strike does not appear to pose a material threat to the recovery currently underway there. If the fallout is greater than anticipated, it could prompt an easing in monetary policy. But, we should note that there was already growing speculation that the Bank of England might be leaning towards a near-term rate cut before Thursday's events. And, following yesterday's monthly ECB meeting, ECB President Trichet said he did not expect the attack to have a significant economic impact, though he indicated that the bank stood ready to act swiftly if need be.
Similarly, the financial market consequences should be fleeting. Indeed, much of the negative market reaction was reversed quickly over the course of Thursday, as uncertainty and fear were quickly replaced by information about what had happened.
Nevertheless, it is instructive to observe how financial markets reacted to the bombings, as it may hold clues as to how they might to respond to similar events in the future. The knee-jerk reaction in foreign exchange markets was a flight from local currencies into safe haven alternatives, like the swiss franc. Traditionally, the U.S. dollar also acts as a safe haven, but as the leading nation in the war against terrorism, the greenback does not appear to be playing this role as much today. Globally, equities took the news badly, but bonds benefited as funds shifted towards the security of fixed income instruments, with the result that yields declined across the entire maturity spectrum in several countries. The price of crude oil fell on fears that the terrorist strike could dampen economic growth and lower demand for energy. However, the market reaction could have just as easily gone the other way if investors had worried instead about the possibility of future terrorist attacks in oil-exporting nations that might disrupt supply- but it should be stressed that there is already a sizeable geopolitical risk premium in the current price of crude. Gold rose on news of the attack, as it usually does during periods of instability and uncertainty, but the advance was slight, amid concerns about slower economic growth and the disinflationary forces this would bring. However, with the exception of the decline in the pound sterling, the vast majority of these trends reversed over the 24 hours following the bombings, as investors quickly came to terms with the tragedy. In past cases, financial markets experienced a similar recovery, but less rapidly.
U.S. economy chugging along nicely
Completely shifting gears, and returning to the more normal commentary on recent economic developments, there have been three key reports since the start of July all showing that the U.S. economy is in solid shape.
First, the ISM manufacturing index posted an increase in June, rising from 51.4 to 53.8, suggesting that manufacturing activity is rising at a faster pace. Moreover, with the exception of export orders, the forward-looking components of the index pointed to a further increase in the coming months.
Second, the ISM non-manufacturing index shot up to 62.2 in June from 58.5 in May, signaling rapid growth in the services sector, which from an employment perspective, constitutes more than 80 per cent of the economy.
Third, Friday's employment report confirmed moderate job growth in an environment of low unemployment. While non-farm payrolls in June increased by slightly less than expected, with a gain of 146,000, upward revisions to the pace of job creation in the prior two months, which added 44,000 positions, took the total advance in payrolls back up to near the consensus expectation. Meanwhile, the unemployment rate edged lower, dropping to a 45-month low of 5 per cent.
Putting these pieces together, the U.S. economy is on track to deliver a close to 3.5 per cent annualized gain in the second quarter. And, with the strength evident in the final month of the quarter, it looks like there will be a healthy kick off to the third quarter. This solid pace of growth and the growing evidence of diminishing economic slack suggest that the Fed will stick to its rate tightening cycle in the coming months, lifting the fed funds rate from the current 3.25 per cent to 4.00 per cent in early 2006.
Tight labour market conditions point to rate hikes in Canada, but not next week
In Canada, the major economic report of the week was Friday's labour force survey, which showed a moderate 14,200 increase in jobs in June. However, the less-than-stellar outturn followed a very strong 35,400 increase in May and the employment growth last month was dominated by full-time positions. Better yet, the unemployment rate edged down to 6.7 per cent, which matches a three-decade low set in mid-2000. Moreover, as my colleague Eric Lacelles noted in his commentary on the data release earlier this morning, the average duration of unemployment is lower today than in mid-2000 and there is a smaller pool of unutilized labour (i.e. involuntary part-time employment and discouraged workers).
So, there appears to be very little slack left in Canada's labour market, while most other measures of spare capacity are suggesting that the output gap is virtually closed. Add to that the evidence that the Canadian economy has largely adjusted to the prior appreciation in the Canadian dollar, as well as the prospects for Canadian economic growth to accelerate in the second half of 2005, and one is left with the impression that it is only a matter of time before the Bank of Canada begins to raise rates. However, the Bank has not provided any indication that it is prepared to hike rates at next Tuesday's fixed policy announcement date (FAD), and we don't expect the Bank to surprise markets. That said, if the economy continues to perform well over the following eight weeks, the central bank might be fully justified in raising rates at the September 7th FAD. As a result, we expect next Tuesday's communiqué to continue to stress that a rebalancing in monetary policy will be required over time, and we keenly await next Thursday's Monetary Policy Report Update for signals about the timing of future rate hikes.
Craig Alexander, VP & Deputy Chief Economist
BMO Weeekly OverviewJuly 8, 2005
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Indicators
The terrorist bomb attacks on London’s public transportation system on Thursday initially spurred safe-haven buying of US Treasuries. But, similar to the market’s reaction to the Madrid train bombings in March 2004, the impact was short-lived as investors concluded that the attacks would have little bearing on the global economy. By week’s end, US bond yields were higher than last week, largely in response to data that suggest a continued solid expansion of the US economy and a high probability of further Fed tightening.
Nonfarm payroll employment expanded 146,000 in June, less than anticipated, though gains in earlier months were adjusted higher. Job growth has averaged an above normal 181,000 in the last three months. The unemployment rate edged down to 5.0%, its lowest level since September 2001. The continued low level of new jobless claims, 319,000 in the week ended July 2, flags strong payrolls growth in July. The institute for Supply Management’s non-manufacturing index jumped to 62.2 in June from 58.5 in May, indicating a high level of activity.
The good US economic data suggest that the Fed will continue to raise rates, in sharp contrast with the chance of rate cuts in the UK and the Euro-zone. The pound hit 19-month lows versus the dollar amid concern that the terrorist attack in London would undermine an already soft UK economy. Meanwhile, the euro’s weakness was abetted by comments from an ECB Governing Council member who suggested that a member country could take its currency out of the European Monetary Union, albeit with considerable risk. This heightened concerns about the stability of the euro in the wake of the rejection of the European Union constitution by France and the Netherlands last month.
The Canadian dollar was one of the few currencies to rally against the strong greenback. The loonie’s strength reflected crude oil prices topping US$60 a barrel and positive economic data that suggest the Bank of Canada will resume tightening soon. While employment rose a moderate 14,200 in June, this followed hefty gains in earlier months. Underlying strength was evident in a 52,000 jump in the number of full-time positions in June. Construction jobs advanced 21,000, a sign of booming housing markets. The beleaguered manufacturing sector, hard hit by the high Canadian dollar, generated 6,000 jobs, suggesting the economic impact of the currency’s past appreciation is abating. A shrinking workforce lowered the unemployment rate a notch to 6.7%, a five-year low. The decline in joblessness is consistent with results from the central bank’s latest Business Outlook Survey that shows firms having increased difficulty satisfying demand, a possible harbinger of inflation pressure.
While the Bank of Canada is widely expected to hold official rates steady at next Tuesday’s fixed announcement date, its press statement (along with the Monetary Policy Report Update on Thursday) should set the stage for a rate increase in September. The comments will likely show diminished concern about the currency’s impact on growth and increased concern about the economy’s shrinking capacity to meet demand.
Sal Guatieri, Senior Economist, 416-867-5258
sal.guatieri@bmo.com
416-982-8064
