July 29, 2005
HIGHLIGHTS
- U.S. growth remains solid
- with housing still a strong force
- Canadian economy surprises, but caution remains
The dog days of summer left markets largely treading on water for much of this week. However, a barrage of high-tier data late in the week not only provided some good insights into how the North American economy faired in the second quarter but also where its heading over the near term.
In the U.S., there were no big surprises as second quarter real GDP grew by an annualized 3.4 per cent thanks to solid contributions from consumers and net exports. As expected, the only major drag on growth in the second quarter came from investment in inventories, which contracted after very strong growth since the end of 2003. However, the inventory adjustment sets the pace for a strong second half to 2005, as businesses will need to boost production in order to meet demand. To that end, real GDP is still expected to grow at around its potential pace over the second half of this year even though it has slowed from loftier rates of growth in previous quarters.
Isn’t the yield curve signaling something else?
Given the U.S. yield curve’s almost flawless record of predicting coming recessions, the continued flattening of the slope of the Treasury curve (measured as the difference between the 10-year rate and the three-month rate) has raised some concerns about a decisive weakening in U.S. economic growth, if not a recession, in the not-too-distant future. Indeed, historically the slope of the Treasury yield curve has turned negative, at least briefly, two to six quarters before every U.S. recession since 1964. It has given only one false signal, in 1966, when an economic slowdown—but not an official recession—followed the inversion of the yield curve.
But the recent flattening in the yield curve is not likely auguring a protracted slowdown of the U.S. economy for at least two reasons. First, the meagre positive slope on the yield curve reflects the failure of bond yields to rise in response to Fed rate hikes. However, this does not reflect expectations of an economic downturn, but rather an array of supply and demand factors – such as strong corporate saving that has impacted fixed income markets. Second, it must be stressed that the economy does not head into recession simply because the yield curve inverts. For example, the U.K. has recently experienced a negatively sloped yield curve without an economic downturn. In essence, inversions do not trigger events that would ultimately drag the economy into recession.
U.S. housing market still a big source of support
Thus, we still expect solid economic growth in the coming quarters and anticipate that the Fed will keep lifting rates into next year. In fact, still low long-term yields and hence mortgage rates will continue to drive the U.S. economy as it did in the second quarter through the housing market. Indeed, investment in residential structures was up 11 per cent in the second quarter.
Meanwhile, recent data this week showed more records in U.S. new and existing home sales with U.S. house price appreciation, at least for existing homes (which makes up 83 per cent of the sales market) up by an unprecedented 28 per cent so far this year. These substantial gains in home prices have helped to support economic growth through another channel called the “wealth effect.” That is, recent financial innovations have given U.S. consumers the ability to transform their unrealized home price gains into cash to spend on other goods or to pay down other forms of debt. Certainly, relying on one’s home as a source of cash could have negative long-term implications, especially in the context of a growing housing bubble in the United States. But as long as mortgage rates remain low, this channel of support should also remain in place for the U.S. economy over the second half of this year. Still, the longer housing persists in driving the economy this year, the bigger the drag on growth it will be next year as this wealth effect reverses.
Canadian economy on track but manufacturing still a concern
On this side of the border, May’s highly anticipated monthly real GDP report revealed that the Canadian economy grew by 0.3 per cent during the month, slightly more than markets had expected. Growth in May was largely fuelled by a 14 per cent jump in oil exploration, as unfavourable weather in April delayed drilling and rigging activities in Canada’s booming energy sector.
But somewhat surprisingly, the manufacturing sector also managed to positively contribute to economic growth in May as output in that sector increased by 0.2 per cent. Of course that’s good news, as it has mostly been the highly international trade dependent goods side of the economy and manufacturing in particular, that has been weighing down Canada’s economy since the loonie began its ascent in 2003.
However, the bad news is that while it looks like the manufacturing sector may finally be findings its legs, Friday’s concurrent release of Statistics Canada’s third quarter Business Conditions survey suggests a weakening of sentiment in that sector. Specifically, the balance of opinion for manufacturing production stood at –3, which was not only a 3 point decrease from the April balance, but is also the first negative balance for production prospects since April 2003 (-8). Furthermore, manufacturers reported growing concerns with the state of orders and inventories, while readings on employment were far from optimistic.
September rate hike still a good prospect
Is the weaker than expected Business Conditions survey enough to keep the Bank of Canada on the sidelines come September? Probably not for two reasons. First, one must concede that this survey is not the most reliable of indicators. Moreover, there are some good fundamental reasons to believe that Canadian manufacturers may not stumble in the months ahead. In particular, the probability of Canadian factories receiving an increase in new orders is now greater given the recent reductions in U.S. inventories.
Second, the Bank of Canada’s plans on setting monetary policy will be shaped, as it always has, on the hard data. And on that score, May’s larger than expected gain in real GDP puts the annualized second quarter rate of advance right near the Bank of Canada’s own estimate of 2.3 per cent. With the economy already operating close to its capacity limits, that should be enough to get the Bank hiking in September. However, the pace of subsequent hikes could be fairly mild if perceived trouble in the manufacturing sector does in fact materialize.
Carl Gomez, Economist
416-982-2557
BMO Weekly report
July 29, 2005
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Indicators
The US data this week presented the best of both worlds with evidence that the US economy continues to grow at a solid pace, while inflation pressures remain muted. US GDP rose an annualized 3.4% in Q2, led by a 5.8% gain in final sales. An unexpected drawdown in inventories provided a key offset but suggests a possible rebound and a source of growth in Q3. Residential and machinery and equipment investment could also support growth as the US housing market remains strong with both existing and new home sales hitting record highs in June. Factory orders of durable goods rose a stronger-than-expected 1.4% in June building on a 6.4% surge in May. Non-defense capital goods orders, excluding aircraft (a proxy for future investment) rose 3.8% in June after a 0.6% decline in May.
This week’s price data showed inflation pressures easing with the core PCE deflator rising an annualized 1.8% in Q2 down from 2.4% in Q1, while the employment cost index eased to 3.2% year-over-year in Q2 from 3.5% in Q1 and 3.9% a year ago. This represents the lowest rate since 1999 Q3.
The data were consistent with the Fed’s view on the economy as outlined in its Beige Book, which suggested that expansion continued, while inflation remained steady despite the rise in oil prices. In this environment, the Fed is expected to continue to raise interest rates, though benign cost pressures will keep the pace gradual. We expect 25-basis point increases at both of the next two FOMC meetings.
In response to the strong economic data, the bond market continued to deteriorate, though the rise in yields was tempered by the benign inflation data.
The US dollar received some support from the data, though developments overseas were significant. Following its 2.1% revaluation of the yuan last week, the Chinese central bank played down the possibility of further appreciation. This supported the US dollar, particularly against the Japanese yen, which is being treated as a proxy for the Chinese currency.
The US dollar’s rise against the Canadian dollar was only moderately tempered by a stronger-than-expected May GDP report. The 0.3% increase reflected strength evident in the natural resource sector as well as signs of recovery in some exchange rate-sensitive areas such as tourism and trade. However, a deterioration in business confidence to -3 in July from 0 in April prevented the loonie from strengthening significantly on the GDP data. We still feel there is sufficient evidence of waning restraint from the high value of the loonie that the Bank of Canada will raise rates in September.
After several weeks under pressure, the British pound recovered, rising against the greenback on better-than-expected economic data, including an improvement in consumer confidence over the period of the first terrorist attack in London.
Laurie Peterson, Senior Economist, 416-867-4793
laurie.peterson@bmo.com
