Risk that interest rates may be hiked too soon

TORONTO, Jan. 14 /CNW/ - While the benefits of record low interest rates and huge stimulus packages will drive solid growth in the Canadian and global economies during the first half of 2010, the economy risks returning to sluggish growth in the second half of the year and into 2011, finds a new report from CIBC World Markets Inc.

The report notes that the actions of central bankers and finance ministers, combined with a rapid recovery in the financial markets, points to a stronger economic performance in Canada and the U.S. in the first half of 2010. But growth could be restrained come the second half of the year as governments turn off the stimulus taps and U.S. consumers continue to deleverage.

"We've lifted our first-half growth forecasts materially for both the U.S. and Canada to the 3 1/2 per cent range," says Chief Economist Avery Shenfeld in the bank's latest Economic Forecast report. "Heroic rescue efforts have clearly paid off. While those still in the ranks of the unemployed might not see it that way, record low interest rates and huge fiscal stimulus around the globe brought both economies and financial markets back from the brink.

"That has the North American economy entering 2010 like a lion. But recoveries are rarely a smooth road, and this one faces a huge speed bump beyond the next couple of quarters. The fading benefits of these measures, and the lingering hangovers from the past two-years' turmoil, will see us exit like a lamb."

Mr. Shenfeld believes that the drivers of growth in early 2010, such as stimulus spending, inventory restocking and, in Canada at least, a short-lived boost in housing wealth, are all temporary and will vanish by the end of the year. In the U.S., he expects there to be a fiscal policy shift from stimulus to a drag in the second half, just as the quarterly lift from inventory restocking abates. While he expects job creation to improve, he also expects consumers to continue to increase their savings. At the same time he sees U.S. credit to households and small business remaining tight, especially if regulators increase capital requirements for banks or trim leverage ratios.

"All of that could see U.S. GDP advance at 2.8 per cent for the year as a whole, but buried within that will be a mere one per cent second half pace, and the growing pressure for fiscal restraint has us cutting our 2011 forecast by a full percentage point to 2.4 per cent," he adds.

Overseas he sees the potential for tighter monetary policy in Europe to avoid inflation which would prolong the recession in the region's weaker economies. He notes that China has already started to tighten as it balances its need for growth against new concerns over inflation risks and its property market overheating.

"The timing of the fiscal and inventory on-off switch for Canada isn't as well defined, nor the pressure for budgetary belt tightening quite as immediate," notes Mr. Shenfeld. "But if the past two years taught us anything, it's that our small open economy can't chart its own course."

He believes that Canadian manufacturing and resources will benefit from the upswing in global growth and inventory rebuilding in the first half of 2010 but will subsequently feel the combined pinch of decelerating foreign demand and an overvalued Canadian dollar.

While he expects the loonie will lose some ground to the American dollar in the first half of the year as solid U.S. growth pumps life back into the greenback, Mr. Shenfeld is concerned that the Bank of Canada might jump the gun and raise interest rates before the U.S. Federal Reserve Board. This would push the Canadian dollar higher and put further pressure on GDP output.

The report notes that the Bank of Canada has historically tightened its monetary policy ahead of the U.S. following continent-wide economic recessions. "After each of the last two major North American slowdowns, the Bank of Canada hiked rates ahead of the Fed, only to have to reverse course when the economy disappointed," says Mr. Shenfeld. "Our upgraded first-half growth forecast will likely see something similar, with (Bank of Canada Governor Mark) Carney hiking 75 bps in the third quarter, only to go back on hold for at least a quarter facing a combination of Canadian dollar gains and weaker growth signals."

He notes that in comparison, Washington didn't see any rate hikes until three years after the prior two recessions. He doesn't expect that Fed Chairman Ben Bernanke will want to maintain near-zero rates for that long this time around but does not expect the funds rate to budge until sometime in 2011.

"But even the first dose of tightening should spark a swing to a bear flattening trend in fixed income markets," finds Mr. Shenfeld. "Inflation won't be the problem for the long end. Rather, it's supply. U.S. deficits will remain in the stratosphere. It's one thing for America to finance huge deficits when nobody else is borrowing, and when the Fed is buying the lion's share of the net issuance, quite another when the private sector starts to borrow again, and the Fed stands aside."

The report notes that China might also slow its Treasuries buying if it starts allowing a modest yuan appreciation later this year. Canada's federal/provincial shortfall will still top six per cent of GDP in 2009/10, and net provincial bond supply will increase next year given the need to fund capital spending programs. With huge deficits also needing funding in Europe, global bond yields will come under pressure. While outperforming Treasuries for 2010 as a whole, this environment should see 10-year yields reach nearly four per cent in Canada in a flattening sell-off ahead of the first rate hikes, before easing off towards year end.

"The stock market could get a decent year's return in the first six months, when year-on-year earnings comparisons will be against the depths of the recession, macro growth rates will be fairly healthy, and resource prices could still be climbing," he adds. "While comparable fixed income yields won't be as low as they are today, the gap between TSX dividend yields and those on bonds is very narrow, and expectations for dividend growth in 2010 and beyond should see yield-hungry investors supporting another leg higher for the TSX."

The complete CIBC World Markets report is available at: http://research.cibcwm.com/economic_public/download/fjan10.pdf.

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