Canada Monetary Policy Monetary

Since the Bank of Canada decided to keep rates on hold at 3% at the July 15 Fixed Announcement Date, there has been a rather significant shift not only in the economic data, but also in how the market is pricing in future rate moves by the Bank. The accompanying statement to the July 15 meeting indicated a neutral bias, saying that "the current level of the target for the overnight rate remains appropriate" and risks were balanced. Since then, however, a raft of soft economic data has prompted the market to price in a rate cut.

The economy is unambiguously weak and the slowing economic activity has had some impact on inflation. But in our view, this does not suggests a slam dunk case for a rate cut. In fact, it seems as though the Bank is comfortable with the overnight rate at 3%. Recent comments by Deputy Governor Longworth reinforced a neutral bias when he spoke on August 26. There remains some uncertainly with respect to where inflation will go in the near term and there remain subtle points of strength in the economy and inflation. There is some degree of credibility risk associated with making a move when the market is mostly pricing no change in the overnight rate. As such, by keeping rates on hold on September 3, the Bank gives itself a bit of breathing room to see how conditions unfold and avoid the market's ire. Thus, we maintain the view that the Bank of Canada will remain on the sidelines on September 3, leaving the overnight rate at 3%.

A slowing Canadian economy means the output gap will move further into excess supply. In turn, that will take some of the pressure off inflation, and indeed, there has already been some evidence of that.

The recent inflation data has certainly come as a welcome surprise. In July, core CPI was a touch soft, with a 0.1% SA M/M gain, leaving the annual rate at 1.5%. Headline CPI remained somewhat elevated with a 0.35% SA M/M gain. On an annual basis, headline CPI rose to 3.4%, which is the highest of the cycle, as food and energy prices continue to figure in to the calculation in a big way.

The breakdown in the inflation data suggests that the slowdown in the Canadian economy is starting to have some impact on prices, and will continue to do so as the economy moderates further. Prices for goods were up only 0.4% M/M in July, after averaging 1.05% M/M in the prior quarter. Moreover, services inflation seems to be moderating as well, with only a 0.25% M/M gain in service prices in July. But both are still elevated when compared to a year ago. Goods inflation rose to 3.2% Y/Y in July, and services remained relatively elevated at 3.5% Y/Y. But continued softening in economic activity should put a lid on goods prices going forward. In turn, that should prevent any significant gains in core inflation.

On the labour market front, any wage pressures that were previously present, have now abated, as the labour market continues to lose steam. Canada has lost 60.2K jobs in June and July and that has taken much of the froth off wage pressures. In this cycle, average hourly wages peaked at 4.9% Y/Y in January, and by July, they were 3.8% Y/Y. As the economy cools further, so too will job growth and workers will ultimately have less bargaining power. In turn, that will further limit wage pressures.

Uncertainty Lingers

But while the outlook for inflation going forward looks tame, there is still some uncertainty.

First, the alternative inflation indicators that the Bank of Canada cares about do not look as tame as the reported inflation data and are trending around the 2-3% range. Second, the Bank has noted some concern about pass through from prior commodity price increases through to headline inflation. Third, energy prices have fallen quite dramatically through August, which suggests that July might be the last time that they factor in to headline inflation so heavily. In July, it was not gasoline prices that drove the energy component of headline inflation, but rather natural gas. The former only rose 1.2% M/M, while the latter rose a massive 8.8% M/M. Gasoline prices have dropped about 5% since July, as demand destruction heats up, which suggests some moderation in the energy price component in upcoming months. Still, energy prices are not governed solely by logic alone, and energy prices could very well begin to rise again, especially if the hurricane season yields some bad storms. This is a risk the Bank must watch for. Fourth, the Canadian dollar has lost just over 4% since July 15, and with the bull market in commodities now largely in the rear view mirror, we expect the Canadian dollar to ease further against the U.S. dollar. This creates an uncertain interplay between the two drivers, and likely leaves the Bank of Canada loathe to act until there is a clear direction in all inflation trends.

Growth Story Winds Down

Second quarter GDP was not as bad as feared, but certainly lower than expected and it missed the Bank's forecast by a sizable margin. GDP posted a 0.3% Q/Q, annualized gain, and first quarter GDP figures were revised down significantly to -0.8% Q/Q, annualized (compared to a decline of 0.3%). It is clear growth in Canada has embarked on a softening trend. Fortunately, it has not entered a technical recession, but softness is still prevalent.

Week in Review

The Japanese yen was the biggest winner last week as seen with yen crosses topping the top movers chart. While most of the moves were done on Friday following the 170pts fall in Dow, such declines did have the significance of indicating that yen is regathering strength for medium term rally. The pair has been steady due to dollar's strength but upside momentum was seen diminishing after making at high at 110.66. Outlook is mixed in the pair for the moment with possibility of a reversal. And if the last defense is taken down and USD/JPY does reverse, further massive buying could be seen in the yen which pushes other yen crosses further lower. This will probably be the main focus in September.

Dollar enjoyed a strong broad based rally in August, in particular against Aussie and Sterling. Though, the greenback consolidated against most currencies last week together with choppy consolidation in oil and gold. Dollar index was basically bounded in tight range of 76.55 and 77.61 last week. In particular, oil was lifted by the worry of Hurricane Gustav, however, such impact could temporary. Some more consolidate may be seen in the greenback in near term, with risk of pulling back further against euro and Aussie, but more medium term strength is still in favor after the hurricane passes.

Euro did have the biggest monthly fall since 1999 in Aug. Though, the common currency was the relatively steady currency against dollar and in general last week. While data from Eurozone were generally weak, the common currency was supported by comments from ECB Weber that the discussion of a rate cut is premature. Such comment could be echoed by ECB Trichet this week and may give the Euro a boost but after all, the case of a medium term reversal in EUR/USD will likely continue to develop, in particular if Euro continues to be dragged down in EUR/JPY cross.

Sterling remained the weakest one among the majors along with the Aussie. GBP/USD has already taken out important support at 1.83 level which added more credence to the case that multi year long term up trend that started in 2001 has reversed. GBP/JPY also showed further sign that medium term down trend from 251.09 is ready to resume. More importantly, the pound was starting to display resumed weakness in EUR/GBP and GBP/CHF crosses, with EUR/GBP set to resume medium term up trend while GBP/CHF could also be resuming medium term down trend. Such weakness will likely continue and even accelerate in September.
Looking ahead, the week will start slightly with market holiday in US on Monday. However, volatility will continue to increase with a number of key events scheduled. Four central banks will meet this week including RBA, BoC, ECB and BoE. In addition, ISM manufacturing, Services as well as Non-Farm payroll from US will be released. Main focus will be on extension of strength in yen, weakness in Sterling, with uncertainty on whether dollar will resume rally.

FOMC minutes didn't revealed much new information. Members generally agree that the economy will remain weak and are generally concerned the possibility that core inflation will moderate as growth slows. The next move from Fed is still likely a hike but the opinion on the timing is rather divided.

Housing data were generally better than expected. Existing home sales rebounded strongly by 3.1% to 5.0m annualized rate in Jul, above expectation of 4.9M. New home sales climbed 2.4% from downwardly revised 0.503m to 0.515m annualized rate in Jul. S&P/CS Composite-20 HPI showed -15.9% fall in Jun, above expectation of -16.2%.

Headline durables jumped 1.3% in Jul versus consensus of 0%. This is the third consecutive months of expansion. Ex-transport orders rose 0.7% versus consensus of -0.5% fall. Ex-defense orders also rose 2.8% versus expectation of 0.2%. The data argued that business spending and confidence are continuing to recover in the US. Conference board consumer confidence improved more than expected to 56.9 in Aug. Jobless claims dropped slightly but remains elevated at 425k.

Preliminary Q2 GDP annualized growth rate was revised higher from 1.9% to 3.3% versus expectation of 2.7%. Record exports and the smallest trade deficit in eight years were the biggest driver in the upward revision. Personal consumption was revised up to 1.7% versus expectation of 1.6%.

Person income dropped more than expected by -0.7% in Jul, spending rose 0.2%. Headline PCE jumped to 4.5% yoy, highest in 17 years while core PCE rose 2.4%. Chicago PMI improved to 57.9 in Aug, much stronger than expectation of 50.0. Finalized reading of Aug U of Michigan consumer sentiment came in better than expected at 63.0.

Data from Eurozone were mixed. Germany IFO Business climate index dropped sharply from 97.5 to 94.8 in Aug, hitting a three year low. Expectation index also dropped sharply from 90 to 87.0. GFK consumer confidence dropped more than expected to 1.5. Eurozone HICP flash moderated more than expected to 3.8% yoy in Aug. However, M3 money supply slowed less than expected to 9.3% yoy in Jul. Unemployment rate was unchanged at 7.3% in Jul.

UK data were generally disappointing. Nationwide house prices fell for the ninth month by -1.9% mom in Aug, dragging yoy rate to -10.5%. CBI distributive trades dropped to -46 in Aug. Though, GFK consumer confidence unexpectedly improved from -39 to -36 in Aug.

Swiss KOF dropped more than expected to 0.68.

Japanese unemployment rate dropped from 4.1% to 4.0% in Jul. Retail sales jumped more than expected by 1.9%. Housing starts rise further to 19% yoy. Industrial production unexpected posted 0.9% mom gain in Jul, with yoy rate at 2.0%. Manufacturing PMI dropped less than expected to 46.9. More importantly, national CPI climbed to decades high of 2.3% yoy in Jul.

Canadian June GDP rose 0.1% mom. More importantly, Q2 GDP was weaker than expected by rising 0.3% only, below expectation of 0.7%. PPI rose 0.4% mom, 6.8% yoy in Jul.

The Week Ahead

The week could start slowly with market holiday in US on Monday. But volatility will continue to increase with a number of key events scheduled. In particular, focus will be on whether USD/JPY will signal a short term reversal and whether further broad based strength in the Japanese yen.

Four central banks will meet this week and RBA will take the lead in announcing rate decision on Tuesday. Markets generally expect a 25bps rate cut to 7.00% and focus will be on whether the bank will signal further rate cuts in the near future. Speculation is that RBA will cut by as much as a whole 1% by early 2009 and the Aussie will likely be further sold off if the RBA statement affirms such speculation.

BoC will announce rate decision on Wednesday and markets widely expect the bank to be on hold at 3.00%. USD/CAD's correction should have completed at 1.0410 last week and is set to extend the medium term rise from 0.9056. A dovish statement from the bank will probably be the trigger in fueling strong rally in USD/CAD this week.

ECB is widely expected to be on hold at 4.25% on Thursday. Near term outlook in EUR/USD is rather mixed with sign of a short term bottom, but without confirmation. Weber's the comment that discussion of rate cut is premature did provide some support to the common currency. Such comments will likely be echoed by Trichet in the press conference after the ECB meeting and will probably provide some lift to the common currency. However, just like last month, focus could quickly shift back to the slowdown in Eurozone and downside risks to growth and such rebound could proof to be short lived.

BoE is widely expected to be on hold at 5.00% and the meeting will likely be a non-event.

From US, ISM manufacturing index will start the calendar on Tuesday, Beige Book on Wednesday, ISM manufacturing index on Thursday and Non-Farm payroll on Friday. Other important data to watch include Eurozone August manufacturing and services PMI, Q2 GDP, Jul retail sales; UK Aug manufacturing and services PMI, nationwide consumer confidence; Swiss Aug CPI, Q2 GDP; Australia Q2 GDP; Canadian Aug job report and Ivey PMI.