Canada: The List of Strong Domestic Indicators is Getting Longer

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1 May 6, : The List of Strong Domestic Indicators is Getting Longer Europe: Investors Underestimate The Stabilization Plan LBS Economic Research Carlos Leitao Chief Economist leitaoc@lb-securities.ca Sébastien Lavoie Assistant Chief Economist lavoies@lb-securities.ca Marie-Claude Guillotte Economist guillottemc@lb-securities.ca Emir Coskun coskune@lb-securities.ca The Bank of : Time to Leave the "ZIRP Club" Subscription: Martine Bérubé berubem@lb-securities.ca Stéphanie Fortin fortins@lb-securities.ca

2 Sébastien Lavoie Assistant Chief Economist The Monitor 6 5 : The list of Strong Domestic Indicators is Getting Longer Robust economic data continue to make headlines in. Total and core inflation both rose by a brisk.3 m/m in April, bringing the year-over-year tally close to the Bank of s target. The eight main CPI components gained ground, a rare occurrence, demonstrating the broad based nature of price increases. In addition, both the volume and value of retail sales rose substantially in March, up by.1 and. respectively over February. A variety of factors drove Canadians into shops, including warmer temperatures, rising consumer confidence and strong job creation. On an annualized basis, retail sales volumes increased by a rock-solid 7.8 during the first quarter of, relative to the previous quarter. This leads us to again revise upwards our estimate of real GDP growth from.3 to.9, showing again how well the recovery is engaged at home (see page for further details). 3 1 : Core Inflation : Total Inflation Sources: Statistics /Haver Analytics Europe: Investors Underestimate The Stabilization Plan Current market volatility related to Europe is not at all comparable with the events of 8-9. The meltdown in the American housing market posed a major systemic risk, a paralysis in the world financial system. This time, reappearance of tensions in the interbank lending market suggest small worries about liquidity, not worries regarding potential insolvency of major institutions. Recent market volatility also suggests that investors have a short-term memory. The 75 billion euro financial stabilization plan announced on May 9 th, was designed in part to reduce banks liquidity constraints. We must also remember that investors initially doubted the Geithner plan s potential effectiveness. We believe that the European initiative will also work well, and that European Central Bank president Jean-Claude Trichet will go as far as he needs in the purchase of government securities, to bring back some stability. The most likely scenario is thus that European markets will stabilize over the course of the year, perhaps this summer, once these measures have been fully implemented Ted Spread (on a daily basis).. MAY JUN JUL AUG SEP OCT NOV DEC JAN FEB MAR APR MAY 9 Source: Haver Analytics Of course the situation is far from perfect. It requires considerable efforts as well as credibility. Fiscal tightening in several countries notably the UK and Italy will no doubt impact short-term growth. However we think this is a small price to pay to get public finances in order and to reestablish stability. Furthermore, it appears to us Spain is in worse condition than either Italy or the UK, given that harmful fallout from the Spanish real estate crisis hits the banking sector just as the economy is about to reel from budget cuts. The 15 billion euros worth of austerity measures announced last week by the Spanish government could drag the country into a double-dip recession and spur loans losses in the banking sector. Already, a few troubled small regional Spanish credit cooperatives have merged, and the Spanish government could well eventually buy bad property loans from the more fragile financial institutions the same way the Irish government did this spring with its National Asset Management Agency year Government Bond Yield Spain Portugal Greece 8 Sources: Financial Times /Haver Analytics

3 The Monitor 6 5 That said, it is highly unlikely that fiscal tightening these countries (as well as in Greece and Portugal) would drag all of Europe into a recession, especially given the fact that the euro s recent depreciation will actually boost the competitiveness of large German and French exporters. The other extreme scenarios that occasionally make headlines about European banks becoming insolvent, kicking Greece out of the euro zone, or the end of the euro currency - are also highly unlikely in our opinion. The European authorities would intervene quickly and aggressively if necessary. The Bank of : Time to Leave The "ZIRP Club" 8 6 Norway: Norges Bank Sight Deposit Rate : BoC Overnight Rate Australia: RBA Interbank Overnight Cash Rate 8 6 The vigorous domestic economy is increasingly pressuring the BoC to announce a hike next week. Its close-to-zero percent policy rate is too low (the real policy rate has been negative for more than a year) particularly if anxieties about Europe fade as we expect down the road. Lately, the Canadian bond market reduced its expectations of a June 1st rate hike in light of European jitters. We think however that it would more prudent for Governor Carney to raise the overnight rate target from.5 to.5. An ounce of prevention on June 1 st is worth a pound of cure later this year. In other words, it would be more risky for the Bank of to stay on the sidelines on June 1st. If the European stabilization plan works, the BoC could be under even more pressure to lift rates quickly during the second half of in order to contain inflation. In fact the central bank has repeated on numerous occasions since this spring that controlling inflation is the priority. Governor Carney notably said in March:... the Bank has an unwavering commitment to price stability. The single, most direct contribution that monetary policy can make to sound economic performance is to provide Canadians with confidence that their money will retain its purchasing power. Given that key statement was also front and center in the April Monetary Policy Report, does the BoC really wants to take any chances of falling behind the curve on inflation? We don't think so. Lastly, the markets could interpret a status-quo on June 1 st by the BoC as a signal that financial and economic conditions are quite bad in overseas markets, and that the downside risks to the Canadian economy are much greater than the upside risks (its April Monetary Policy Report stated risks were balanced). All in all, we are of the view that a 5 bp increment in the overnight rate target on June 1 st, combined with a statement revealing more hikes are potentially in the cards in the medium-term, will feel like a wake-up call for the short-end of the curve, contributing to a flattening of the yield curve Sources: NB, BoC, RBA /Haver : Core Inflation BoC Forecasts : Core Inflation (Monetary Policy Report, April ) Sources: Statistics, Bank of /Haver Analytics : Benchmark Bond Yields: -years 9 : Treasury Bills: 6-months Sources: Bank of /Haver Analytics 8 9 3

4 The Monitor 6 5 North American Forecasts This Week's Forecasts () This Week Next Weeks In 3 Months 3-Month T-Bills Year Bond Year Bond Canadian Dollar (CAN$/US$) Month T-Bills Year Bond Year Bond Yen (Yen/US$) Euro (US$/Euro) /5/ Historical Data Forecasts* Q1 9 Q 9 Q3 9 Q3 9 Q Q Q3 Q 11 Q1 11 Q Overnight Rate Month Treasury Bills Year Bond Year Bond Year Bond Federal Funds Rate Month Treasury Bills Year Bond Year Bond Year Bond Canadian Dollar (US$/C$) Canadian Dollar (Euro/C$) Euro (US$/Euro) Yen (Yen/US$) Quarter-end data and annual averages May th, Interest-Rate and Exchange-Rate Forecasts

5 The Monitor 6 5 Market Review: Bonds and Currencies International 3-Month Rates Current Spreads (b.p.) against U.S. Yield May week - weeks -1 quarter - 1 year Jan-- U.S..17 #N/A #N/A UK France International Bonds: Benchmark -Year Yield Current Spreads (b.p.) against U.S. Yield May week - weeks -1 quarter - 1 year Jan-- U.S UK France Germany Greece Portugal Spain Japan Provincial Bonds: Benchmark -Year Yield Current Spreads (b.p.) against Yield May week - weeks -1 quarter - 1 year Jan Alberta British Columbia Prince Edward Island Manitoba New Brunswick Nova Scotia Ontario Quebec Saskatchewan Newfoundland Currencies Currencies May week - weeks -1 quarter - 1 year Jan-- () (/US$) (US$/) Australia (Australia/US$) U.K. (US$/ ) Japan (US$/Yen) Euro (US$/Euro) Data updated as at: 7/5/ 5

6 The Monitor 6 5 Market Review: Fixed Income Charts 7. Yield on 3-Month T-Bills 7. Yield on -Year Federal Bonds U.S. 6. U.S May- May-3 May- May-5 May-6 May-7 May-8 May-9 May- May- May-3 May- May-5 May-6 May-7 May-8 May-9 May Yield Curve 5-May- -1 month -1 year U.S. - Yield Curve 5-May- -1 month -1 year 3m 6m y 5y y 3m 6m y 5y y 3y Yield Spreads in basis points ( minus U.S.) 5-May- -1 month -1 year 9 7 Spreads on -Year Federal Bonds (Can-U.S., base pts) m 6m y 5y y - May-8 Aug-8 Nov-8 Feb-9 May-9 Aug-9 Nov-9 Feb- May- 6

7 The Monitor 6 5 Market Review: Stocks Exchange and Commodities Stock Market Summary Level Change () May-5-5w HI 5w LOW (-1W) (-W) (-13W) (-5W) Jan-- S&P/TSX 11,518 1,81 9, S&P/TSX S&P/TSX Small Cap Index S&P 5 1,7 1, Dow Jones, 11,5 8, Nasdaq,11,53 1, International U.K. - FTSE,91 5,85, Germany - DAX 5,67 6,33, France - CAC 3,331,66, Japan - Nikkei 5 9,6 11,339 9, Hong Kong - Hang Seng 18,986,9 16, Russia - RST 1,98 1, Australia - ASX All Ordinaries,86 5, 3, Brazil - Bovespa 59,18 71,785 8, S&P/TSX Sector Summary Level Change () May-5-5w HI 5w LOW (-1W) (-W) (-13W) (-5W) Jan-- S&P/TSX 11,518 1,81 9, Energy Materials Industrials Consumers Discretionary Consumers Staples Health Care Financials Information Technology Telecommunication Services Utilities Commodities Level May-5-5w HI 5w LOW (-1W) (-W) (-13W) (-5W) Jan-- London -- Gold (US$/once) London -- Silver (US$/once) Copper (US$/LB) WTI Crude Oil (US$/barrel) Natural Gas (Henry Hub) (US$/MMBTU) Data updated as at: 6/5/ 7

8 The Monitor 6 5 Calendar of Major Economic Indicators Date Time Release Unit Data for: LBS * Consensus Previous Feb 6 8:3 Current Account (BOP) Billions 1Q $ -$9.8 * Laurentian Bank Securities Forecast Consensus from Bloomberg L.P. KEY ECONOMIC INDICATORS WEEK OF MAY, Date Time Release Unit Data for: LBS* Consensus Previous May : Existing Home Sales Millions April May : Existing Home Sales M/M April May 5 : Consumer Confidence - May May 6 8:3 Durable Good Orders M/M April May 6 8:3 Durable Good Orders Ex. Transportation M/M April May 6 : New Home Sales Thousands April May 6 : New Home Sales M/M April May 7 8:3 GDP (Annualized) Q/Q 1Q S May 7 8:3 GDP Price Index Q/Q 1Q S May 7 8:3 Core PCE Q/Q 1Q S May 7 8:3 Initial Jobless Claims Thousands May May 8 8:3 Personal Income M/M April May 8 8:3 Personal Spending M/M April May 8 8:3 PCE Core M/M April May 8 8:3 PCE Core Y/Y April May 8 9:55 U. of Michigan Confidence - May F /5/ 8

9 The Monitor 6 5 North American Economic Indicators Period Monthly Chg. ( or Level) Cumulative change Current Previous - 3 Month - 1 Year Gross Domestic Product (GDP) February Manufacturing Shipments February Housing Starts ( ' ) * March Retail Sales February #N/A.7 #N/A #N/A Trade Balance (M$) * February Employment ( ' ) * * April Unemployment Rate * April Wages (avg. hourly earnings) April Total CPI inflation April Inflation ex-food & energy April Industrial Product Price Index March Raw Materials Price Index March Period Monthly Chg. ( or Level) Cumulative change Current Previous - 3 Month - 1 Year ISM - manufacturing * March ISM - Non-manufacturing * March Industrial Production * March Capacity Utilization Rate * March Consumer Confidence Index * April Retail Sales March Trade Balance (M$) * February -39,7-36,95-36,11-8,816 Housing Starts ( ' ) * March Existing home sales March Median price of ex. home sales March Non-Farm Payrolls ( ' ) * * March Unemployment Rate * March Wages (avg. hourly earnings) March Total CPI inflation March Inflation ex-food & energy March Producer Price Index March Ex-Food & Energy March * Level * * Change in level for the last month, 3 months and 1 year * * * Annual change Data updated as at: 6/5/ 9

10 The Monitor 6 5 North American Forecasts 9Q3 9Q Q1 Q Q3 Q 11Q1 11Q Real GDP () Consumption Business investment Non-residential structures Machinery and equipment Residential construction Government spending Exports Imports Current account balance in of GDP Inflation () Total CPI (y/y) Core CPI (y/y) Unemployment rate ()* Employment Housing starts (s) Before-tax Corp. Profits (y/y) *Average rate for the quarter or the year. Forecasts as of May 19th, Period-Over-Period Annualized Per Cent Change Unless Otherwise Indicated Annual Average th Qtr/th Qtr 9Q3 9Q Q1 Q Q3 Q 11Q Real GDP () Consumption Private investment Machinery and equipment Residential construction Government spending Exports Imports Inflation () Total (y/y) Core (y/y) Unemployment rate ()* Housing Starts (s) Before-tax Corp. profits (, y/y) * Average rate for the quarter or the year. Period-Over-Period Annualized Per Cent Change Unless Otherwise Indicated Annual Average th Qtr/th Qtr Forecasts as of April 3th, This document is intended only to convey information. It is not to be construed as an investment guide or as an offer or solicitation of an offer to buy or sell any of the securities mentioned in it. The author is an employee of Laurentian Bank Securities (LBS), a wholly owned subsidiary of the Laurentian Bank of. The author has taken all usual and reasonable precautions to determine that the information contained in this document has been obtained from sources believed to be reliable and that the procedures used to summarize and analyze it are based on accepted practices and principles. However, the market forces underlying investment value are subject to evolve suddenly and dramatically. Consequently, neither the author nor LBS can make any warranty as to the accuracy or completeness of information, analysis or views contained in this document or their usefulness or suitability in any particular circumstance. You should not make any investment or undertake any portfolio assessment or other transaction on the basis of this document, but should first consult your Investment Advisor, who can assess the relevant factors of any proposed investment or transaction. LBS and the author accept no liability of whatsoever kind for any damages incurred as a result of the use of this document or of its contents in contravention of this notice. This report, the information, opinions or conclusions, in whole or in part, may not be reproduced, distributed, published or referred to in any manner whatsoever without in each case the prior express written consent of Laurentian Bank Securities.