2014, a break out year for growth

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1 Inside... Overview...page Interest rate outlook...page Economic outlook...page Currency outlook...page Central bank watch...page 8 A turn for the better..page 9 FINANCIAL MARKETS MONTHLY January,, a break out year for growth The world economy is headed for a breakout year with real GDP growth forecasted to accelerate for the first time since. Global growth steadily slowed to just.9 in from. in, as heavy and widespread fiscal restraint, political uncertainty, and the implementation of structural reforms weighed on activity. To be sure, banking sector reforms and additional government spending cuts are likely to limit growth in some regions; however, with much of the heavy lifting already done, forecast surprises, should they come, are likely be to the upside. The arrival of the long-awaited global growth upturn will likely have limited implications for monetary policy in the near term. In December, the US Federal Reserve made a tentative step in pulling back the amount of ongoing stimulus by announcing a $ billion cut to the monthly bond purchase program. By itself, this was a small step as the Fed will continue to buy $ billion worth of securities in January; however, it signalled that policymakers view the downside risks to the economy as having dissipated. With that said, further cuts to this program are predicated on the economy maintaining this improved momentum. Other central banks have yet to signal a change in the policy outlook. In Canada, the Bank is watching for evidence that the strengthening in the US will translate into higher demand for Canadian exports while the European Central Bank (ECB) continues to remind markets that there are policy tools, including asset purchases, that can be implemented if the economic outlook does not improve. In the UK, the Bank of England s (BoE) forward policy guidance linking the level of the unemployment rate to the timing of policy changes looks likely to be reset to ensure that the rest of the economy is able to catch up with the sharp improvement in labour market conditions. Central bank near-term bias Three-months out, policy rate With economic momentum picking up in H/ but inflation remaining below target, we expect the BoC will maintain a neutral policy stance in the near term. The Fed will continue to taper asset purchases in, although stronger forward guidance points to the fed funds rate being held at its current level until late. With unemployment continuing to fall toward the BoE s threshold, we expect forward guidance will be strengthened to assure markets that the Bank Rate will not be raised in. Dawn Desjardins Assistant Chief Economist dawn.desjardins@rbc.com Josh Nye Economist josh.nye@rbc.com Weak inflation continues to highlight the need for exceptional monetary stimulus, and we expect rates will be held at current levels. The ECB continues to emphasize its willingness to act further if the economy fails to improve. The RBA maintained a mild easing bias in December, but Governor Stevens has noted that the effect of further stimulus would be limited. With the RBNZ noting that, it is becoming unnecessary to maintain the OCR at., we continue to expect tightening will begin in Q/.

2 Highlights Financial market volatility spikes Stronger as investors global growth worry is about likely in the. global recovery. Data With reports significant have excess erred on capacity the weak keeping side. global inflation low, central banks are likely to keep their policy However rates steady. there were many one-off factors that curtailed activity. The US Federal Reserve trimmed its monthly bond purchase As these program factors by ease, $ growth billion although will accelerate. will still buy $ billion of securities this month. The US recession was deeper than was previously reported and GDP output Financial markets took the stands Fed s announcement. pp below its in prerecession stride. More peak. tapering is likely to be announced later this month given the improved tone in the economic data. Financial markets took the Fed s December announcement that it would taper its asset buying program in stride with US stock markets continuing to chalk up gains. The selloff in the US Treasury market was relatively limited as markets anticipated this policy change, albeit with most expecting the announcement to come in early. US economy full steam ahead Third-quarter annualized US gross domestic product (GDP) growth was revised upward to. from., reflecting faster consumer spending growth and modestly firmer business investment. The final revision showed a slightly more favourable composition in the drivers of the quarterly increase although it was still a sizeable inventory build that provided the biggest contribution. Data on activity in the fourth quarter point to another solid gain, and we upwardly revised our forecast to show a. annualized increase even after incorporating a drop in government spending related to the shutdown of the federal government in October and the partial reversal of the third quarter s inventory build. Retail sales, industrial production, and durable goods orders all showed strong increases in October and November. Similarly, the real trade deficit narrowed in this period to stand well below the third-quarter average, which is consistent with net exports giving a lift to the economy s growth rate in the fourth quarter. All of this good news was accompanied by somewhat modest employment growth, with a weak December payroll report limiting the fourth quarter average gain to,, which marks only a slight strengthening from the, average increase in the third quarter. Nonetheless, recent job numbers show the unemployment rate dropped down to an average of. in the fourth quarter from.8 a year ago. Measured steps Despite the run of stronger growth reports, inflation pressures remain tame with the annual increase in both the overall and core measures remaining well below the Fed s objective of as of November. Thus, the Fed s decision to start the taper process reflected its assessment that the improvement in economic growth and labour market conditions would eventually translate into the inflation rate reaching the target. We expect the economy will be able to maintain the above-potential growth exhibited in the second half of, thereby keeping downward pressure on the unemployment rate and reducing the amount of spare capacity in the economy. Against this backdrop, the Fed is likely to continue gradually to reduce the size of its monthly purchase program with the upcoming meeting in late January providing the next opportunity. This will be the last meeting with Chairman Bernanke as head of the Federal Reserve with Janet Yellen stepping into the role on February,. Further reductions in the size of the monthly bond buying program are contingent on labour market conditions continuing to improve and inflation moving toward the longterm objective, and even then, policy changes will be made in measured steps. Our baseline view is that the Fed will cut the size of the program at upcoming meetings by $ billion per month with the program likely to end in the second half of. Changes to the more traditional policy tool, the fed funds rate target band, will be slower, with the current range of. to. likely to be maintained throughout. Our forecast is for the unemployment rate to break through the Fed s. threshold and the inflation rate to approach the objective in mid-, thereby setting up for the Fed to raise the funds target band late in the year. The profile for Fed policy is consistent with interest rates rising, albeit at a slow pace. The yield on the two-year bond is expected to hold below. throughout while the -year rate is forecasted to reach. by year end. Short-term interest rates are likely to rise more aggressively in with the two-year rate projected to end at. and the - year at..

3 Canada s economy flexes its muscles Real GDP increased by. in October, which was faster than expected and set the stage for a second consecutive above-potential quarterly increase. Growth in the second half of was running much faster than the close to pace recorded in the first half of the year and above the. average pace forecasted by the Bank of Canada in the October Monetary Policy Report. Backed by the monthly GDP report, we upwardly revised our fourth-quarter forecast to. from., only marginally slower than the third-quarter. rise. The upgrade reflected signs of strength in business investment and consumer spending as well as a firming in housing starts. The stronger than expected gains in these spending components more than made up for the soft performance in the trade sector in both October and November. Disappointingly weak exports and imports in the two-month period set up for net exports to act as a drag on growth in the fourth quarter, rather than a support as we previously expected. Governor Poloz sees current policy rate as appropriate Despite the stronger than expected spending activity in the fourth quarter, the combination of weak exports and low inflation sets up the Bank of Canada to maintain its neutral policy stance in the near term. In early January, Governor Poloz stated that the current level of interest rates would remain appropriate until the data flow changes. The Governor acknowledged that inflation has been underperforming the Bank s models although this has not translated into a shift in inflation expectations, which remain anchored about the target. He reiterated the Bank s view that the global outlook has improved and correspondingly the expectation that Canadian export growth will strengthen ahead. Financial markets remain on heightened alert that the Bank may lower the policy rate to stimulate spending growth further; however, acceleration in growth over the second half of makes a rate cut unlikely. While marked a year of extreme volatility in monthly employment data, including a sharp drop in December, employment in the fourth quarter was still up.9 relative to a year ago with the unemployment rate dropping to. in the quarter from. a year ago. Despite this drop in the unemployment rate, it still denotes some slack in the labour market corroborated by the sluggish pace of wage gains. Back-to-back quarters of above-potential growth will chip away at the output gap; however, the economy will need to maintain this pace for the next couple of years to reach full capacity and eliminate the slack in labour markets. Against this backdrop, we expect the Bank of Canada to maintain the current level of policy stimulus with the overnight rate at. in to ensure that the economy continues to grow at a pace that is sufficient to reduce the amount of spare capacity and halt further downward pressure being exerted on inflation. Canadian dollar s fall builds speed Even with the economic news surprising on the side of strength, the currency s tumble took on speed in early, losing. against the US dollar is the first five trading days of the year. This resulted in the currency falling to its lowest level against the US dollar since October 9. The slide began in late October when the Bank shifted away from its mild tightening bias with the momentum building thereafter. Fundamentally weakening commodity prices outside of energy, reduced rate hike expectations, and the significant slowing in foreign purchases of Canadian bonds supported the Canadian dollar s losses. We, however, view the recent negative sentiment as overdone given the general improvement in the economic backdrop and our view that although the Bank will not raise the policy rate in, neither will it lower the overnight rate. Canada s economy is likely to record another abovepotential quarter of growth in Q/. The economy maintained a solid clip in October, leading us to revise our Q/ forecast upward to.. Highlights While the growth picture is improving, inflation remains low and is running below the Bank s target band. The Canadian dollar took a drubbing in early ; however, the improvement in the economic data flow and steady BoC policy will likely put an end to the rapid pace of decline.

4 Highlights The euro area continues to grow modestly, but inflation remains well below the ECB s target. With the UK unemployment nearing the MPC s threshold, we expect forward guidance will be strengthened in February. Sub-trend growth in will see the RBA keep rates low for an extended period. Above-trend growth and an expected pickup in inflation put the RBNZ on track to begin tightening in March. Weak inflation reinforces ECB easing bias Survey-based indicators point to modest growth continuing in the euro area with the composite purchasing managers index (PMI) remaining in expansionary territory for a sixth consecutive month in December; however, the headline index continues to mask divergences within the core economies as German activity strengthens while French readings point to further contraction in the euro area s second-largest economy. Italian and Spanish readings improved in December and indicated expansion in both economies. Overall, we expect euro area growth will pick up modestly to a. pace in the fourth quarter from. in the third quarter. Weak underlying growth has kept inflation subdued, with the flash estimate showing prices rose just.8 in the year to December. We forecast inflation will remain below the ECB s target in and thus expect rates will be held at current levels for that period. While deterioration in the economic outlook or further softening in inflation could lead the ECB to act on its easing bias, continued contraction in business credit makes it more likely that the ECB s next move will be to implement targeted measures to boost lending by announcing another longer-term refinancing operation (LTRO) linked to credit creation. Bank of England likely to adjust forward guidance Strong PMI readings in the final quarter of are consistent with growth being maintained at the solid.8 non-annualized pace seen in the third quarter. Although the composite PMI trended lower in the quarter, it stood at an elevated 9. in December, which is consistent with the economy continuing to grow at a solid clip, albeit at a more sustainable. quarterly rate. The unemployment rate continued to fall faster than anticipated, having dipped to. in October from. in the previous month, with expectations for a further decline in November. With the unemployment rate moving rapidly toward the Monetary Policy Committee s (MPC) current. threshold, we think it likely that the BoE would adjust the forward guidance in the February Inflation Report to emphasize that despite the drop in the unemployment rate, slack remains in the economy. A broadening in the forward guidance will be aimed at allaying concerns that a rate hike is imminent, and we expect the policy rate will be held at its current level at least through. Reserve Bank of Australia (RBA) to keep rates low for long Growth in Australia is likely to remain anaemic although strength in retail sales in November hint that the RBA s rate cuts may be gaining some traction. With that said, a weak labour market is likely to keep the economy growing at a subpar pace in the near term. Consumer spending and exports need to become the main sources of growth going forward, as the economy transitions away from relying heavily on resource-driven investment. Given the weak pace of growth and limited inflationary pressures, the RBA maintained a mild easing bias in December with the minutes of that meeting showing that the Board has not closed off the possibility of a further reduction in the Official Cash Rate (OCR). With that said, Governor Stevens recently hinted at limitations to further monetary policy stimulus with the cash rate at an historic low. While we maintain our call for a final -basis point cut in the second quarter of, we acknowledge the hurdle to do so remains high. More importantly, we expect the cash rate to stay at an historical low for an extended period in. Reserve Bank of New Zealand (RBNZ) on track for rate hike Growth in New Zealand accelerated to a. non-annualized pace in the third quarter from. in the second quarter, validating expectations that the economy shifted into higher gear in the second half of. Strengthening demand boosted underlying price pressure, with inflation picking up to a. year-over-year rate in the third quarter, following a year of sub- inflation readings. Solid growth momentum and the pickup in inflation (with further increases expected) put the RBNZ on track to tighten monetary policy in the first quarter of. While a move could come as early as January, we expect the first rate hike will be made in March as the RBNZ awaits further evidence on the effects of macro-prudential measures introduced in October to curb high house price inflation. We expect basis points of hikes in bringing the official cash rate to. by year end.

5 Interest rate outlook, end of period Actuals Q Q Q Q Q Q Q Q Q Q Q Q Canada Overnight Three-month Two-year Five-year year year United States Fed funds Three-month Two-year Five-year year year United Kingdom Bank rate Two-year year Eurozone Refi rate Two-year year Australia Cash target rate Two-year year New Zealand Cash target rate Two-year swap year swap Yield curve Canada 88 United States United Kingdom 9 Eurozone Australia 9 8 New Zealand * Two-year/-year spread in basis points Source: Reuters, RBC Economics Research, end of period Central bank policy rate Current Last United States Fed funds.-.. Dec., 8 Canada Overnight rate.. Sep. 8, United Kingdom Bank rate.. Mar., 9 Current Last Eurozone Refi rate.. November, Australia Cash rate.. August, New Zealand Cash rate.. Mar., Source: Bloomberg, Reuters, RBC Economics Research

6 Economic outlook Growth outlook change, quarter-over-quarter in real GDP Q Q Q Q Q Q Q Q Q Q Q Q A F F F Canada* United States* United Kingdom Eurozone Australia New Zealand *Seasonally adjusted annualized rates Inflation outlook change, year-over-year Q Q Q Q Q Q Q Q Q Q Q Q A F F F Canada United States United Kingdom Eurozone Australia New Zealand Source: Statistics Canada, Bureau of Labor Statistics, Bank of England, European Central Bank, Reserve Bank of Australia, Reserve Bank of New Zealand, RBC Economics Research Inflation tracking Inflation Watch Measure Current period Period ago Year ago Three-month trend Six-month trend Canada Bank of Canada core CPI Nov..... United States Core PCE Nov..... United Kingdom All-items CPI Nov Eurozone All-items CPI Nov Australia Trimmed mean Q.. N/A N/A New Zealand CPI Q.9. N/A N/A Seasonally adjusted measurement. Personal consumption expenditures less food and energy price indices. Source: Statistics Canada, US Bureau of Labor Statistics, Bank of England, European Central Bank, Reserve Bank of Australia, Reserve Bank of New Zealand, RBC Economics Research

7 Currency outlook Level, end of period Actuals Q Q Q Q Q Q Q Q Q Q Q Q Canadian dollar Euro U.K. pound sterling New Zealand dollar Japanese yen Australian dollar Canadian dollar cross-rates Q Q Q Q Q Q Q Q Q Q Q Q EUR/CAD GBP/CAD NZD/CAD CAD/JPY AUD/CAD Rates are expressed in currency units per US dollar and currency units per Canadian dollar, except the euro, UK pound, Australian dollar, and New Zealand dollar, which are expressed in US dollars per currency unit and Canadian dollars per currency unit. Source: Bloomberg, RBC Economics Research RBC Economics outlook compared to the market The following charts track historical exchange rates plus the forward rate (dashed line) compared to the RBC Economics forecast (dotted line) out one year. The cone for the forecast period frames the forward rate with confidence bounds using implied option volatilities as of the date of publication. Canadian dollar Euro Jan- Jul- Jan- Jul-. Jan- Jul- Jan- Jul- Japanese yen. U.K. pound Jan- Jul- Jan- Jul-. Jan- Jul- Jan- Jul-

8 Central bank watch Bank of Canada Canada s economy is on track to grow at a above-trend pace in Q/, almost matching the. recorded in Q. Inflation remained below the BoC s target range in November, but stronger than expected growth should result in a neutral stance being maintained at the next BoC meeting. Canadian real GDP growth Quarter-over-quarter annualized change Canadian overnight rate 8 9 Source: Statistics Canada, RBC Economics Research ed values: Source: Bank of Canada, Federal Reserve Board, RBC Economics Research Federal Reserve Final domestic demand growth is expected to strengthen in Q/, while a slower inventory build would limit GDP growth to a still-strong.. The Fed began tapering asset purchases in January but strengthened forward guidance by noting that the fed funds rate may be held in its current range well past the time unemployment falls to., if inflation stays below target. European Central Bank Euro area growth is expected to pick up modestly to. in Q/ although divergence among core economies will continue, with France in particular underperforming. The ECB held rates steady in January slightly strengthening its forward guidance; we expect another LTRO likely tied to credit creation to be announced early this year. Bank of England The UK economy looks set to expand by a solid.8 again in Q/. The pace of activity is likely to moderate thereafter to a near-trend pace in. With the unemployment rate nearing the BoE s threshold, we expect forward guidance will be strengthened with the February Inflation Report. Australia and New Zealand Sub-trend growth and limited price pressure will allow the RBA to keep the cash rate at an historically low level through. Growth and inflation picked up in Q/, and solid momentum puts the RBNZ on track to begin tightening in March Quarter-over-quarter annualized change U.S. real GDP growth 8 9 Source: Bureau of Economics Analysis, RBC Economics Research change, quarter-over-quarter Eurozone GDP ed values: 8 9 Source: Eurostat, RBC Economics Research U.K. real GDP growth change, quarter-over-quarter ed values: 8 9 Source: Central Statistical Office, RBC Economics Research change, quarter-over-quarter Australia and New Zealand GDP growth Australia New Zealand 8 9 U.S. target rate 8 9 Source: Bank of Canada, Federal Reserve Board, RBC Economics Research ECB refi rate 8 9 Source: ECB, RBC Economics Research U.K. policy rate 8 9 Source: Bank of England, RBC Economics Research Australia and New Zealand inflation change, year-over-year Australia New Zealand 8 9 Source: Australian Bureau of Statistics, Statistics New Zealand, RBC Economics Research Source: Australian Bureau of Statistics, Statistics New Zealand, RBC Economics Research 8

9 A turn for the better Outside of the UK, forecasts for growth in stagnated or inched lower throughout. RBC forecasts are on the high side for both Canada and the US. Inflation forecasts fell steadily as incoming data showed very limited price pressures. real GDP forecasts over the course of. Canada U.S. Euro zone UK inflation forecasts over the course of. Canada U.S. Euro zone UK Jan, Feb, Mar, Apr, May, Jun, Jul, Aug, Sep, Oct, Nov, Dec, Jan, Feb, Mar, Apr, May, Jun, Jul, Aug, Sep, Oct, Nov, Dec, Source: Consensus Economics Inc., RBC Economics Research Source: Consensus Economics Inc., RBC Economics Research After trending lower for three consecutive years, global economic growth in is finally headed higher. With that said, central banks will be in no hurry to tighten policy given large amounts of spare capacity will keep inflation at bay. World GDP growth change Central bank policy rates Percent, eop..9.. Canada U.S. UK Eurozone Source: International Monetary Fund, RBC Economics Research Source: Bank of England, European Central Bank, Federal Reserve, Bank of Canada, RBC Economics Research The material contained in this report is the property of Royal Bank of Canada and may not be reproduced in any way, in whole or in part, without express authorization of the copyright holder in writing. The statements and statistics contained herein have been prepared by RBC Economics Research based on information from sources considered to be reliable. We make no representation or warranty, express or implied, as to its accuracy or completeness. This publication is for the information of investors and business persons and does not constitute an offer to sell or a solicitation to buy securities. Registered trademark of Royal Bank of Canada. Royal Bank of Canada. 9