Inside... Overview...page Interest rate outlook...page Economic outlook...page Currency outlook...page Central bank watch...page 8 Low interest rate backdrop to persist throughout....page 9 Keep calm and carry on FINANCIAL MARKETS MONTHLY May, Yields on Canadian and US -year bonds sank to their lowest levels since December, and short-term securities yields fell to recent lows in April on fears that the global economy was falling into another spring swoon. The main stock indices put in a mixed performance with the TSX recording a. drop while the S&P rose.8 in the month, which was half the pace of March s gain. Investors are monitoring the economic data to determine if the growth will continue to decelerate in the spring as has happened in the past three years. Generally, the economic data fed investor concerns regarding the ability of the various key economies to maintain their momentum. In the US, the economy is likely headed for slower growth in the second quarter of as the effect of sequestration kicks in. In fact, data indicate that the second quarter s growth rate is likely to be lower than the first quarter s disappointing initial print of.. Canada s reports on the pace of growth in the first quarter, conversely, have surprised to the upside although this followed a six-month slump that increased the amount of spare capacity in the economy. What is different about this spring is that although this pattern feels all too familiar, the likelihood that the global economies momentum will falter has been reduced by the jelling of structural changes that have been underway. In the US, the fiscal drag will weigh down growth in the near term but is unlikely to be sufficient to overcome the much improved backdrop for the US consumer. In Canada, the factors that conspired to dampen growth in the second half of have eased thereby opening the door to a sustained acceleration in activity. Central bank near-term bias Bias three-months out The subdued outlook for inflation likely means that the BoC and its new Governor Poloz will maintain the current stance in the near term, but a gradual increase in the economy s momentum will prompt less policy stimulus starting in Q/. Any tightening in policy, although not imminent, is likely to come from a pulling back on the non-traditional measures rather than a hike in the fed funds rate target. Recent data are unlikely to sway BoE policymakers one way or the other. We continue to anticipate that the current policy stance will remain unchanged during the summer. Dawn Desjardins Assistant Chief Economist -9-99 dawn.desjardins@rbc.com David Onyett-Jeffries, CFA Economist -9- david.onyett-jeffries@rbc.com The ECB cut the refi rate by bp to.. President Draghi hinted heavily that the Governing Council is open to further policy easing if conditions continue to deteriorate, yet it is not likely to be warranted. The minutes from the April RBA meeting emphasized the headwinds facing the economy and set the stage for further policy easing with a bp expected in June. RBNZ Governor Wheeler reiterated his expectation that the current level of the OCR will be unchanged through the end of the year, and we continue to believe the same.
Highlights Financial market volatility spikes as investors worry about the global recovery. Bond yields fell in April, and Data we reports revised have our forecasts erred on to account the weak for side. the lower starting point. However there were many one-off Nervousness factors about that curtailed the US activity. economy will weather how the sequester and how quickly Europe escape recession As are these keeping factors investors ease, growth jittery. will accelerate. The US recession was US growth is likely to be deeper slower in than Q/, was previously but the reported downward and pressure GDP output from the stands government. pp spending below its cuts prerecession will be temporary. peak. US consumers are in a much better position with balance sheets largely repaired and labour market conditions improving. Central banks remain calm Despite the nervousness created by the prospect of a weaker second quarter of, the US Federal Reserve maintained its policy stance at its May meeting with the target for the federal funds rate holding in the. to. range. The Fed expects to hold the funds target in this range at least as long as the unemployment rate remains above., and the outlook for inflation remains no more than a half percentage point above the Committee s longer-run goal. Asset purchases were maintained at a monthly pace of $8 billion with maturing principal payments continuing to be reinvested. The Bank of Canada, in mid-april, also confirmed its outlook that the current amount of policy stimulus will likely remain appropriate for a period of time and that some modest withdrawal will likely be required thereafter. US economy working through sequestration The US economy firmed in the first quarter of with real GDP growth of. following the fourth quarter of s paltry. annualized gain, yet the acceleration was less than expected with the main downward surprise being another sizeable drop in government defence spending that subtracted.8 percentage points from overall annualized first-quarter GDP growth in the quarter and likely reflected the March sequestration cuts. Outside of the government sector, the US economy s expansion reflected a jump in consumer spending and a rebuilding of inventories following the very large reduction that occurred in the fourth quarter of. Business investment growth slowed, but residential investment growth was strong and posted a double-digit increase in four of the past five quarters. First-quarter acceleration is unlikely to be maintained in the near term as the full effect of the government s spending cuts are felt. To be sure, a number of indicators showed slower activity in March and April. The follow through from government spending cuts likely was a factor in the weakening in hiring in manufacturing and the decline in the manufacturing sector Purchasing Managers Indexes (PMI) in March and April. This weakening and the government s cuts set up for US growth to slow to a.9 annualized pace in the second quarter. US economy to rally back in second half We expect downward pressure from fiscal policy will be short lived and forecast that growth will rebound in the second half of. The improved state of household balance sheets and increased appetite for housing will provide a much-needed boost to consumers in the second half of. An easing in lending conditions and very low interest rates will also fuel a pick up in spending especially because the run rate in non-farm payroll has stayed above,. In turn, businesses are expected to increase investment in both the residential and non-residential markets. Additionally, the weight from government restraint will ease with time. In summary, the US economy s growth rate is forecasted to pick up to.9 in the second half of the year from the first half s. average pace. Interest rate forecast profile lowered The weakening trend in the economic data in recent weeks, persistent concerns about Europe, and niggling worries about the pace of Chinese growth resulted in US interest rates falling sharply in April. The decline in the headline inflation rate to. in March also curbed any upside move in yields. With the upcoming run of data likely to be heavily affected by the government s spending cuts, either directly or indirectly, the scope for a rebound in interest rates is limited. As a result, we lowered the profile of our projections such that the -year yield, trading at. today, is forecasted to rise to. by the end of rather than the. in our previous forecast. Tweaks to short-term maturities were smaller in size. Our view of the likely progression of Federal Reserve policy is little
changed with a tapering of bond purchases expected late this year, followed by the cessation of purchases. Interest rates during this time are expected to remain low with the fed funds target holding in the current. to. until. The slow pace of the unwinding in policy stimulus reflects our expectations that even with as acceleration in activity in the second half of and in, the unemployment rate is unlikely to slip below the Fed s. threshold until. This suggests that any tightening in policy in this period will come from pulling back on the non-traditional measures rather than an increase in the target for the fed funds rate. The Fed articulated a willingness to alter the pace of securities purchases to be in line with any changes in the outlook for inflation or the labour market in its May statement. Canada s economy coming back to life After a run of disappointing real GDP reports, the back-to-back gains in January and February support our forecast for a strengthening in first-quarter growth. In fact, upside surprises in the monthly GDP and March trade data led us to boost our first-quarter forecast to. annualized growth from.9. This pace of growth is in line with the economy s potential and a vast improvement from the. average gain recorded in the previous two quarters. Bank of Canada sees larger output gap for longer The Bank updated its forecasts in mid-april with GDP growth downgraded to. (from.) while s growth rate was revised up to.8 (from.). The Bank maintained the tenets of its previous forecasts with business investment still expected to provide significant support to the economy accompanied by an improvement in exports. Lower government spending and residential investment will weigh on activity. The economy s weak growth in the second half of and moderate pace in resulted in the Bank estimating that the output gap will not close until mid-, which is later than the second half of that was previously expected. Slack in the economy, therefore, is larger than previously thought and is expected to persist longer thereby resulting in inflation holding below until the second quarter of. Despite the tweaks to the outlook, the Bank left the overnight rate unchanged at. and maintained that the current monetary policy stimulus is likely to remain appropriate for a period of time. With that said, the Bank also retained the statement that some modest withdrawal will likely be required thereafter. While the widening in the output gap and subdued outlook for inflation will likely see the Bank maintain this policy stance in the near term, our forecast is that conditions will support a gradual and persistent increase in the economy s momentum such that the inflation rate will approach the target in late. To ensure that inflation pressures remain in line with the target, we expect that the Bank will start to reduce the amount of policy stimulus via raising interest rates in the second half of. Canada s real GDP surprised to the upside in both January and February. March s trade report showed a jump in exports that provided a larger boost to growth in Q/. The economy likely grew at a. annualized pace in Q/, which is the fastest pace since Q/. Highlights The Bank of Canada maintained its mild tightening bias in April. Stephen Poloz was named as Bank of Canada Governor effective June,. Interest rates surprisingly low and other surprising events Our underlying view is unchanged: the Bank will raise the policy rate before the US Fed; however, neither bank is likely to move in. Interest rates on Canada bonds moved in step with US Treasury yields because, although the economy is performing better, uncertainty remains about how Canada will fare as the US works through the sequester. Stephen Poloz was named the new Bank of Canada Governor, which was a somewhat surprising result given that the current Senior Deputy was heavily favoured to take the position. Poloz comes from Export Development Canada and in his initial press conference described the Bank s flexible inflation targeting as sacrosanct. His initial comments suggest that he is of the same ilk as the current members of the Governing Council, and as such, no changes to the policy platform are likely in the near term.
Highlights The ECB cut the refi rate by bp in May, and President Draghi hinted heavily that further policy easing may still be warranted in the coming months. UK real GDP increased by a non-annualized. in Q/ thereby avoiding falling into a third technical recession since 8. Headwinds to growth in the Australian economy combined with benign inflation set the stage for further policy easing, with a bp cut to the OCR expected in June. ECB cuts policy rates in May and keeps the knife on the table The most recent indicators continue to paint a fairly bleak picture of economic conditions in the aggregated euro area. The flash April PMIs were little changed from the previous month and point to ongoing weakness in the second quarter extending the recession that began at the end of. The lack of growth in the euro area has resulted in a significant build up of economic slack, acutely evident in labour markets where the unemployment rate ticked up to a new record high of. in April. The excess capacity means inflationary pressures are quiescent, and Harmonised Index of Consumer Prices (HICP) inflation fell to a three-year low of. in April. While the effect of value-added tax (VAT) increases in several countries should result in a mechanical increase in inflation in the next few months, once these base effects fallout of the calculation, euro area inflation will moderate rapidly into. Given that the European Central Bank s (ECB) mandate is to maintain inflation at rates below, but close to, over the medium term, such an outlook warranted further policy easing. Accordingly, central bank policymakers cut the refi by bp to. in May while also deciding to extend the fixed-rate, full-allotment, main-refinancing operations until at least July. In the press conference following the monetary policy decision, ECB President Draghi hinted heavily that the Governing Council was open to further standard policy easing if conditions continue to deteriorate. We do not expect another rate cut is in the offing (our forecast is for the refi rate to remain at its current level until the end of ); however, if the upcoming slate of indicators materially disappoint, then another -basis point rate cut next month cannot be ruled out. UK economy takes a step back from the ledge The UK economy faced the possibility of falling back into a technical recession in the first quarter of following the. quarterly contraction recorded to close out, but real GDP expanded by a non-annualized. in the quarter. While this represents only a modest pace of growth, the details of the report were encouraging, with the bulk of strength in the first three months of this year accounted for by the services sector while industrial production also provided some support. More importantly, because we estimate that the Bank of England s February Inflation Report penciled in a. increase in the first quarter, the data represent an upside surprise to policymakers expectations. We do not anticipate that this report will shift the opinions of the Monetary Policy Committee (MPC) members who voted in favour of further quantitative easing in April, especially given the continued indications of underlying weakness in overall economic activity. It is likely to mitigate the risk that anyone from the majority will join their camp in the near term. Accordingly, we anticipate that the upcoming MPC meeting will be another non-event and continue to expect that the policy stance will remain unchanged at least until the changing of the guard at the Bank this summer. Headwinds to the Australian economy reinforce RBA s easing bias The recent run of domestic data indicates that the aggressive policy easing by the Reserve Bank of Australia (RBA) since is finally paying dividends and supporting the rebalancing of the Australian economy away from a dependence on the country s natural resource endowments and toward the more interest-rate sensitive sectors. While the level of housing market activity remains fairly modest by historical standards, there is a clear upward trend in homebuilding, financing activity, and an attendant pick up in house prices. As well, household spending has improved considerably this year with the strong retail spending data prompting a modest upward revision to our forecast for overall growth in to. from. previously. The minutes from the RBA s April meeting emphasized the headwinds facing the economy, namely the elevated exchange rate, the pullback in investment in the natural resource sector, and fiscal consolidation. These concerns underpin the central bank s easing bias, while the softer than expected first-quarter inflation print provided the scope for further policy easing as warranted. Against this backdrop, we maintain our long-held view that the RBA will cut the OCR one final time (a bp cut in June), but we acknowledge that the hurdle for such a move remains high given the nascent signs that previous policy moves are gaining traction.
Interest rate outlook, end of period Canada Actuals Q Q Q Q Q Q Q Q Q Q Q Q Overnight............ Three-month.9.88.9..98....... Two-year......9...... Five-year...........9. -year.....88.8.9.9....8 -year.........8... United States Fed funds............ Three-month..9..9........ Two-year...........8. Five-year........9...8. -year.....8.8.9..... -year...8.9..9.....8. United Kingdom Bank rate............ Two-year............ -year..8...8.8...... Eurozone Refi rate............ Two-year.9... -........ -year.....9....... Australia Cash target rate............ Two-year.9..9..8..8..... -year...9.......8.. New Zealand Cash target rate............ Two-year swap.....8..8.9.... -year swap....8.9.9.....9. Yield curve Canada 9 88 9 9 9 United States 8 8 9 9 8 United Kingdom 8 9 9 Eurozone 8 8 8 Australia 8 9 New Zealand 8 * Two-year/-year spread in basis points **New Zealand s yield curve: -year vs. three-year 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.. May, Australia Cash rate.. Dec., New Zealand Cash rate.. Mar., Source: Bloomberg, Reuters, RBC Economics Research
Economic outlook Growth outlook change, quarter-over-quarter in real GDP Q Q Q Q Q Q Q Q Q Q Q Q A A F F Canada*..9.....9...9.8...8.8.9 United States*.....**.9.8......8...9 United Kingdom -. -..9 -..**........... Eurozone -. -. -. -. -......... -. -.. Australia.......8..9.8.8.8.... New Zealand......8.........9. *Seasonally adjusted annualized rates; ** actual Inflation outlook change, year-over-year Q Q Q Q Q Q Q Q Q Q Q Q A A F F Canada....9.9...8.8.8.9.9.9...9 United States.8.9..9....8.9.9.8.9....9 United Kingdom..8....9........8.8. Eurozone.....9........... Australia.........8.8.9...8..9 New Zealand...8.9.8.9.....8..... 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 Mar....9. United States Core PCE Mar..... United Kingdom All-items CPI Mar...8.. Eurozone All-items CPI Apr. -.... 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
Currency outlook Level, end of period Actuals Q Q Q Q Q Q Q Q Q Q Q Q Canadian dollar...98.99........ Euro...9..8....... U.K. pound sterling..........8.. New Zealand dollar.8.8.8.8.8.8.8.8.8.8.8.8 Japanese yen 8.9 9.8.9 8.8 9.. 9. 9. 88. 89. 9. 9. Chinese renminbi.9..9........8. Australian dollar..........8.. Mexican peso.8..9.9.....9.8.8. Canadian dollar cross-rates Q Q Q Q Q Q Q Q Q Q Q Q EUR/CAD..9.......... GBP/CAD...9...8...... NZD/CAD.8.8.8.8.8.89.89.89.88.8.8.8 CAD/JPY 8. 8. 9. 8. 9. 9. 9. 88. 8. 8. 9. 9. AUD/CAD...........8. 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.........9...8 May- Nov- May- Nov-. May- Nov- May- Nov- Japanese yen. U.K. pound 9.8 8.. May- Nov- May- Nov-. May- Nov- May- Nov-
Central bank watch Bank of Canada Canadian real GDP came in at a stronger than expected. in February following an upwardly revised. gain in January. Quarter-over-quarter annualized change 8 Canadian real GDP growth Canadian overnight rate The widening in the output gap in H/ and subdued inflation will keep the BoC sidelined in the near term, but we anticipate conditions will improve such that a reduction of stimulus will be warranted by Q/. Federal Reserve The first estimate of US Q/ GDP growth showed growth accelerated to an annualized. rate following the. increase recorded in Q/. As economic momentum builds, the Fed will likely taper the pace of asset purchases, yet this is only likely to occur late this year with the fed funds rate expected to remain at its current. to. range into. European Central Bank The flash PMIs for April were broadly unchanged from the previous month and point to continued weakness in economic activity in the euro area at the start of the second quarter. The ECB cut the refi rate by bp to. in May and announced an extension of the fixedrate, full-allotment procedures at least until. - - - -8-8 9 Source: Statistics Canada, RBC Economics Research ed values: U.S. real GDP growth Quarter-over-quarter annualized change 8 - - - -8-8 9 Source: Bureau of Economics Analysis, RBC Economics Research ed values: Eurozone GDP change, quarter-over-quarter.... -. -. -. -. -. -. 8 9 Source: Eurostat, RBC Economics Research ed values: 8 9 Source: Bank of Canada, Federal Reserve Board, RBC Economics Research 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 Bank of England The preliminary estimate of UK real GDP showed a non-annualized. increase in Q/ to help the economy avoid falling into its third technical recession since 8. The minutes of the April MPC meeting provided little in the way of news, and we anticipate that the upcoming May meeting will yield no change of tack at the BoE. Australia and New Zealand Australian Q/ inflation undershot expectations, lent further support to the RBA easing bias, and reinforced our long-held view that the OCR will be cut by bp to. in June. The RBNZ left the OCR unchanged at. at its late-april meeting, and Governor Wheeler reiterated that he expects the policy rate to remain at this level until the end of the year, which would be consistent with our own view. U.K. real GDP growth change, quarter-over-quarter.... -. -. -. -. -. 8 9 Source: Central Statistical Office, RBC Economics Research change, quarter-over-quarter...... -. -. -. Australia and New Zealand GDP growth Australia New Zealand 8 9 Source: Australian Bureau of Statistics, Statistics New Zealand, 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 8
Low interest rate backdrop to persist throughout Yields on -year government bonds fell in April to the lowest levels since December. Yields will go up over time but the pace will be slow and the levels will remain historically low. Canada s economy s showed surprisingly large monthly increases in real GDP in January and February... year bond yields: U.S. and Canada.. Canada U.S. Real GDP: Canada Month-over-month, change.8........ -.. Jan- Jan- Jan- Jan- Jan- -. Jan- Jul- Jan- Jul- Jan- Jul- Jan- Source: Reuters, Federal Reserve, RBC Economics Research Source: Statistics Canada, RBC Economics Research...combined with March s surge in exports sets up for the real GDP growth of. at an annualized rate in the first quarter. No action by central banks is likely this year given the high levels of slack in the economies and low inflation. Contribution to GDP: Net exports in Canada Pt, annualized 8 Overnight rates: Canada and the U.S. U.S. - - Canada 8 9 Source: Statistics Canada, RBC Economics Research Source: Federal Reserve Board, 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