The weekly ovewview (ZT 7.22)

BMO Weekly Ovewview

The US bond market extended its recent downtrend after Alan Greenspan warned of the need for further rate increases and the Chinese government announced a revaluation of the yuan. The Chairman, in his semi-annual Monetary Policy Report to Congress, projects "sustained economic growth and contained inflation pressures," although this outcome requires the Fed "to continue to remove monetary accommodation." Barring unexpected weakness in the economy, the Fed appears committed to raising rates at the next two policy meetings at least.

The Chinese government revalued the yuan by 2% against the greenback and announced a shift from a fixed regime vis-à-vis the dollar to a managed float relative to a basket of currencies. The initial revaluation alongside the prospect of a further gradual appreciation of the yuan should, over time, moderate the Chinese government’s appetite for US Treasuries. In recent years, China has held the yuan’s value steady against the dollar largely by purchasing massive quantities of Treasuries to recycle its earnings from a soaring trade surplus with the US.

The US economic data, though a sideshow to the other important events this week, were generally positive. Housing starts stayed at a high level of 2.0 million units annualized in June. The leading economic indicators index surged 0.9% in the same month. The Philly Fed index of manufacturing conditions returned to positive territory in July, rising to 9.6 from -2.2 in June. Initial jobless claims plunged to 303,000 in the week ended July 16 from 337,000 the previous week. The claims data, however, are notoriously volatile in July due to the difficulty of adjusting for the seasonal influence of auto plant shutdowns.

Most overseas currencies rose against the dollar after the yuan announcement, as China will likely act to diversify more of its foreign exchange reserves. Sterling, however, was one of the few major currencies to fall against the greenback. It was undermined by growing expectations of a UK rate cut and by concerns about the possible economic fallout from a second terrorist bomb attack on London’s transportation system. The minutes of the Bank of England’s July policy meeting revealed that almost half of the voting members opted for a rate cut. The minutes, coupled with a soft 0.4% expansion of UK real GDP in the second quarter (not annualized), likely flags a reduction in the repo rate at the August policy meeting.

Due to weak data, the Canadian dollar rose only slightly against the generally soft greenback. Canadian retail sales plunged 1.3% in May, highlighting a downside risk to our estimate of 2.8% growth in second-quarter GDP. The Bank of Canada’s core measure of annual CPI inflation eased to 1.5% in June from 1.6% in May, and sits comfortably below the 2% mid-point target. The data, though unlikely to dissuade the Bank from raising rates at the September 7 fixed announcement date, will keep the pace of future tightening gradual.

Sal Guatieri, Senior Economist, 416-867-5258
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TD The Weekly Bottom Line

July 22, 2005

HIGHLIGHTS

• Chinese currency is revalued upward – the start of more to come?
• Greenspan reiterates higher rates to come in the U.S.
• Canadian inflation remains subdued

What started as a quiet week morphed into a rather notable one in the blink of an eye on Thursday morning by two very different, but equally unanticipated, events. The first was another series of terrorist attacks on London, suggesting that the attacks of two weeks ago may not be an isolated incident. As with the previous attacks, although the psychological damage may be profound, the economic implications appear rather limited. By contrast, the potential economic implications arising from the second event of note may prove to be rather more substantial. The Chinese currency was finally revalued, and although the appreciation was quite modest and the currency is still not truly floating, the action marks a telling change in stance that could jump-start the rebalancing of some of the more egregious trade imbalances around the world. In other, less ground-breaking news, Alan Greenspan weighed in on the U.S. economy, and Canada had a couple of major economic releases, revealing subdued inflation and declining retail sales.

Chinese revaluation

For years, many have called for an appreciation of the Chinese renminbi so as to more accurately reflect market fundamentals. But when the move was actually made early Thursday morning, it caught just about everyone by surprise. Officially, the renminbi appreciated by 2 per cent versus the U.S. dollar, bringing the exchange rate to 8.11 per U.S. dollar. This in itself isn’t a very large shift, and will do little on its own to dampen China’s growing trade surplus or the U.S.’s massive trade deficit. But the situation is complicated by the fact that China is switching to what they call a managed floating exchange rate (more conventionally known as a crawling peg). As a result, the currency will be allowed to shift by up to +/-0.3 per cent per day. While this doesn’t sound like much, it can certainly add up over time. To illustrate, under the most optimistic scenario of a 0.3 per cent appreciation per trading day, the renminbi could theoretically end the year more than 30 per cent higher than today – and clearly a change of this magnitude would have a substantial impact on trade balances. This extreme scenario seems unlikely, however, and early evidence suggests China may continue to intervene in markets to prevent excessive appreciation of their currency. As such, the true extent of the currency regime shift remains difficult to gauge, and is compounded by the fact that the crawling peg is versus an undisclosed basket of currencies (although apparently U.S.-centric).

Regardless, the move represents a baby step in the right direction, both for China and the rest of the world. China has to be happy removing stimulus (however little) from its economy in an effort to slow its recent pace of alarmingly fast economic growth. Meanwhile, China will also benefit from slightly cheaper commodity imports and be incrementally better positioned to make foreign acquisitions on the global stage, to boot. By contrast, the U.S. is clearly pleased that a step has been made toward enabling their own manufacturers to compete more readily with Chinese exporters. Not unexpectedly, U.S. bond yields rose as a consequence of the revaluation as Chinese financing of U.S. government debt is expected to abate somewhat. The issues surrounding the revaluation are addressed in far greater detail in a new TD Economics topic paper entitled “China Revalues the Renminbi”, which is available on our website at http://www.td.com/economics.

Greenspan speaks

Given all of the currency excitement, one could be excused for overlooking Alan Greenspan’s semi-annual speeches to the two legislative bodies of the U.S. government. On this front there was little in the way of groundbreaking news, but the speeches did provide a useful opportunity for the Fed to reiterate their commitment to a path of rising interest rates in the U.S.

Greenspan continued to paint a picture of cautious optimism for the U.S. economy. To quote, “the fundamental factors that supported the U.S. economy in the first half of 2005 should continue to do so over the remainder of 2005 and in 2006.” This is high praise indeed, as the U.S. economy has grown at a very robust pace in recent quarters. As a result, the stage seems set for a continuation of the now-familiar trend of “measured” quarter percentage point increases at each Fed meeting. Consequently, we expect that the U.S. Fed Funds rate will rise to 3.5 per cent on August 9th, the next Fed meeting date, and we further anticipate two additional hikes beyond that one before the year is out.

Greenspan also highlighted four key risks to the U.S. economic outlook: the possibility of a productivity slowdown, the effect of high energy prices, the sustainability of the housing market boom, and the ongoing stimulus from low long-term interest rates. Each of these have the potential to adversely affect the U.S. economy in different ways. We share his qualms, and have accordingly reflected this in our U.S. economic growth forecast for 2006, which tails off sharply toward the end of 2006 as some of these risks hit home. This anticipated slowdown could, in turn, weaken the Canadian economy over the same time frame.

Canadian economic data

Canadian inflation arrived in a rather subdued fashion, with core prices unchanged in the month of June. Seasonal factors were the main cause of the decline, but the fact remains that the annual pace of core inflation is just 1.5 per cent right now, and prices are unlikely to gain much momentum in July given the unrolling of “employee discounts for all” on car prices across the country. Why, then, has the Bank of Canada signaled its intention to raise interest rates in the “near term”? The answer is that a number of precursors to inflation have reared their heads, such as a tight labour force, high capacity utilization, and rising inflation expectations. And, the fact that Canadians pulled back on spending in May via a 1.3 per cent drop in retail sales is unlikely to change the Bank’s thinking very much. This is because retailers enjoyed a sizeable amount of spending growth earlier in the year, and also because the primary culprit for the drop in May – lower auto sales – has apparently been reversed in June and will almost certainly see massive growth in July as a result of the aforementioned discounts.

Eric Lascelles, Economist
416-982-6420