The weekly ovewview (ZT 8.5)

TD weekly report

August 5, 2005

HIGHLIGHTS

• Canadian economy creates only 5,900 jobs in July, but Bank of Canada rate hike still on tap for September
• U.S. labour market pumps out 207,000 new positions, setting stage for Fed to raise rates next week

In a holiday-shortened week on this side of the border, the Canadian Labour Force Survey for July was the only data release of note, and it certainly ended the week on a sour note. In contrast to expectations for a gain of about 20,000 positions, Canada’s labour market managed to eke out only 5,900 new jobs last month. And, the details of the report weren’t a great deal more encouraging. Employment in the goods-producing sector fell by 40,000 positions, led by big declines in manufacturing and construction. The offset came from the creation of 46,000 jobs on the service side, led by gains in retail and wholesale trade, health care and social assistance, and information, culture and recreation. Full-time employment was also down, and the weaker pace of job creation overall helped nudge the unemployment rate up a notch, to 6.8 per cent.

A disappointing report, then, but not bad enough to warrant a change in our view that the Bank of Canada will resume raising interest rates this September. First of all, the pause in employment growth in July follows several months of strong increases, with gains since the start of the year averaging just under 16,000 positions a month. Given that the Canadian labour market typically creates about 20,000 positions a month when the economy is growing at its potential rate of near 3 per cent, this recent performance is consistent with the sub-par growth the economy has recorded so far this year. Second, the reasons for that sub-par performance – weakness in Canada’s export-oriented manufacturing industries, which are still coping with the fallout from last year’s rise in the Canadian dollar – were also the main contributors to the shortfall in the July jobs tally. By contrast, domestic demand in Canada has been expanding at close to a 4-per-cent pace, accounting for the strong gains in service sector employment.

As we noted in the June TD Quarterly Economic Forecast, we believe the Canadian economy is gradually completing the adjustment to a stronger currency, which suggests that the drag from the external sector should fade in the second half of the year. With domestic demand still robust, the Bank of Canada will be eyeing capacity pressures in the economy – indeed, at 6.8 per cent, Canada’s unemployment remained just a snick above a multi-decade low last month. To be sure, lingering concerns about the manufacturing sector suggest that the Bank does not need to take an aggressive approach to reining in monetary stimulus. But, with the overnight rate at 2.50 per cent, there is clearly room to nudge short-term rates higher to guard against a build-up in inflationary pressures. But, that won’t be enough to reverse the recent widening in Canada/U.S. interest-rate spreads, which have gapped out by about 20 basis points since early July. The catalyst here has been a string of positive U.S. economic data – of which this morning’s payrolls report was only the latest example – that has sparked a bigger sell-off in bonds south of the border.

U.S. jobs data complete case for Fed rate hike next Tuesday

After several months of fretting publicly about the unusually low level of U.S. bond yields, Fed Chairman Alan Greenspan will likely have been comforted by the recent action in the Treasury market, which has seen yields rise by about 25 basis points since the start of July. Some hawkish remarks from the Fed Chairman in his semi-annual monetary policy testimony to the U.S. Congress last month probably contributed to the rise, but yields were already getting a lift from strong economic data and the upward revision to the core PCE deflator released with last Friday’s U.S. GDP numbers. Those GDP numbers also show that the U.S. economy is still firing on all cylinders, with real final sales expanding by nearly 6 per cent. Indeed, the only thing that held overall real GDP growth back to 3.4 per cent was a massive drag from inventories, which actually declined outright, shaving 2.3 percentage points off the headline tally.

Earlier this year, there were concerns that the U.S. economy might have hit a soft patch. It looks as if U.S. firms shared those fears and were cautious about stocking their shelves. As a result, when demand came in stronger than expected in the second quarter, businesses had to draw down on existing stock – delivering in a single quarter an inventory correction that some had feared might be a drag on growth through the second half of the year. Instead, the stage is now set for production to rebound strongly in the third quarter – also the message conveyed by this week’s ISM manufacturing index, which recorded its second consecutive monthly gain, with the new orders and production indices both climbing back above the 60 mark.

And now, this morning brings a better-than-expected performance from the U.S. labour market – something that has not been a common occurrence in this business cycle. Beating expectations for a gain of 180,000 positions, the U.S. cranked out 207,000 new jobs in July, along with an extra 40,000 added to the two prior months’ totals. Other than some weakness in the manufacturing sector, the gains were broadly based and were accompanied by respectable growth in average hourly earnings. Given the strength in other indicators seen over the last month – retail sales, industrial production, durable goods orders, and new and existing home sales all came in above expectations – even a weak labour market report would likely not have stayed the Fed’s hand next week. Today’s numbers virtually seal the deal for a move, giving the FOMC the last piece of ammunition it needs to take the funds rate up another 25 basis points to 3.50 per cent.

Setback for the U.S. dollar this week

The strong U.S. payrolls report helped reverse what had otherwise been a fairly steady decline in the U.S. dollar this week, as speculation mounted about another near-term adjustment in the Chinese renminbi’s U.S. dollar exchange rate. Chinese authorities were quick to downplay the idea, but the U.S. dollar still ended the week in the red. And, outside of the emerging market bloc, where the Brazilian real was the star performer, one of the biggest gainers for the week was the euro. The single currency shrugged off another week of high crude oil prices and a less than favourable report from the IMF, rising by 2 per cent to nearly 1.24 USD/EUR. The euro was buoyed by better data out of Germany, where factory orders and industrial production both surprised on the upside – suggesting that the European Central Bank may continue to keep rates on hold, as it did again this week. The pound sterling also managed to gain ground versus the dollar, despite the Bank of England’s decision to lower its base rate by 25 basis points – the first move in U.K. rates in more than two years. Indeed, the Canadian dollar was the laggard of the industrialized country pack this week, edging up by less than half a per cent versus the greenback, as negative spreads and today’s less than stellar jobs report took their toll.

Gillian Manning, Economist
416-982-2559

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BMO weekly report

The week saw some encouraging US economic reports that reinforced expectations that the Fed will continue to tighten policy near term. This had the expected effect of sending long bond yields higher over the week though it only tempered the extent of the US dollar’s depreciation. The latter occurred despite the Bank of England cutting its repo rate 25 basis points to 4.50% and the European Central Bank holding the refi rate unchanged at a still low 2.00%. The more dominant factor in foreign exchange markets was increasing speculation that overseas central banks were diversifying their reserves away from the greenback. This was reinforced this week by reports that the Russian central bank was increasing its holdings of the euro at the expense of the US dollar.

The most encouraging news this week was Friday’s solid 207,000 gain in July US payroll employment which followed upwardly revised gains in the previous two months of 166,000 and 126,000. The July unemployment rate remained low at 5.0% though this was unrevised from June. The gain in employment was largely skewed towards services-producing sectors though within this component the gains were relatively broadly based.

The week started on an optimistic note with Monday’s ISM diffusion measure for manufacturing rising much more than expected in July to 56.6 from 53.8 in June. The comparable ISM measure for non-manufacturing remained very strong in July at 60.5 though this was down from 62.2 in June. Also providing encouragement was a 1.0% jump in June manufacturing new orders which built further on a 3.6% surge in May. Non-defense capital goods orders excluding aircraft, a good leading indicator of investment activity, soared 3.9% in the month and more than offset a 0.7% drop in May. Finally, July motor vehicle sales were exceptionally strong rising to an annualized 20.9 million units up from 17.5 million units in June. However this strength largely reflected the temporary introduction of generous buyer incentive programs that may have just borrowed activity from subsequent months.

The Canadian dollar appreciated this week as it too benefited from speculation that central bank diversification out of the US dollar will spur greater demand for the loonie. High energy prices and expectations that the Bank of Canada was poised to resume tightening in September abetted this trend. A 25-basis point hike in the Canadian overnight rate next month to 2.75% remains fully priced in financial markets. However, the probability of further hikes was lowered somewhat in the face of a disappointing Canadian July employment report this week. Net hiring in Canada rose a negligible 5,900 (0.0%). This was insufficient to offset new entrants coming into the labour force, contributing to the unemployment rate rising to 6.8% from 6.7% in June. Particularly disappointing was a large drop in manufacturing employment which resurrected concerns about the high value of the Canadian dollar providing too much restraint on export activity.

Paul Ferley, Assistant Chief Economist, 416-867-7842
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