The greatest source of weakness seemed to emanate from real estate and construction. On the housing side, it was reported that “nearly all Districts reported sluggish housing markets” although this was in large part due to the expiration of the homebuyer tax credit April 30. The picture was bleaker for the commercial and industrial real estate side of the economy, where markets “continued to struggle in all 12 Fed Districts” and did not reflect any payback from some earlier strength.

Discussion of consumer spending was somewhat more upbeat with reports that “retail sales during the early summer months were generally positive, although in most Districts the increases were modest.” It was noted, however, that necessities tended to be the strong sellers with “big-ticket items” moving more slowly.

The assessment of the manufacturing sector was that activity “in most Districts continued to move up,” although it was the case that activity had slowed or levelled off in six of those Districts. In June, it was stated that manufacturing activity was gradually improving in all 12 Districts.

The characterization of labour markets was that “market conditions improved in several Districts” led by gains in New York, Chicago, Minneapolis, Richmond and Atlanta. Four districts noted “that they continued to rely in temporary staff over permanent hires.” Within the Dallas area, it was noted there were significant layoffs in the energy sector related to the moratorium on deepwater drilling in the gulf region.

With high unemployment persisting, it was reported that “wage pressure remained largely contained” and that “prices of goods and services were relatively stable in most Districts.”

Most districts reported that bank lending standards remained restrictive.

Today’s beige book report implies some easing in the pace of growth. Although some of this deterioration may be attributable to earlier strength in areas such as housing that borrowed from subsequent periods, this was not generally the case. This slowing implies even less progress in terms of reducing a still high unemployment rate. Thus, with inflation likely to remain very low, the central bank is unlikely to be in any rush to start tightening. Our forecast does not have the Fed funds being hiked until the second quarter of 2011.

• Stress test results are in–Yawn
• Sterling bolstered as some of the economic gloom lifts
• German recovery becoming difficult to ignore
• JPY-strength becoming an issue in Tokyo
• Key data and events to watch next week

Stress test results are in–Yawn

The long-awaited results of the Eurozone banking sector stress tests were delivered on Friday and markets greeted them with a collective yawn. Earlier leaks led markets to conclude the adverse scenarios would not be especially stringent, causing most to discount the results. To re-cap, only 7 of the 91 banks tested failed, requiring a total of only EUR 3.5 bio to be raised in new capital. To put that number in perspective, some analysts reckon Spanish banks alone need to raise EUR 40 bio to be adequately capitalized. The stress tests also excluded the potential for a sovereign debt default and focused only on securities held in banks’ short-term trading books, and not the 90% of banks’ government bond holdings that are classified ‘hold to maturity.’ But the basis of the European debt crisis was exactly that–banks holding large amounts of Euro-area government debt were vulnerable in the event of a sovereign default. The lack of credibility of the stress tests raises the risk that market concerns over Euro-area financial sector stability will resurface, leading to another round of speculation that the EUR is a doomed currency.

The one potential bright spot to emerge from the stress tests are disclosures of individual bank’s holdings of government debt of Greece, Spain and Portugal, but those numbers were not available on Friday. They are expected to be divulged over the next two weeks. Revealing which institutions hold what amounts of troubled government debt will allow banks to more accurately determine which of their counterparties are most risky, and potentially improve credit market functioning and overall stability. Another possibility is that revealing government debt will lead to a two-tiered lending environment, with those holding significant exposures being forced to pay up or rely further on the ECB. We will be watching closely to see how European inter-bank lending rates move to start next week as the decisive measure of the market’s acceptance of the stress test results. Going into the stress test results on Friday, with all that was known about the tests beforehand, 3-month Euribor rates were at the highest levels for the year, suggesting that credit markets remain on edge.

Against this backdrop, risk assets performed reasonably well in the past week, with stocks rebounding and making new gains, JPY-crosses at their highs (but still below recent highs), and the USD nearer to its lows against most others. Continued positive corporate earnings reports appear to be holding sway, but the overall environment remains extremely fragile and of low conviction. At the close of the week, risk looks like it may test higher next week, just as it looked set to extend losses at the end of last week. The passing of the stress test ‘event risk’ may propel risk higher in the near-term, but with more questions raised than answered, we think gains in risky assets are likely to prove unsustainable. As well, recent positive data surprises obscure the risks from a pending US slowdown into year-end, which is likely to echo around to other major economies. In this environment, we would suggest maintaining an extremely short-term trading bias and remaining alert for sharp intra-day reversals.

Sterling bolstered as some of the economic gloom lifts

There is a broad consensus that the second half of this year will be difficult for the UK economy as it struggles in the face of budget reform. The news that Q2 GDP was far stronger than expected (+1.1% q/q) doesn’t change this impression but it significantly reduces the chance that the UK economy will fall back into double dip recession on the back of austerity measures. The additional growth should soften the government’s budget projections and should help heal the deficit a little faster than previously expected. Since UK growth in Q2 was quicker than expected it follows that inflation potential may also be a little firmer. Recent economic data does not support this view with headline CPI slipping back and average earnings moderating. That said there is sufficient fodder in price data for the UK inflation hawks to remain on edge. The impact of the GDP report was thus to send sterling sharply higher. EUR/GBP pushed below the 0.8390 technical support following the data release. A fall below 0.8310/20 could suggest another leg lower. Cable has broken above the USD1.5330 level which has strengthened the technical outlook. A break above USD1.5450 may see towards 1.5525.

German recovery becoming difficult to ignore

The German July IFO survey surged to 106.2 in July, outpacing both the market consensus and the June data by a generous margin. The release comes on the heels of stronger than expected German PMI data and provides more evidence that Germany’s economic recovery continues to gather pace despite the loss of momentum in the US economy. Both the current and expectations components of the IFO surprised on the upside. Recent German surveys have shown some hesitancy in the expectations components, so the IFO’s result suggests that the impact of the sovereign debt fears may have peaked. The current disparity between US and German economic data provides an interesting backdrop for the continued move higher in Euribor; though the ECB have attributed this to market forces. While there is little risk that the ECB will hike the refi rate at least before the middle of next year, the firmer Euribor is likely to offer EUR/USD decent near-term support. Medium-term the EUR remains susceptible to difficulties that some European banks may have in recapitalising themselves. Near-term, the USD1.2700 support continues to hold solid and risk is for another run at the USD1.3000 level.

JPY-strength becoming an issue in Tokyo

Japanese officials have stepped up their verbal rhetoric against continuing JPY strength, with comments coming from senior leaders at the BOJ and the MOF. Most highlighted the risk of a stronger yen being a significant danger to future growth in the Japanese economy. This week’s Q2 earnings reports, as well as the highly awaited announcement of the European stress tests were major sources of pessimism over the past few weeks. The fact that both came and went without much fanfare has calmed the markets and reassured investor sentiment. Thus, the Yen has weakened against every major currency in the G10 this week; of note: USD/JPY (86.50 to 87.40), EUR/JPY (111.60 to 112.90) and AUD/JPY (75.25 to 78.30) rose over 4% this week alone.

The BOJ will continue to monitor market activity closely as increased global risk aversion is still on the forefront and could lead to fresh JPY-strength. There have been rumors of semi-official interest to buy USD/JPY down around 86.20/30 in the short term and we’re likely to see further verbal intervention if it reaches 85.00. However, it is rather unlikely the BOJ will take further measures on additional strength unless it rapidly appreciates towards the 80.00 level, then the odds of actual intervention would become highly probable.

Key data and events to watch next week

The calendar in the US is moderately busy in the week ahead. Housing numbers kick off the week with June New Home Sales on Monday and the May S&P/CaseSchiller Home Price Index to follow on Tuesday. Also on tap for Tuesday are the Richmond Fed Manufacturing Index and the Consumer Board’s Confidence Index for July. The data slate for Wednesday sees Durable Goods Orders for June followed by the Fed’s Beige Book in the NY afternoon. Weekly Jobless Claims are scheduled for its regular release on Thursday. Friday’s data sees Q2 GDP, Q2 Personal Consumption, Q2 GDP Price Index, and Q2 Employment Cost Index. Data for the week wraps up with Chicago PMI and University of Michigan Survey of Consumer Confidence Sentiment for July.

In the Eurozone, Wednesday sees the release of the Business Climate Indicator, Consumer Confidence, and Industrial Confidence numbers for July. Friday closes out the week with June Euro-zone Unemployment Rate and July CPI Estimate. In Germany, Tuesday sees the August GfK Consumer Confidence Survey and June Import Price Index. The data session comes to a close on Thursday with July Consumer Price Index and July CPI – EU Harmonized. In addition to the upcoming data releases, there will be top tier Q2 and first half earnings releases, kicking off with Deutsche Bank on Tuesday.

A light week of data in the UK starts with July Nationwide House prices, June Net Consumer Credit, and June Mortgage Approvals on Tuesday. There is no significant data due out until Friday, however the BOE’s King, Bean, Fisher, and Sentance will be testifying on the May Inflation Report at Parliament’s Treasury Committee on Thursday. Friday closes out the week with the July GfK Consumer Confidence Survey.

Data out of Tokyo is moderate, starting with June Retail Trade and Large Retailers’ Sales on Wednesday. Thursday sees June Unemployment Rate, July Tokyo CPI, June National CPI, and June Industrial Production. Friday wraps up the week with June Housing Starts.

Canada begins a light week of data with Industrial Product Prices and Raw Materials Price Index for June on Thursday. The data session comes to a close with May Gross Domestic Product MoM on Friday.

A light calendar down under begins with Q2 PPI and CPI due out on Sunday and Tuesday. The week wraps up with June Private Sector Credit on Thursday. New Zealand begins the week with July NBNZ Business Confidence on Tuesday. Wednesday will have the RBNZ rate decision with expectations for a 25 basis point hike to 3%. Data continues on Wednesday with June Trade Balance and wraps up on Friday with June Building Permits.

Home Is Where the Economy’s Heart Is

• Housing starts and existing home sales declined in June, reflecting the winding down of homebuyer tax credits.
• Building confidence fell to 14 in July, and June’s numbers were revised down slightly.
• The effect from the unwinding of various economic stimulus programs is evident in other data, with the leading indicators declining 0.2 percent and weekly firsttime unemployment claims bouncing back to 464,000.
• Bernanke’s midyear report to Congress outlined possible future steps the Fed may take to boost economic growth.

We Have Got to Get in Shape

If the state of the nation’s housing market is at the center of the economy’s near-term prospects, then we have got to get in shape. Nearly all of the major housing indicators reported this past week showed more weakness than was widely expected, suggesting that the payback from the homebuyer tax credit program will be a bit deeper and longer lasting than many had hoped. One of the most disconcerting pieces of news was housing starts, which fell 5 percent in June, following a downwardly revised 14.9 percent drop in May. A slight 2.1 percent rise in building permits initially took some of the sting out of the headline number, but all of that gain was in the volatile multi-family unit series. Permits for new single-family homes fell 3.4 percent, following 10.3 percent drops in both May and April

Single-family permits are now running at just a 421,000-unit pace, well below the recent trend in starts. When you couple this with July’s decline in the Wells Fargo/NAHB homebuilders’ index, there is no reason to expect housing starts to increase in July, and we may not see a gain in August either. With demand flat and credit for homebuilders still extremely tight, there is no incentive for builders to get out ahead of demand.

Existing home sales actually fell less that expected, but the trend remains unfavorable. Existing home sales have been harder to read because of the extension of the closing deadline for homebuyer tax credits from June 30 to September 30. The net effect of the deadline extension will be to moderate the slide in existing home sales over the new few months.

The latest data from the National Association of Realtors (NAR) shows that first-time homebuyers accounted for 43 percent of home sales, about the same as the prior month. Distressed transactions, which include foreclosures and short sales, accounted for 32 percent of existing home sales in June, and investor purchases accounted for 13 percent. One of the more worrisome aspects of the report is that the number of homes on the market increased in June and remains relatively high. There is currently a 10.6-month supply of condominiums on the market and 8.7-month supply of single-family homes.

There were also a couple of pieces of encouraging news. The median price of an existing home rose 1.0 percent from last June to $183,700. The NAR also noted that home prices rose in 10 of the 19 MSAs that report monthly, and sales increased in 12 of those 19 areas. In addition, mortgage applications for the purchase of a home rose 3.4 percent, as the lowest mortgage rates on record are beginning to pull some buyers back into the market.

Fed Chairman Bernanke delivered his midyear report to Congress this week and basically reiterated the forecast released in the minutes of the June FOMC meeting. The markets were initially bewildered that the Fed chairman did not focus more on the deterioration in economic activity and growth prospects that has occurred since that forecast was put together. He redeemed himself, however, by focusing on what steps the Fed could take to further stimulate economic activity.

U.S. Outlook

New Home Sales • Monday

Giving back two months of solid gains, new home sales plummeted 32.7 percent in May to a 300,000-unit pace, the lowest level on record. Demand for new homes was pulled forward due to the homebuyers’ tax credit, which required buyers to sign a contract by April 30. With mortgage applications for purchase declining 14.8 percent in June, we expect at least one more month of payback. New home sales will likely fall 3.3 percent in June to a 290,000- unit pace, setting a new record low. Moreover, the downward trend in other indicators such as builder sentiment, permits, and starts continue to suggest weakness in the housing market. With new home sales at such depressed levels, a modest recovery in sales could be imminent following the tax credit payback, but any rebound in housing will likely be painfully slow.

Previous: 300K Wells Fargo: 290K Consensus: 320K

Durable Goods • Wednesday

Advance orders for durable goods fell 1.1 percent in May, driven largely by a 29.6 percent drop in nondefense aircraft orders. The decline in aircraft bookings was mostly payback from a 215.7 percent surge in April. The underlying components of the report were far more sanguine than the headline suggested, with machinery, primary metals and computers and electronics bookings all increasing on the month. New orders excluding the volatile transportation sector were up 0.9 percent in May and will likely continue to improve in coming months, but at a modest pace. Moderating its positive momentum, the ISM manufacturing index pulled back for the second consecutive month in June, likely suggesting slower manufacturing activity in the second half of the year. We expect headline durable goods to increase 1.2 percent in June, with orders excluding transportation rising 0.8 percent.

Previous: -1.1% Wells Fargo: 1.2% Consensus: 0.8%

GDP • Friday

The economic recovery that likely began a little more than a year ago is beginning to lose momentum. Much of the slowdown can be attributed to the fading of fiscal stimulus programs and the ending of the inventory cycle. Moreover, recently released economic data on retail sales and foreign trade also suggest the economic recovery is moderating. Core retail sales, which excludes auto dealers, gasoline stations and building material stores, rose only 0.2 percent in June and posted negative readings in April and May. This component of retail sales closely parallels personal consumption and suggests another quarter of weak consumer demand. International trade could also weigh down economic growth. The trade deficit widened in May and may shave 1.0 percentage point from second quarter GDP growth. Consequently, we expect real GDP likely grew at a 2.4 percent pace in the second quarter.

Previous: 2.7% Wells Fargo: 2.4% Consensus: 2.5%

Global Review

U.K. Economy Breaks into a Sprint, but Will It Last?

• The U.K. became the first major economy to report GDP growth for the second quarter. Expectations were blown away as growth expanded at the fastest clip in nearly a decade. But, given the fiscal deficit problems and upcoming cuts in government spending, does the U.K. economy really have the legs to keep up this pace?
• Fiscal tightening is not the only concern in the United Kingdom. The overall rate of CPI inflation is well above the Bank of England’s target of 2 percent, and the January increase in the value-added tax complicates the outlook for inflation.

Strong Growth Will Face Headwinds in the U.K.

During the global recession, the U.K. economy was among the hardest hit in terms of major developed economies, with real GDP falling more than 6 percent. Since then, a tepid recovery has taken hold and, until very recently, sequential economic growth has been weak even with the benefit of low base effects. But developments in the United Kingdom this week including a decent retail sales report and a stellar GDP print for the second quarter might seem to suggest something different. Is the U.K. economy finally catching the wind in its sails? Unfortunately, we suspect the sequential growth rate in the second quarter will likely be the high-water mark for the next several quarters and the expansion will slow somewhat as fiscal tightening and deficit reduction programs sap economic growth in coming quarters.

The Bank of England’s (BoE) Monetary Policy Committee (MPC) on Wednesday released the minutes from its meeting earlier this month. As was widely expected, the MPC left rates at the very stimulative present level of 0.50 percent. There is clearly a divergence among the members of the MPC as to the timing of dialing back stimulus from the U.K. economy. Even as one member voted for a hike in the target benchmark rate, the minutes revealed that the “committee considered arguments in favour of a modest easing in the stance of monetary policy.” While the recovery appears to be building up steam, the overall rate of CPI inflation is well above the Bank of England’s target of 2 percent at present. Adding to inflation concerns, the MPC agreed that, in the near term, “inflation was likely to be higher.” Our view is that fiscal tightening will exert headwinds on growth over the next few quarters, and there seems to be support for that position among the MPC members. That is why we are not forecasting a rate hike until the second half of 2011. The valueadded tax hike in January may keep the overall rate of CPI inflation elevated, but underlying inflationary pressures should remain benign.

Thursday’s retail sales report for June showed that sales climbed 0.7 percent in the month and, excluding the volatile auto fuel component, sales climbed 1.0 percent. Month-to-month changes in retail sales are notoriously choppy, and it should be noted that retail sales have been tepid so far in this recovery; the jump in June may also reflect a temporary boost in spending related to England’s participation in the World Cup.

Finally, at the end of the week, the United Kingdom became the first major developed economy to report second quarter GDP. U.K. GDP grew at a 4.5 percent pace in the second quarter after increasing at a mere 1.3 percent pace in the previous quarter. We do not yet have a breakdown of GDP into its various components, but preliminary details suggest a jump in construction sector spending. There was also an increase in government services output, an area where support will likely be absent in coming quarters as government spending is scaled back. Going forward, we do not expect the U.K. economy to match this pace of growth as it struggles to overcome headwinds from fiscal tightening.

Global Outlook

Japanese Retail Sales • Tuesday

The Japanese economy has expanded in each of the past four quarters, and total real GDP has retraced roughly half of the ground lost in the recession. Part of the recovery story in Japan has had to do with surprising strength in domestic demand. Indeed, retail sales climbed steadily in every month of the year through April before falling 2.0 percent in May. This moderation is consistent with our outlook for slower growth in the second half of the year. On Tuesday, retail sales data for June will become available. The June measure of consumer confidence surged to its highest level since 2007, which may suggest shoppers in Japan returned to the stores in June, but we do not expect strong consumer spending to last. Also out next week in Japan are data on housing starts and construction orders on Friday, which will shed light on the housing situation.

Previous: 2.8% Consensus: 3.2%

German CPI • Wednesday

As the largest economy in the Euro-zone, economic trends in Germany can influence decisions made by the European Central Bank (ECB). In ordinary times, the ECB targets an inflation rate of just under 2 percent. The year-over-year harmonized inflation rate for Germany slipped to 0.8 percent in June. A July CPI figure is expected on Wednesday of next week. A modest recovery in oil prices during the month could help lift the year-over-year rate somewhat, but inflation pressures will likely remain benign for the near future. This gives the ECB cover to keep its target rate at 1.00 percent, and to continue its other unconventional methods of stimulating the economy such as providing a nearly limitless supply of credit to banks. In addition to usual concerns like balancing growth and inflation, the ECB has the additional consideration of keeping the sovereign debt situation from spinning out of control.

Previous: 0.8% Consensus: 1.1%

Euro-zone Unemployment Rate • Friday

The unemployment rate in the Euro-zone held steady at 10 percent in May – the highest level of joblessness in more than 11 years. When the ECB recently dialed back its growth outlook for the second half of the year, ECB President Jean-Claude Trichet noted “weak labor market prospects” as one of the bank’s primary worries.

The June unemployment number will hit the wire on Friday and will give financial markets a sense of whether hiring is picking up. We suspect employers across the Euro-zone will be sitting on their hands, holding back on big expansions or mass hiring until they become convinced that the sovereign debt situation is under control and until they get a better sense of how growth will be shaping up in the second half of the year.

Previous: 10.0% Consensus: 10.0%

Point of View

Interest Rate Watch

The Fed Still Has Some Bullets Left

Fed Chairman Ben Bernanke broke precious little new ground in his midyear report to Congress and essentially reiterated the forecast issued in the minutes of the June FOMC meeting. The problem with that is economic conditions have clearly deteriorated since the Fed last met, and many forecasts for second quarter growth have been scaled back by a full percentage point or more. With conditions widely thought to have deteriorated further, many of the questions the Fed chairman faced were whether the Fed had any bullets left if the recovery should falter.

Bernanke outlined the steps the Fed could take to provide more stimulus if conditions warranted. He stated the Fed could change its policy statement to indicate that shortterm interest rates would remain near zero for an even longer period. The Fed could also reduce the interest rate it pays on excess reserves. In addition, it could reinvest the proceeds of maturing mortgage backed securities or buy more securities.

While Bernanke’s reasoning is perfectly sound, the first option already appears to have been played out. The financial markets have already pushed the first Fed tightening all the way out into late 2011. Announcing that the extended period had been extended further would seem anticlimactic at this point.

We believe the Fed is putting on a brave front. While he stood by the Fed’s forecast, Bernanke also noted there are downside risks to the forecast and also spent considerable time lamenting the problems with persistently high unemployment. We expect the Fed to reduce its forecast later this year.

A second round of quantitative easing was always a long shot unless we saw severe deterioration in the economic outlook or some sort of exogenous shock. That said, the Fed would be wise to keep its powder dry. There are still huge unresolved issues with the sovereign debt crisis in Europe and municipal finances in the U.S.

Consumer Credit Insights

A New Credit Paradigm

Consumer spending as a share of real gross domestic product (GDP) has risen from 60 percent in the early 1950s to 70 percent today. These were the heydays of American consumer might. These were the days when if you wanted something, you bought it, with little thought to if you could afford it. This was fueled by a post-war economy that continued to innovate, expand and grow. More recently, this was accompanied by a severe lack of concern for the credit quality of borrowers, which led to a credit explosion. Even the Great Recession didn’t stop this trend, as the peak of consumers’ share of real GDP was reached in the third quarter of 2009. But the U.S. economy is going through a structural shift, characterized by a new credit paradigm.

With the passage of the Financial Regulation (FINREG) Bill, as the banks warned, credit is likely to be more scarce than it already is. The new rules will force banks to hold more capital, which could restrain loan growth. In addition, due to the reduction in interchange fees and other stipulations in the bill, banks will need to find new sources of revenue. All of this will likely lead to less reliance on credit, a more frugal consumer and a smaller consumer contribution to GDP. But maybe this isn’t such a bad thing. After all, diversification is a good thing, right? Maybe it’s time to focus more on trade. Increasing exports would support economic growth, likely create more jobs and would help to reduce the current account deficit.

Topic of the Week

A Glimmer of Hope in the Construction Outlook

The Architectural Billings Index (ABI) is a monthly diffusion index that can serve as a leading economic indicator for nonresidential construction spending. The American Institute of Architects surveys around 300 architecture firms across the country where participants are asked whether their billings increased, decreased, or stayed the same. In June, the ABI posted a reading of 46.0, remaining below the breakeven of 50 for nearly two and a half years. The score continues to suggest further weakness ahead for nonresidential outlays.

All is not doom and gloom, however. The ABI, although still below the threshold of 50, has risen significantly since reaching its record low of 33.9 in January 2009. Despite May’s subpar reading, a closer look at its components sheds some light on the future of the nonresidential construction industry. Billings for architecture firms with a commercial/industrial specialization posted a score of 50.6 in June, putting the sub-index in expansionary territory for a second consecutive month. Commercial and industrial construction spending can lag the commercial/industrial sub-index up to 11 months, which suggests better times could be less than a year away in this sector.

The ISM Manufacturing Index, which also closely parallels the commercial/industrial sub-index, has been in expansionary territory for nearly a year and could also portend future growth in the commercial and industrial sector.

It is still too early to predict what will come of the sector and nonresidential construction spending overall, however. Sure, the commercial/industrial sub-index surpassed the breakeven of 50, but two months in positive territory is not nearly enough evidence to prove a recovery. Moreover, while the index provides valuable insight, it is a diffusion index, which can only accurately portray the breadth and not the depth of the industry’s strength. We expect nonresidential construction outlays will continue to fall well into 2010.

HIGHLIGHTS OF THE WEEK

• Fed Chairman Bernanke delivers semi-annual testimony to Congress, in which he noted uncertainty in the economic outlook but stuck to his guns in continuing to prudently plan the ultimate withdrawal of the extraordinary monetary accommodation.
• Chatter of U.S. double-dip recession remains in the headlines. High frequency and leading indicators do support a slowdown, but the indicators are nowhere near levels required to flash a re-entry into a recession. A mid-cycle slowdown remains the most likely outcome.
• No sign that the housing market is breaking free from the doldrums. Starts slip more than market expectations, and while existing home sales beat market expectations, they still backtrack by 5.1% in June.
• In Canada, markets were unscathed by the widely anticipated 25 basis point rate hike by the Bank of Canada (BoC). Reactions, however, followed the ensuing dovish BoC communiqué.
• BoC affirmed that fiscal austerity measures relating to the European sovereign debt crisis appeased the risk of an adverse outcome and lifted the likelihood for sustainable long-term growth, but the global economy will recover at a more moderate pace than previously anticipated. The BoC observed that the Canadian economy has largely developed as anticipated, except for growth in business investment which seems to be constrained by uncertainties surrounding the global outlook.
• We expect a protracted renormalization of the overnight rate, with gradual hikes of 25 basis points through the latter half of 2010 and 2011, albeit interrupted by occasional pauses. The overnight rate should reach 1.25% and 2.50% by the end of 2010 and 2011, respectively.

UNITED STATES – THE BATTLE OF WORDS

When Fed Chairman Bernanke delivered his semi-annual testimony to Congress on Wednesday, equity markets sold off on trepidation that the speech did not address or make a case for additional monetary stimulus. Rather, the central banker noted that "the Federal Reserve continues prudent planning for the ultimate withdrawal of extraordinary monetary policy accommodation." The market reaction was curious in many respects, because the US economy is already one year into an economic recovery and rates remain at record lows alongside a bloated Fed balance sheet. What more can be expected of the Fed? Shouldn’t we be thinking of monetary withdrawal, the potential for persistent low rates to fuel bubbles in other areas, and unacceptable inflationary pressures taking hold one to two years out? The problem rests with the market perception that the recent slowdown in some economic indicators could be a harbinger that the US economy is headed for a double dip. Before addressing this possibility, there must first be an understanding on what a ‘double dip’ actually means. It is not a mid-cycle slowdown, such as real GDP growth downshifting from an average annualized pace of 3.5% over the past three quarters to a 1-2.5% range, which is what we believe is actually occurring. Rather, we take a double-dip to refer to broad-based weakness, marked by a contraction in domestic demand indicators, such as industrial production and private sector jobs. In other words, a return to a recessionary period, like that which occurred over the 1980-1982 period.

So, are the economic indicators pointing to a double dip recession? No. High frequency and leading indicators do support a slowdown, but they are nowhere near levels required to be flashing a re-entry into a recession. The manufacturing ISM index stands firmly in expansion territory at 56.2 – which is even above its long term historical average. An index in excess of 42 generally indicates an expansion of the overall economy and, at the very least, it would have to drop towards the 46 level to be consistent with historical signals of when the US economy was nearing (but not yet in) recession. Private sector hiring is proceeding at a snail’s pace relative to any economist’s preference, but it is proceeding nonetheless. Since the 1960s, a recession has always ensued when the 6-month annualized change of private sector employment was decelerating and went as low as 0.6%. Currently this is not the case, the trend is accelerating and is well outside this danger zone at 1.1% – but this is a great indicator to keep an eye on in upcoming payrolls data. As an aside, the nearly 400,000 temporary workers hired since the end of the recession certainly speaks to the ongoing cautiousness of corporations, but not their disdain to hire. Temporary workers are a leading payrolls indicator, which is still flashing a green light for the expansion.

I could go on through a list of other leading indicators, but since word space is at a premium, I would rather discuss one other possibility tied to the last point made. An alternative to the double-dip recession is what is referred to by the NBER as a ‘growth recession’. This is when the economy is expanding but not at a pace that prevents the level of unemployment from continuing to rise. Although the post 2001 period was not officially marked as a ‘growth recession’, the job losses that ensued in the 19 months following that recession would have made that expansionary period still feel like a recession to many Americans. With firms having hired nearly 600,000 workers since the start of this year, the US economy currently does not satisfy this definition. However, among the various downside risks to the base case mid-cycle slowdown, it seems more probable that an over-cautious business mentality could bleed back into private sector job losses rather than we end up in a position of a double-dip recession. If the former were to occur, however, the Fed would likely be wary about adding in more stimulus in an economy that was still expanding and already had record amounts of monetary stimulus, as it could create problems elsewhere in the domestic or global economy… like investors taking inappropriate risk in search of yield… been there, done that.

CANADA – THE BANK OF CANADA TIPTOES THROUGH RATE HIKES

Attention centred this week around the Bank of Canada’s (BoC) overnight rate announcement on Tuesday and the subsequent release of its quarterly Monetary Policy Report (MPR) on Thursday. While markets were unscathed by the widely anticipated 25 basis point rate hike, reactions followed the ensuing dovish BoC communiqué.

The BoC pointedly characterized the global economic recovery as one that is "not yet self-sustaining". It stressed that while the fiscal austerity measures relating to the European sovereign debt crisis appeased the risk of an adverse outcome and lifted the likelihood for sustainable long-term growth, the global economy will recover at a more moderate pace than previously anticipated. Moreover, it noted that growth in U.S. private demand, while picking up, remains uneven. The BoC affirmed that the Canadian economy has largely developed as anticipated, except for growth in business investment which seems to be constrained by uncertainties surrounding the global outlook. Going forward, business investment and net exports are now expected to contribute more significantly to growth.

All said, the BoC downgraded its real GDP forecast for 2010 and 2011 by 20 basis points relative to its April MPR (from 3.7 to 3.5 per cent in 2010 and from 3.1 to 2.9 per cent in 2011). Our forecast is slightly more pessimistic as we forecast a stronger Canadian dollar (and hence, weaker net exports) and a weaker contribution from consumer spending. While the BoC’s downward revision in forecast growth may seem insignificant, it is projected to delay the closing of the output gap by two quarters, to Q4/2011.

The BoC statement cautiously concludes that "any further reduction of monetary stimulus would have to be weighed carefully against domestic and global economic developments", thereby leaving the door open to an interest rate pause if conditions warrant. The marginal increase in the overnight rate can be expected to have limited economic consequences beyond raising the cost of borrowing on variable rate loans. Longer-term borrowing costs (for example, on a 5-year mortgage) have actually retreated since May, thereby reducing associated debt service costs.

We expect a protracted renormalization of the overnight rate, with gradual hikes of 25 basis points through the latter half of 2010 and 2011, albeit interrupted by occasional pauses. The overnight rate should reach 1.25% and 2.50% by the end of 2010 and 2011, respectively.

The release of the BoC communiqué brought about a temporary appreciation of the CAD vis-à-vis the USD. This was reversed in short order on Wednesday following U.S. Fed Chairman Bernanke’s testimony before Congress stating that the "economic outlook remains unusually uncertain".

This week’s data releases for Canadian retail sales and the Consumer Price Index (CPI) echoed the BoC’s cautious tone regarding the economic outlook. In real terms, retail sales posted a M/M gain of 0.4% in May, largely supported by weaker prices. Meanwhile, the core measure of CPI decelerated to 1.7% in the twelve months leading to June from a gain of 1.8% in May. The upcoming release of the monthly GDP for May next Friday will be closely tracked to gauge activity in Q2 and the extent of the economy’s deceleration from 5-6% growth of the previous two quarters.

U.S.: UPCOMING KEY ECONOMIC RELEASES

U.S. Real GDP – Q2/10

• Release Date: July 30/10
• Q1 Result: 2.7% Q/Q ann.
• TD Forecast: 2.1% Q/Q ann.
• Consensus: 2.5% Q/Q ann.

The slowdown in economic growth following the stimulus and inventory driven recovery came a quarter earlier than expected. After average growth of 3.5% over the last three quarters (all rates annualized), real GDP growth is expected to have slowed to 2.1% in the second quarter of 2010. Much of the slowdown is attributable to a deceleration in consumer spending growth from a rate of 3.0% in the first quarter to just over 2.0% in the second quarter. Retail sales at the outset of the quarter were given a boost by strong spending on building materials, but this wore off quickly and retail sales declined outright in both May and June. Similarly, the homebuyer’s tax credit contributed to rising home sales at the outset of Q2, but this too reversed course as the quarter closed out. Business fixed investment, and especially spending on equipment and software, stands out as the one major bright spot for the quarter, increasing by close to 20%. The rebound in machinery investment comes after an unprecedented decline that has led the stock of capital goods to fall over the last three quarters. On the whole, final domestic demand likely had a fairly good quarter, increasing by close to 4.0%, mostly due to growth early on. Nonetheless, as the trade data revealed, much of this demand went to foreign producers. Import growth is expected to be more than double the pace of export growth, leading net-trade to subtract close to 2 percentage points from real GDP in the quarter. Peering into the second half of this year, expect much of the same – growth to continue but at a not quite satisfying pace.

CANADA: UPCOMING KEY ECONOMIC RELEASES

Canadian GDP – May

• Release Date: July 30/10
• April Result: 0.0% M/M
• TD Forecast: 0.1% % M/M
• Consensus: 0.2% % M/M

The pace of economic activity in Canada has clearly decelerated from the blockbuster rate set during the first quarter of the year. This was to be expected, as one must go back to the heady days of the tech boom to find as rapid of a six month growth rate as we enjoyed through the end of 2009 and into 2010. Alas the release of April’s GDP report, which showed economic activity screeched to a halt, was perhaps a bit too shocking of a deceleration. Looking over the recent spate of soft data, we approached our forecast for May real GDP with some trepidation. Although the nominal growth rate for manufacturing shipments and retail sales were on the weak side, we credit subdued price pressures for supporting their constant-price counterparts. So we anticipate that the service sector will help underpin a 0.1% increase in real GDP in May. When we build out our quarterly forecast, the impact of the slowdown through the first two months of Q2 will make it difficult for the annualized growth rate to exceed 3.0%. This is broadly in line with what the Bank of Canada expects and is consistent with our expectation for a gradual economic recovery over the balance of the year.

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The information contained in this report has been prepared for the information of our customers by TD Bank Financial Group. The information has been drawn from sources believed to be reliable, but the accuracy or completeness of the information is not guaranteed, nor in providing it does TD Bank Financial Group assume any responsibility or liability.

The Fed Chairman, Ben Bernanke dominated currency trading this week adding risk and trader’s aversion back into the mix. When the Federal Reserve worries in public about the lack of job creation in the United States, and says that “properly executed’ tax cuts can benefit an economy, a policy in direct opposition to the government’s plans, markets begin to doubt the security in their own positive economic judgments. The Fed Chair has always been most circumspect in hi economic assessments, if he is willing to pass comment on current government policy, what fears does he hold if no changes are made in Us economic policy?

In the hour after his congressional testimony at 2:00 pm Easter Time the euro dropped almost a figure against the dollar. If the United States economy is then the rest of the world, including China and Asia is as well. Risk renters the currency market and the dollar is the risk slayer of choice.

After taking the cue from their American regulatory colleagues, the European bureaucrats conducting the bank capital adequacy ratings have relied, as they have said they would, on Europe accounting standards to measure their institutions. The 91 banks being assessed will have to take haircuts on sovereign debt that they own only if it is classified as belonging to their trading portfolios not their investment books. The probably result is that a majority of the outstanding debt of Greece, Ireland Spain Portugal and the rest of Europe, owned by European banks will not have any reductions in value and hence the banks will not incur additional capital requirements.

The stress tests assume losses of 23.1% on Greek debt, 14% on Portuguese bonds, 12.3% on Spanish securities, 5.9% on French and 4.7% on German issues, according to Bloomberg.

The different market reaction to potential further quantitative easing by the Federal Reserve between March 2009 and Wednesday is striking.

Last March 18th when the Fed announced its $300 billion Treasury purchase program in the context of new trillion dollar deficits and the dollar got hammered, losing almost five figures on the day again the euro. But that was then. Trillion dollar deficits have become routine. The administration has planned a decade of such and the market reaction is passé. But worry about the state of the US economy and by default the world recession recovery is the current topic. When the Chairman said that “significant time will be required to restore 8 ½ million jobs”, traders heard economic slowdown and potential quantitative easing, one of the few monetary tools remaining to the Fed. This time mortgage rates and the ten-year Treasury are at or close to historic lows; the markets do not fear the monetization jinn. The last two years have proved that the dollar is the world’s risk destination. If the US economy is headed for a serious trough or recession risk will rise in every market and economy. When risk goes up so does the dollar. The US currency gained almost two figures against the euro in New York afternoon trading once Chairman Bernanke began speaking before Congress.

The EU bank stress tests will satisfy no one. These tests were primarily about sovereign debt. To exclude this debt form the capital adequacy measures, no matter how adverse the supposed ‘stress test’ scenarios are, entirely begs the question. What security is there that Greece of any of the other impaired sovereign will be able to pay these debts at maturity? Holding them as investments is irrevelent. The only measure of the current value of these bonds and sovereign paper is the market judgment upon sale, essentially the haircut applied by the testers themselves. The euro cannot proper until the European banking system takes the full measure of its medicine.

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(Chart courtesy of FX Solutions’ FX AccuCharts. Price on 1st pane, Slow Stochastics on 2nd pane; uptrend lines in green; downtrend lines in red; horizontal support/resistance lines in yellow; 200-period simple moving average in light blue.)

Overview

A week spent speculating which banks might fail their ‘stress tests’, and whether these were worth doing at all, indices alternating between fairly large up and down days to end the week in positive territory. Jakarta, Mumbai and Thailand set new highs for 2010. The Japanese stock market closed near the lowest levels in two years, pressured by a strong yen (86.27) and dragged down by the banks index. The US dollar has lost ground against all major currencies this week, the Australian dollar leading at $0.8972 (a ten-week high) and the Swiss franc at 1.0400, best this year. The Hungarian forint weakened to 292.00 per Euro because of new PM Viktor Orban’s refusal to implement IMF-suggested austerity measures. Top-quality Treasuries remain well bid, those of weaker Eurozone countries still all too close to their records over Bunds. US asset-backed securities the first casualty of new financial regulation, so the SEC has had to allow a 6-month grace period for implementation. [Rating agencies can now be sued for fraud and reckless behaviour so they are not allowing their ratings to be published in prospectuses]. ICE Sugar rallied to 18.66 cents per pound, its most expensive since March though a fraction of February’s unsustainable 30.40 peak. Most Baltic Freight rates are at their lowest in a year or more.

Political and Economic Developments

The Bank of Canada raised it key rate by 25 basis points to 0.75%; Brazil raised its Selic rate 50 basis points to 10.75%, slightly less than expected on negative inflation in June.

UK Q2 GDP came in a better than expected +1.1% Q/Q taking Y/Y growth to +1.6%, helped in part by June Retail Sales which rose by 1.0% M/M and +3.1% Y/Y excluding auto-fuel. No doubt the football World Cup had an effect, but this keeps it at the average of the last decade. With June Core CPI also running at +3.1% Y/Y (RPI +5.0% Y/Y and among the highest in two decades) yet Gilts maturing within 9 years yielding under 3.00%, real interest rates are decidedly negative. Pity then that National Savings and Investments was forced to withdraw its index-linked securities (RPI +1.00% per annum) to all new investors, the first time in their 35-year history, because of huge inflows. Hometrack has annual house prices rising by under 3.00% or shrinking since December 2007, Rightmove suggests +3.7% Y/Y, though the Halifax and Nationwide calculate 6.3% and 8.7% respectively. Gains on main homes tax free.

German and Eurozone Purchasing Managers’ Indices, IFO and Consumer Confidence Surveys all upbeat versus June’s.

Underlying Themes

For several weeks now politicians and central bankers have been suggesting we shouldn’t be so gloomy, that in fact the economy was growing and banks were sound, many giving lengthy TV interviews on these subjects. Mercifully chairman Bernanke in his semi-annual testimony to the Senate Banking Committee spared us the usual drivel. Saying the number one concern for small businesses was a lack of demand not access to credit and that funding was not a constraint on large firms, that state and local governments were under fiscal stress, plus the worrisome structural problems of high unemployment, were all drags on economic recovery; above all the ‘economic outlook remains unusually uncertain’. Perhaps they have at last grasped the enormity of the problem; perhaps they now know there are no more tools in the box; perhaps they now understand that deleveraging and rebuilding overstretched balance sheets takes a very long time. Perhaps the Bank of England’s MPC is also adopting a more realistic approach. After predicting UK CPI would be back at target by the end of this year (their usual mañana mentality) chief economist Spencer Dale suggested this might now not happen until the end of 2011, and that the country would not get back to normal ‘for an awfully long time’.

What to watch for next week

Monday Japan June Trade Balance, German Import Prices due from this day, US New Home Sales and UK July Hometrack Survey. Tuesday Japan June Corporate Service Prices, EZ16 M3 Money Supply, UK CBI July Distributive Trades, US Consumer Confidence, German August GfK Consumer Confidence and US May CaseShiller House Prices. Wednesday Japan July Small Business Confidence, ECB Bank Lending Survey, July CPI for the various German states due and US June Durable Goods Orders. Thursday Japan June Retail Trade, Large Retailers’ Sales, UK Net Consumer Credit, Mortgage Approvals, German July Business Confidence, Unemployment, EZ16 Business Climate and Confidence and the Fed’s Beige Book. Friday Japan June Unemployment, Household Spending, CPI, Industrial and Vehicle Production, Housing Starts, Construction Orders and Tokyo July CPI. Then EZ16 June Unemployment, CPI, US Q2 GDP, July Chicago Purchasing Managers and final University of Michigan Confidence Survey. Monday 2nd August holidays in Canada and Iceland.

Positioning and Technical Analysis

The last week of another thin summer month and many markets are tottering at fairly pivotal levels. August will probably see trends develop and more chaotic conditions predominate. Watch FX weekly closes for important breaks; another round of generalised US dollar selling is due, something which should prop up commodity prices. Top-notch Treasuries and Corporate bonds should remain well bid maintaining the pressure on credit spreads. Stock markets will probably be subject to increasingly violent intra-day swings.

About the Author

Mizuho Corporate Bank

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The information contained in this paper is based on or derived from information generally available to the public from sources believed to be reliable. No representation or warranty is made or implied that it is accurate or complete. Any opinions expressed in this paper are subject to change without notice. This paper has been prepared solely for information purposes and if so decided, for private circulation and does not constitute any solicitation to buy or sell any instrument, or to engage in any trading strategy.

From the Release: “Reflecting all of these factors, the Bank has decided to raise the target for the overnight rate to 3/4 per cent. This decision leaves considerable monetary stimulus in place, consistent with achieving the 2 per cent inflation target in light of the significant excess supply in Canada, the strength of domestic spending, and the uneven global recovery.

Given the considerable uncertainty surrounding the outlook, any further reduction of monetary stimulus would have to be weighed carefully against domestic and global economic developments.”

Expectations are that the BOC will hike rates again to 1%, but then consider pausing in order to gauge how the global economy and the US – Canada’s main trading partner – performs throughout the rest of this year.

As the BOC pushes its interest rate to 1%, and the assumption is that the Fed will hold pat, that increases the spread between Canadian and US yields and should be supportive of the Canadian Dollar.

On the other hand, further Canadian rate increases could slow Canada’s recovery by boosting the country’s dollar and curbing exports. In terms of borrowing costs, strong demand for Canadian debt from foreigners should work to keep longer term yields down, so the effect of the bank’s hikes will be felt more on the short term end of the yield curve.

We had a report yesterday showing foreign investors bought a record monthly net C$23.16 billion (US$22.29 billion) of Canadian securities in May, fueled by the second-largest investment in bonds on record. Foreigners acquired C$15.22 billion of Canadian bonds, the largest since the all-time high of C$19.5 billion a year ago. It’s generally a trend that I believe will continue as the Bank of Canada raises interest rates going forward, while most other advanced economies are on the sidelines.

Again this lends support to the Canadian Dollar, and it should also keep Canada’s longer-term interest rates low in the face of monetary tightening.

In a short term view of this pair, we see recent greenback strength as concerns build around the US recovery which has hampered the outlook for global growth and weakened commodity currencies. Following the BOC decision, the USD/CAD tested its resistance for this week near the 1.0585 area, as the downgrade to growth assessment weakened the CAD. If the pair moved above this resistance, we can see an attempt to test the 1.0670 area.

In a longer term view of this pair, we see that the USD/CAD has been mainly confided to ranged trading, with the bulk of action coming between the 1.07 and 1.02 area. We have some factors working against each other in this pair. While higher interest rates and demand for Canadian debt from foreigners should help the CAD, weaker Canadian growth and a larger than expected slowdown in the US hampers the CAD’s prospects. For now, the pair looks to test the upper regions of its recent trading range, however, in the medium term I think the CAD is better positioned, and as oil price pressures pick up (from the US moratorium and potential pick up in growth following this summer’s slowdown due to stress from the Euro-zone debt crisis) the CAD should regain its footing and again test the 1.03 area and even parity.

Eurodollar futures – A three day rally for bonds last week saw 21 basis points shaved off the cost of government borrowing as investors rushed headlong into the safety of fixed income. The 10-year note faces a weaker start today even ahead of an expected decline in home builders’ confidence later this morning. September notes are a couple of ticks lower to stand at 123-04 yielding 2.95%. Meanwhile nearby Eurodollar contracts have made minor gains while contracts maturing from June 20011 onwards have declined by one or two pips.

European bond markets – Friday’s rally for September bunds was remarkably suspicious. The recent recovery for the euro on account of better Eurozone data than has been the case in the U.S. put the contract in focus since it appeared to have boiled over. The market was giving plenty back until the American market caught fire as stocks wilted. Today even after a Moody’s downgrade for Ireland, bunds are not in rallying mode today and the contract is 43 ticks lower at 128.73. Euribor futures are a shade lower also.

British gilts – September gilt futures are also 20 ticks lower lifting the yield two basis points to 3.35% despite evidence that the property market continues to lose momentum. A leading real estate broker indicated a 0.6% nationwide decline in home prices, exacerbated in the more expensive districts of the capital. Three times as many homes are currently offered for sale compared to the number of mortgage approvals as lending standards have risen since lenders pulled in their horns following the financial collapse. Short sterling futures have nevertheless made gains despite the repeated warning from lone Bank of England hawk Andrew Sentance who over the weekend continued to call for an exit from easy monetary conditions.

Japanese bonds – Closed for national holiday.

Canadian bills – With the Canadian central bank widely expected to unleash its second interest rate increase for 2010, bill futures expiring at year end don’t expect too much more this year. The December contract is now reflecting a lower yield than the several days after the government announced a record pace of jobs growth in the second quarter. The contract reached an implied yield of 1.45% in light of the 226,000 jobs gained in the April to June quarter but investors have locked into rising yields forcing them back down to 1.29% today. The contract typically trades 20 basis points above the Bank of Canada’s official rate meaning that investors see the prospect of further increases as only mild for the remainder of the year. Throughout 2011 dealers currently imply a further 75 basis points of tightening with the Bank lifting rates to 2% within 18 months time.

Australian bills – Despite the call for national elections for August 21 by the new Prime minister, neither interest rates nor the exchange rate appear to have been unsettled in response. Aussie government bond yields are static at 5.10%.