HIGHLIGHTS OF THE WEEK

• U.S. economic recovery appears to be losing steam. Data out this week showed a decline in net-trade and a pull-back in retail spending.
• The Federal Reserve’s Flow of Funds reported a 2.0% increase in household net-worth in the first quarter of 2010 as assets rose and liabilities declined.
• Household deleveraging and poor credit ratings are limiting the impact of monetary policy in stimuluting aggregate demand.
• With growth decelerating, a core rate of inflation below 1% and market measures of inflation expectations trending downward, don’t expect the Fed to take their foot off the pedal any time soon.
• The Canadian economy has reached another turning point in its recovery
• The Bank of Canada began raising interest rates last week and this will have a major impact on highly-indebted households that have largely driven the economic recovery, thus far.
• The housing sector, which has been the primary beneficiary of this spending boom, will pull back through the latter half of 2010 and through to 2011.
• But these impacts will be mitigated by continued improvement in the labour market and export sector, as well as stronger business investment.
• So while 2009 marked the transformation of recession to recovery, 2010 will mark the maturation of a vigorous recovery dependent on a few key sectors, low interest rates, and fiscal stimulus, to one that is more moderate and where drivers of growth will include sectors that have lagged so far.

UNITED STATES – CAUTION: SLOWDOWN AHEAD

Economic data out over the past week covered a myriad of sectors and told a cautionary tale about the state of the U.S. recovery. In some cases, data showed an unwinding of gains seen over the past months, and in other cases old gains were revised away altogether. Nonetheless, amid the vulnerabilities, signs of resiliency also emerged. Consumer confidence turned-up in May and jobless claims showed a continued gradual improvement in early June.

First on the docket: the Federal Reserve’s Flow of Funds report showed a 2.0% increase in household net worth in the first quarter of 2010. In a recession characterized by its impact on balance sheets how well households are rebuilding their lost wealth is an important element of the recovery. Interestingly, over the last several quarters the improvement in wealth has come both due to a rebound in asset growth as well as a decline in liabilities.

On the liability side of the balance sheet is a story as unique as the Great Recession. Since reaching a peak in the second quarter of 2008, total household liabilities have fallen by close to $600 billion. The evolution of household liabilities is important because impaired credit growth throws a wrench in the application of monetary policy, making interest rates a less effective tool in stimulating aggregate demand. Improving credit is an important ingredient in how quickly the economy rebounds from the recession. The monthly consumer credit report showed a slight improvement in total consumer credit outstanding in April. However, it came alongside a major downward revision to past consumer credit. As of April, total consumer credit was down 5.5% from its peak in July 2008. Underlying this decline is a 14.1% decline in revolving consumer credit (mainly credit cards).

Parsing out how much of the decline in total consumer credit is due to consumers paying off debt is complicated by the fact that when debt is written off by lenders, it is also removed from the total. Based on the charge-off rates of commercial banks, consumer defaults have been responsible for a significant portion of the decline in credit outstanding. As of the first quarter of 2010, the charge-off rate for consumer loans stood at 6.5%. The charge off rate for credit card debt reached a high of 10.25% in the third quarter of 2009, and fell only slightly to 9.95% in the first quarter of this year. Even excluding charge-offs, the pace of consumer credit growth has slowed to a virtual stand-still over the past year. Perhaps just as important, with so many households defaulting on their debt, the pace of future credit growth will continue to be impaired by the deterioration in the credit ratings of U.S. households, offering plenty of reasons to be cautious about the pace of recovery going forward.

Next up is international trade. In April, the U.S. trade deficit widened to $40.3 billion. While both exports and imports declined in the month, the fall in exports was the greater of the two. Adjusting for price growth, real exports declined by 2.5%, while imports fell by 1.5%. Given recent events in Europe and the appreciation of the dollar, the outlook for trade has become increasingly less positive. For some time, talk of a shift in production away from domestic consumption and towards exports has been championed as a way to maintain growth while also helping to mend global imbalances. Unfortunately, recent events do nothing to make this transition any easier. Instead, net trade will subtract from growth over the next year and a half, leaving the recovery solely in the hands of the domestic economy and global imbalances as large as ever.

On that note, this week also brought data on the all important consumer. Rebounding retail sales have been an important element of the recovery to date. While strong retail sales in March and April set the stage for a pull-back in May, the magnitude of the decline was a surprise. Total retail sales fell by 1.2%, led by a 9.3% decline in building materials. The source of the pullback is a reminder that temporary stimulus measures have been an important in boosting spending in recent months. When stimulus wears off, spending pulls back. Expect this to be a theme in a number of data releases over the next several months.

All told, with credit growth remaining tepid, net-trade becoming a drag, and consumer spending showing signs of stimulus fatigue, the thrust of the evidence this week was that we’re not quite out of the woods yet. While the continued improvement in household confidence and jobless claims point to a sustained recovery, growth is likely to slow in the second half of the year, and improve only gradually through 2011. With a core rate of inflation below 1% and market measures of inflation expectations trending downward, don’t expect the Fed to take their foot off the pedal any time soon. For more on the outlook for the U.S. economy please see our Quarterly Economic Forecast on our website.

CANADA – A TALE OF TWO RECOVERIES

The Canadian economy has been on a tear in the past year. Over the latter half of 2009 and well into 2010, most major indicators were turning what was originally anticipated to be an elongated U-shaped recovery, into a well-defined, jagged V. Almost all of GDP losses and about three-quarters of the job losses that accrued over the course of this recession have already been recovered. Consumer spending, which has been the main driver of this economic recovery, has moved 2.6% beyond its pre-recession level. That being said, the aforementioned “V” was heavily dependent on fiscal and monetary stimulus measures that were instituted in the early parts of the financial crisis, and much of the strength we are experiencing now is being borrowed from the future, particularly in the consumer spending and housing departments. So while the second quarter of this year will likely continue to be characterized by outsized gains across the board, following suit from the two preceding quarters, the next six quarters should tell a different story. It is typical during economic recoveries for gains to diminish, and to become less transitory.

The recovery, thus far, has been characterized by a swarm of consumers taking advantage of record low interest rates to ramp up debt-financed consumption and real estate acquisitions. And though this has been the vanguard of Canada’s economic recovery, households are now more indebted that at any other point on record, and so a wellearned rest will likely characterize the recovery going forward. This is especially true due to the fact that the Bank of Canada, recognizing that interest rates at effectively 0% are no longer necessary, began raising interest rates last week. This will put additional pressure on debt-laden consumers, albeit minimal pressure since interest rates remain as low as they have ever been. The Bank will have to renormalize interest rates in order to have any feasible chance of combating inflationary pressures should they begin to accelerate significantly.

In particular, this will have a major impact on the housing market, which has been the primary beneficiary of rockbottom interest rates. The housing market recovered before any other sector in any other developed economy and, as a result, residential investment has been a major contributor to overall economic growth over the last few quarters. But with the combination of rising mortgage rates and overspent consumers, the party is likely over. Existing home sales have already begun to pullback, falling by almost 7% since December of last year. This will likely continue over the next 18 months which will put downward pressure on new construction. May data on housing starts released earlier this week indicated a 6.3% decline in new starts, and though one month of data does not indicate a trend, this will likely emerge as new supply comes online alongside slowing sales.

Alongside residential investment pulling back and consumer spending easing, government spending will also decline as fiscal stimulus measures wear off. In other words, the support for outsized gains in overall GDP growth is shrinking. Fortunately, prospects for continued employment and income gains will help to soften the blow; 20,000-25,000 net new jobs are expected to be added, on average, each month through 2011. In addition, business investment is expected to pick up, as are net exports, as the U.S. economic recovery gains more traction. So while overall GDP growth going forward will pale in comparison to the 5-6% annualized growth we’ve been seeing in the past few quarters, this merely indicates that the recovery, itself, is maturing and that the drivers of growth will include those sectors that have lagged the recovery so far. TD Economics expects annual average real GDP growth of 3.6% in 2010 and 2.5% in 2011.

U.S.: UPCOMING KEY ECONOMIC RELEASES

U.S. Industrial Production – May

• Release Date: June 16/10
• April Result: Industrial production: 0.8% M/M, Capacity utilization: 73.7%
• TD Forecast: Industrial production: 0.6% M/M, Capacity utilization: 74.2%
• Consensus: Industrial production: 0.8% M/M, Capacity utilization: 74.5%

Industrial production is expected to remain on a solid uptrend in May posting a gain of 0.6%. New orders growth on the ISM provides a leading indicator on production activity and those orders have remained around cycle highs as manufacturing continues to be one of the most robust sectors of the economy. Production has been supported by a variety of factors. Export growth has been strong, investment spending has accelerated, and personal consumption has bounced smartly off its recent lows. Stronger levels of production have pushed capacity rates higher and in May usage will hit a new cyclical peak of 74.2%. This represents significant progress off the cyclical trough of 68.2% in July 2009, but it also remains well off its long term average of almost 80%. Industrial production remains over 8.5% off its recent peak in December 2007 so recent strength must be viewed in the context of the collapse in activity during the recent downturn. If output continues on its current pace that gap would not be closed until August 2011. Achieving that may be a challenge. Investment spending will provide ongoing support to output demand but export orders are expected to decelerate on the back of USD strength, and the contribution from inventory building is likely to diminish.

U.S. CPI – May

• Release Date: June 17/10
• April Result: core 0.0% M/M, 0.9% Y/Y; all-items -0.1% M/M, 2.2% Y/Y
• TD Forecast: core 0.0% M/M, 0.8% Y/Y; all-items -0.2% M/M, 1.9% Y/Y
• Consensus: core 0.1% M/M, 0.9% Y/Y; all-items -0.2% M/M, 2.0% Y/Y

Core inflation in May is expected to show ongoing deceleration in prices remains intact with the m/m change rounded down to a 0.0% change on the month. The change will leave core prices rising close to 0.8% y/y, a fresh 50 year low. Headline prices are expected to fall for the second consecutive month owing to a hefty decline in gasoline prices, with a 0.2% M/M drop. The change will leave headline prices rising at a 1.9% rate y/y, down from 2.8% y/y as recently as December of last year. Base effects ensure that headline prices will move sharply lower in y/y terms in June, close to 1.3% y/y. The broad contours of inflation remain biased to the downside over coming months. High levels of slack in the economy, weak rents, and a deceleration in core commodities suggest that core prices are likely to remain on a downtrend for much of the year troughing around 0.5% y/y in Q4. With core price inflation dangerously anemic the expectation is for the Fed to remain on hold over the course of this year. If the bottom in core inflation is lower or extends beyond our current expectation, then we would assign a lower probability to the Fed raising rate in Q1 of next year.

CANADA: UPCOMING KEY ECONOMIC RELEASES

Canadian Manufacturing Shipments – April

• Release Date: June 15/10
• March Result: 1.2% M/M
• TD Forecast: -0.5% M/M
• Consensus: 0.5% M/M

After the brisk start to the year, Canadian manufacturing sector activity looks set to falter in April as the impact of soft global demand and the strong Canadian dollar eat into the recent positive momentum that has been building up in the sector. The strong gains in exports of machinery and equipment, and automotive products should bolster shipments in these categories, partially offsetting weakness in other sales categories. In the end, we expect total manufacturing shipments to decline by 0.5% M/M. In real terms, manufacturing sales should be up marginally, suggesting that the manufacturing sector will add to Canadian economic activity during the month. Looking ahead, with the Canadian and global economic recovery likely to gain further traction, we expect Canadian manufacturing sector activity to advance further, though the strong Canadian dollar should provide some headwinds.

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HIGHLIGHTS OF THE WEEK

• The U.S. economy created 431K jobs in the month of May. However, the details of the report were disappointing as temporary census hiring dominated the headline figure and only 41K jobs came from the private sector.
• A host of strong data came out earlier in the week, including the ISM manufacturing and non-manufacturing indexes, pending home sales and motor vehicle sales.
• Financial markets remained agitate this week following Friday’s job report and as fears over Europe and North Korea continue to linger in the background.
• This week’s weak job report serves as a stark reminder that in this post recession world, the recovery will not always be even-handed and is full of uncertainty.
• The Canadian economy expanded by a staggering 6.1% Q/Q annualized in the first quarter of the year.
• The Canadian economy added 25,000 jobs in May, although the unemployment rate remained unchanged at 8.1%
• The Bank of Canada increased the overnight rate by 25 basis points to 0.50%, becoming the first G7 nation to hike interest rates since the start of the recession.
• We expect the Bank of Canada to continue its tightening cycle with a series of 25 basis point hikes, reaching 1.50% by the end of this year.

UNITED STATES – FURTHER SIGNS OF A RISK FILLED RECOVERY

This week, economic and financial conditions were very reflective of the nervous optimism that has surrounded our outlook since the recovery started last year. Data points to strong second quarter growth, but an unimpressive jobs report did not send the signal that markets were hoping for – namely that the lagging labor market is fully on board with the recovery. Uncertainty abounds, and financial markets remain agitated after weeks of elevated volatility.

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News and Events:

FX markets continue to languish with low volumes and less than convincing directional moves. The story today has been the stellar performance of both US & Asian equity markets which should give risky assets a temporary respite from selling. FX volatilities and the VIX together have dropped off which signifies a reduction in market disturbance. Overall we doubt there has been any real shift in risk appetite, so it’ll remain prudent to sell into rallies. We believe that the European debt crisis will remain the core driver and expect the EUR to downtrend – especially against the USD and JPY. Just to note, 10 yr bond spreads between Spanish/German and Italian/German have both peaked at 10 year highs, illustrating the market’s desire to punish any countries with loose fiscal policy.

The JPY took a hit as the FX market has been pricing in the selection of Yen ‘Perma-Bear’ Finance Minister Kan. Most suspect that the anti-deflation & economic growth policy of Kan will lead to a weaker JPY. We agree but at this point the Kan nomination has been fully priced in and traders should look for concrete action to contribute to any further JPY deprecation.

In Australia, trade balance for April was well above expectations, flipping to the positive side of A$0.13 bn after March’s deficit of -A$2.04 bn. Exports led the way hitting 10.7% y/y, as firm commodity prices more than negated the effect of a stronger AUD. While in New Zealand, S&P confirmed the nation’s AA+ sovereign rating and stated the outlook for the nation’s credit rating remained stable. The analyst went on to add ‘the implications for New Zealand due to the sovereign debt problems in Europe are fairly muted.’ Finally some good sovereign credit news.

Economic data out of the US continues to support the theory that recovery is progressing nicely even though the pending home sales index jump in April needs to be taken with a grain of salt. ADP numbers today will set the stage for what could be a whopper of a NFP on Friday (ISM non-manufacturing survey will take a back seat). The (pre-ADP) market is expecting NFP at 575k and unemployment at 9.8%. Even when you carve out the consensus, the figure will still be impressive and should be USD positive. There is still considerable debate whether positive US data will support the USD or risk appetite (which would cause USD selling). (more…)

Highlights

• Risk correction fails to materialize, so far
• Weaker Q1 GDP may give the Tory party, and GBP a short-term boost
• Greece enters the next phase of its funding crisis
• US corporate earnings well ahead of expectations
• Key data and events to watch next week

Risk correction fails to materialize, so far

Last Friday’s sell-off in risky assets suggested this past week might see a broader correction lower in risk, but it only lasted a few hours at the start of this past week. Markets quickly shrugged off the fraud indictment of a US investment bank and took some solace in ongoing US corporate earnings surprises (more below). Greece funding concerns weighed on the EUR and risk appetites most of this past week, but news on Friday that Greece has requested access to the EU/IMF loan package has allowed a mild relief rally to unfold. Whereas last week risky assets (stock, commodities, JPY-crosses) finished out at the bottom of recent ranges, this past week sees them closing nearer to recent range highs. The key word here is ‘range’ and we’re still stuck in them. The most puzzling development of this past week is not that we’re back at recent range highs, but that we’re not above them.

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Time to Regroup

Wednesday’s forex activity was notable for two things: The dollar weakened as risk appetite accelerated sending riskier asset classes and currencies to multi-month peaks. The euro failed to join the party closing down on the day. It should, like a strong derby favorite, have taken up the early running, but we all quickly noticed how hobbled it looked resting at the back of the pack. Sure enough we find today that the questions are starting to arise about the very existence of a financial rescue package for Greece in the event it can’t roll over spring bond maturities over the next two months. Overnight developments leave us with the mental imagery of politicians in Berlin holding up traffic signs emblazoned with the words, "U-turn here for IMF building."

Euro – We have become accustomed to hearing little substantive in the aftermath of EU ministerial meetings at which defense plans were supposedly discussed. Any press conferences or statements have been confined to merely stating facts surrounding the need for Greece to get its own house in order coupled with strong supportive words from fellow nations. However, the words yesterday from Germany’s chief finance minister telling Greece to pay a visit to the IMF if it feels the need for financial assistance is a real deviation from the previous script. It also leaves Chancellor Merkel treading a fine line between standing behind Greece and actual facing up to the nation as an opponent.

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The declining equity market was fully reflected in the value of the dollar index in midweek trade. The dollar index, which tracks the performance of the greenback against a basket of six currencies, gained 85 basis points throughout the day breaking above the 78.00 benchmark level. The major currencies started weakening from the early hours of Wednesday’s session, and to some extent continued to decline throughout the U.S. session. Since December, the market had a strong desire for dollar long positions, however, today’s major currency sell-off had a first; the major currencies moved lower as one, something not often seen over the last few weeks of trading.

Dollar Index Technical View: TheLFB Member Charts

Daily chart trend: Mixed. Main price points: 74.19, and 76.82. Looking for: A Long wave I/ A

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