Weekly Wrap-Up March 31 - April 4, 1997

Closing Numbers

The bond markets in North America were looking for reasons to carry on with the negative tone, established several weeks ago, again this week. With the economic numbers coming out of the dominant US economy, there was no where to go but further south. The host of economic data released in the US point to another Fed tightening of short-term rates, as early as the next FOMC meeting, May, 20. Out of the US, personal income rose 0.9% month over month in March, construction spending was higher, index of leading economic indicators was higher, and the National Association of Purchasing Managers Index was higher at 55 (53.4 expected). But the number most of the market was waiting for was released Friday, the US non-farm payrolls, which rose 175M for the month of March. The headline number was slightly below expectations, but the real concern came from the underlying statistics which showed an increase in average hours worked, and an increase of 0.4% in hourly earnings (providing 4.0% annualized wage growth). All this taken together allowed the bond markets to sell off, as increasing concerns about underlying US inflation has sparked the market to start to discount a further 25 basis point increase in the Fed Funds rate.

The Canadian market, while significantly influenced by its larger southern neighbour, had reasons of its own to sell off, which were only exacerbated by the inflation concerns in the US. Much of the focus in Canada centered around the $CDA, which has been on a steady decline since mid-January. The currency has felt the sting of international investor dollars being moved out of Canada into the higher yielding, stronger credit US market. As a result, the Bank of Canada has had to come into the market on several occasions to attempt to slow the fall. Many market watchers believe that the Bank of Canada will be forced to raise short-term interest rates in order to defend the currency. The Bank has been quiet since just before the Federal Reserve Board in the US raised short-term interest rates 25 basis points. This is causing the majority of the speculation. With no new information on the Bank's intentions, the market is nervous. A strong Canadian employment report, released Friday morning, added to the possibility that the Bank may raise rates without hurting economic growth in Canada. The output gap in Canada is wide, unemployment stands at 9.3%, and inflation is well under control, so there is little reason to raise rates to prolong the economic expansion. The true test remains the currency.

Both bond markets continued there negative momentum this week. This action was predicated both on fundamentally strong economic numbers, as well as a technical bias to test the psychological 7.125% level in the long end of the US yield curve. Once the 7% level had fallen late last week, with the weekly close above 7%, the next psychological level became the target. The US 30 year treasury finished the week 3 basis points higher at 7.12%. The Canadian 30 year bond fared much worse than its US cousin as currency concerns, and possible Bank of Canada action, loomed over the market. The Canada 30 year bond finished 15 basis points higher, at 7.45%. The Canada/US 30 year spread snapped back out after collapsing last week, to close at 33 basis points, 12 wider than last Friday. (A basis point is 1/100th of a percent.)

The correction in the equity markets continued this week as stocks underperformed the bond market closing broadly lower. Inflation concerns, and the possible Fed reaction continues to weigh heavy on the equity markets. As well, Q1 earnings to be released shortly are causing grief as analysts attempt to assess the impact of the Fed move on business conditions. The third pillar of the equity markets strength has been the participation of the retail investor, through investment vehicles such as mutual funds. This participation, via the influx of funds driving the market, may have waned in its enthusiasm over the past few weeks, as people take a wait and see approach to investing. This may cause some of the underlying support for the equity markets to evaporate, as conservative investors stay in cash, or move to bonds now that the yield at the long end of the yield curve is above 7%.

All major North American markets were lower this week. The DJIA closed down 214.52 points on the week, and 7.89% from its high close on March, 11. The TSE closed down 114.46 points, as the Bre-X hangover continues to hurt the Canadian markets. Down 1.93% on the week, and 8.14% from its high close on March, 10, the TSE is being hurt by the currency concerns plaguing the bond market, as well as the weakness in the US equity markets.

Next week brings several reports which will be used to decipher the next Fed action, including PPI and retail sales figures. Clearly, that move will be to higher short-term interest rates. The question remains when. The next FOMC meeting May, 20, will most likely bring another 25 basis point increase. The Bank of Canada will remain under pressure to raise short-term interest rates as long as the currency remains under pressure. If the Fed moves again in May, the Bank of Canada will surely be forced to follow. Good trading.