FIRST QUARTILE ECONOMICS |
All appeared reasonably well for the currency until Wednesday when the senior deputy governor of the Bank of Canada gave a speech indicating a policy shift away from further increases in interest rates. The policy announcement was sensible since earlier in the day the December CPI was reported down on the month while the yr/yr gain slipped further to 0.8% from 0.9% the month before. The deputy governor also predicted the CPI would range between 1 and 2 % for the next 18 to 24 months. From a trading perspective the speech was a disaster since it meant the Bank of Canada would let the currency find its own value in the market. Accordingly, just as it appeared the 1.45 target level would cap the current phase of CAD weakness and possibly suggest a significant buying opportunity, all bets are now off.
From a technical perspective, there are few obvious objectives ahead. The most obvious target now would be the 1.50 level which translates into 66.66 cents (a bit on the demonic side for those who think in such terms). It is doubtful however that such a large move is on the immediate horizon. A re-drawing of trend channel lines points to the 1.4650 area as being the next major area of resistance. On strength, there is some scope for a re-test of the 1.4465 level (previous record low from 1986) but it seems hard to imagine why this level would be broken, just yet.
U.S. DOLLAR: The big dollar was simply crushed against the other majors this past week as political scandal in the U.S. combined with positive economic signs out of Japan fueled the rout. The dollar fell to 125.8 Yen from 129.35 Yen last week (a move of 2.7%) while the decline versus the DM was 3.0% given a close of 1.7770 versus 1.8315 the prior week.
Senior Japanese officials were quoted as suggesting the Yen was heading back to 120, presumably with some possible help from the Bank of Japan. That’s all it takes these days to wound the dollar, especially amidst the other official measures of late to shore up the Japanese economy and financial system.
For the week ahead, the dollar has technical support around the 125 Yen level, based on the trend channel dating back to mid-1997. A break will not be pretty since this would likely target 120 as the next general objective. The DM is mainly keeping pace with the Yen now and will tend to move in tandem against the US$. This means the DM should stop strengthening around 1.76 but could also target 1.70 if the Yen leads the way.
U.S. BONDS: It was a sloppy end to an otherwise quiet week on the fixed income side. Long Treasuries fell 1 1/2 points on Friday for a net weekly decline of 1 1/2 points. Unlike two weeks ago when only the 30 year Treasury yield was above the 5.5% Fed Funds rate, the 5 year and over terms are now back above. This represents a significant moderation in the expectations of eventual Fed ease in 1998, in contrast to the tightening expectations that have generally been the norm. Still, the market is basically priced for no Fed policy change whatsoever in 1998 which remains a positive for the market in general.
In recent days, the threat of deflation as a result of Asia has calmed down while Richmond Fed President Broaddus on Friday suggested the U.S. economy was still in danger of overheating and was likely to re-accelerate shortly with NO risk of deflation. That’s bad stuff for bonds while rumors of the resignation of Treasury Secretary Rubin were also taken badly on Friday. The President’s personal difficulties which contributed to the dollar decline were just another negative for fixed income markets that could not be overcome.
CANADIAN BONDS: The domestic market held very well considering the weaknesses in the U.S. and the Canadian Dollar. In fact, most interest rates were down at least slightly or steady on the week and spreads to the U.S. moved considerably in our favour (30 years for example moved to -23 bps from -8 bps the prior week and stood at +7 bps four weeks earlier).
Canadian bonds barely reacted at all to C$ weakness early in the week as the old record low level of 1.4465 was gradually approached. Upon news of the apparent Bank of Canada policy shift, domestic rates began the bulk of their outperformance of the U.S.
The Bank of Canada comments came out of the blue as one might think this kind of revelation would come from Governor Thiessen himself. As a result, everything has now changed in terms of market expectations. Indeed with a 1% inflation rate it seems inappropriate to raise interest rates under any circumstances and maybe this is what the Bank concluded.
A lot has changed since the Bank first signaled a course of “less accommodation” in terms of Monetary Conditions last summer. Asia is a problem, lower commodity prices are a problem, and if anything we need a lower currency to work out from the past year’s current account deficit rebound. As it stands, for all the work the BoC has done on the interest rate side, the Monetary Conditions Index is now moderately above last summer’s most accommodative levels and has amounted to the interest rate equivalent of a 100 basis point decline since the end of December.
CANADIAN EQUITIES: The TSE 300 rose 1.1% on the week and remains down 0.7 % over the past four weeks. Paper and forest products led the upside with an increase of 8.6% while the Gold index advanced 6.6%. Metals and minerals rose by 4.9%.
Helped largely by the intended merger announcement by the Royal Bank and Bank of Montreal on Friday, the Financial Services index rose 2.6 % on the week. Earlier on however, the market had been driving the bank stocks down on concern about exposure to Asian borrowers. On the downside, Pipelines and Utilities declined 2.7% and 2.2% respectively with Oil and Gas down 1.5%.
INTERNATIONAL EQUITIES: The U.S. indices were mixed on the week as the S+P 500 was down 0.4% while the Nasdaq rose 0.8%. Daily swings were significant in reaction to the continued rise in Japan (up 4.6% on the week and 13.4% over four weeks).
CANADIAN ECONOMIC DATA: November saw declines of 0.8% and 1.2% for wholesale and retail sales respectively. This points to a soft GDP figure for the month which could generate a soft quarter as well. The most impressive story is still the CPI for December which is up by 0.8% yr/yr at the ex food and energy level (the index followed by the BoC for target purposes). Even after stripping out the temporary impact of the cable pricing distortion from November to January, this is as low as we have seen in over thirty years (the 1994 tobacco tax reduction that took the yr/yr CPI gain to zero did not count as a legitimate inflation decline).
UPCOMING DATA: The key Canadian data report next week is Friday’s GDP report for November. The U.S. has a heavy slate of data including the Q4 Employment Cost Index, Durable Goods Orders for December, Consumer Confidence Indices for January and preliminary Q4 real GDP. As well, Fed Chairman Allan Greenspan delivers two days of Congressional testimony and no doubt everyone wants to know what’s on his mind these days. In sum, combined with the State of the Union Address, it could be a very flaky week in the debt markets and likely for equities as well.
CONCLUSIONS and STRATEGIES: The flight to quality in terms of U.S. bonds has run its course and the question remains, is there any value left in the bond market? I think you have to focus on U.S. inflation and as it edges lower in upcoming months there will be a renewed attractiveness of long bonds in terms of their real interest rate level. I think the Fed will do nothing this year which is a plus for bonds.
For Canada, the steady policy bias of the Bank of Canada should play out in terms of steady money market rates and lower long rates. There is room for more spread improvement versus the U.S. but nothing enormous.
Equities remain too skittish to be of comfort. Maybe there is not a lot of economic drag ahead as a result of Asia but with economies on a decelerating trajectory in North America one should not get overly fond of stocks generally.
Friday, January 23, 1998.
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