FIRST QUARTILE ECONOMICS |
Although I have been suspicious of the CAD’s upside prospects near term it appears a more positive view is now warranted. Technically, a reasonable facsimile of a head and shoulders formation has played out on daily bar charts and a move to the 1.3900 range is feasible over the next couple of months.
U.S. DOLLAR: The dollar moved in a narrow trading range despite early week reaction to the apparent Iraqi agreement and several Fed member speeches. Presently, the most interesting technical scenario is against the DM as there have been several continuous weeks of bumping up against an overhead resistance line, now around the 1.83 level. Earlier in the week, German officials indicated a lack of concern over inflation risk with the implication of steady domestic interest rates. Meanwhile, markets have gradually begun to price in some probability of Fed tightening by mid-year. Against this background, it is likely the dollar will soon break to stronger levels versus the DM and likely the Yen as well.
U.S. BONDS: Treasury futures put in a 2 1/4 point range on the week but declined a net 1 1/2 points. Importantly, however, prices bounced sharply off trendline support levels on Friday which corresponded to a successful test of 6.0% on the 30 year cash Treasury. Earlier in the week, Fed Chairman Greenspan gave a balanced view of the economy in his Humphrey-Hawkins testimony which seemed to be more positive for stocks than bonds.
The Fed Chairman also indicated that the rise in the real Fed funds rate was deliberate (“not inadvertent”) and this is how the Fed has been “passively” tightening over the past year (in conjunction with a rising dollar). Accordingly, there is some reason to believe the Fed will begin to raise the Fed Funds rate as soon as the yr/yr CPI trend appears to have bottomed out, if not earlier.
Nevertheless, there is no powerful bearish case against bonds at the present time and much of the re-adjustment seen lately is a swing from the Fed easing view of mid-January to the Fed tightening bias in place now. If everything goes according to plan, there will soon be evidence of the spring economic slowdown the Fed has predicted. As such, the first signs of economic moderation will be bullishly received by the market and with the February non-farm payroll report next Friday, the market will not likely throw in the towel until then, at a minimum.
CANADIAN BONDS: Domestic bonds held in moderately better than their U.S. counterparts and spreads widened through the yield curve. The Budget was non-eventful as many expected and has long been priced in to the rate structure. As expected in last week’s letter, the Minister of Finance used the Budget umbrella to extend the inflation control targets through 2001. The targets maintain the present 1 to 3 percent range but I view this as an eventual negative. Specifically, now that most countries (including the U.S.) are centering on a 2 percent inflation rate, we will eventually lose the monetary policy flexibility benefits that have been won at the expense of lower inflation in Canada versus most other countries.
Without a lower inflation rate here, there is no basis for the C$ to rise over time and hence there is no basis to sustain negative interest rate spreads to the U.S. While nothing results from this view over the near term, foreign investors will ultimately cash in more of their Canadian fixed income holdings over time.
For the very near term, the spike down in CPI inflation has reversed as the January CPI stood at a yr/yr gain of 1.1 percent versus 0.7 percent in December. While nobody is heading for the hills over Bank of Canada tightening there should be a gradual deterioration to the 1.5 percent zone as 1998 unfolds (primarily as the lower C$ adds to the CPI). As of January, the Canada - U.S. CPI differential stood at 1/2 percent versus a more typical 1 to 1 1/2 percent over the past five years. Once again, foreign investors may begin to wonder why they continue to hold or buy Canadian bonds that yield less than those in the U.S.
CANADIAN EQUITIES: The TSE 300 rose by 2.5% on the week and is up 5.9% over the past four weeks. Paper and forest products rose a smart 6.6% on the week (based on takeover activity) while Communications were not too far behind at a gain of 5.0%. The TSE outperformed most of the U.S. indices but remains below its record high of October.
INTERNATIONAL EQUITIES: The S+P 500 hit more new highs during the past week with a net gain of 1.5%. The NASDAQ had been lagging but rose 2.5% to a new record level. Little seems to stand in the way of more equity price gains as the recent surge is still pretty fresh. Technical levels have given way and the risk of Asian equity market contagion has been progressively downplayed.
The star of the Asian markets responsible for the domestic equity calm is the rebound in Hong Kong. The Hang Seng Index is up a cool 45 percent from last month’s lows but a lot of the regional problems remain. Further, there is now a range of technical resistance to much further Hang Seng price gains and in all probability some profit taking will soon be in order.
In Japan, the Nikkei 225 rose a mere 0.5% on the week but is up a decent 16% from December lows. Here too the charts present obstacles to continued gains. With last week’s toothless economic support package it is hard to believe Japanese equities can rally any further over the next several months.
COMMODITIES: Oil prices plunged at the start of the week as the Iraqi agreement appeared to have removed the threat of any oil supply disruption. As a result, the glut of oil on the world market is now fully free to find its own price level. By the end of the week there were calls for an emergency OPEC meeting to do something about the price of oil and this created a bit of a price bounce. However, there is indeed an oil glut now and for several more months regardless, and jawboning will do nothing on a sustainable basis to push oil prices meaningfully higher.
Oil closed February at long term support around $15/B/L but is likely to eventually break lower. For North American inflation this remains a major, if temporary, plus.
UPCOMING DATA: Canada starts the week off with Q4 GDP and Current Account data. I expect December GDP to rise about 1.0% versus a decline of 0.3% in November. Even this closing quarter surge will not be enough to produce a strong overall quarter. It appears Q4 GDP will rise at an annualized rate of about 2.0% versus 4.1% in Q3. The Current Account deficit should improve a bit from the $25 billion annualized pace in Q3, perhaps to the $20 billion zone.
The U.S. data calendar is above average with the February Purchasing Managers’ Index on Monday and Non-farm Payrolls on Friday. Employment gains have been huge for three consecutive months yet the fixed income market has seen past them in anticipation of some kind of economic slowdown on the horizon. Look for payroll employment to rise about 225,000 versus 358,000 in January.
Monday, March 2, 1998.
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