FIRST QUARTILE ECONOMICS |
Odds favor meaningful economic repercussions in Asia as economies slow in response to wealth effects and tighter bank lending standards. Japan is perhaps most exposed to the region in terms of lending and trade reliance, and this works to keep the Japanese economy on ice for several more quarters .
Although the North American economy should not suffer significantly from these international developments, there will be a dampening impact on growth and corporate profits here. Conversely, there should be a favorable impact on import prices as Asian goods strive to become more competitive.
Against this background, while Fed Chairman Greenspan continues to worry out loud about unsustainably tight labor markets, it is doubtful U.S. monetary policy will tighten anytime soon. This week's report of a 3.5 percent GDP gain in Q3 versus 4 percent in the first half represents some deceleration in growth that should continue into 1998. Were it not for fabulous inflation performance the Fed would have tightened much more by now . Specifically, the Q3 Implicit Price Deflator rose 1.4 percent (the slowest since 1962) versus 1.8 percent in Q2 (a fine number too). Meanwhile the CPI is up 2.2 percent year over year as of September and has grown at an annualized rate of about 1.5 percent during the past half year.
By my reckoning , the year over year CPI gain in the U.S. will drift to about 1.8 percent by early 1998 (virtually equal to the Canadian level). I think this is a pretty dramatic development. If the Fed does eventually tighten policy in a pre-emptive manner against higher inflation, it means that inflation will remain stuck around 2 percent if not head even lower amidst an economic slowdown (soft landing 2 ?). In turn , this is a great environment for bond yields especially amidst a now meaningless federal deficit level. With 30 year Treasuries just above 6 percent , the real interest rate of about 4 percent still looks attractive.
For Canada , the prospects are for the U.S. inflation rate settling in around "our" levels . As a result , there is less and less basis for Canadian long rates to drift below U.S. levels. Indeed , to the extent the Bank of Canada raises interest rates over the next year , the scenario of negative spreads to the U.S. (most pronounced in the short end of the yield curve) will gradually evaporate. This is not welcome news to foreign investors who now stand to gain little if anything by being in the Canadian market. This is not good news for the Canadian dollar. The currency is also under some downward bias from the return of a moderate Current Account deficit in 1997 as export growth has cooled while imports (reflecting a stronger domestic economy have accelerated). Moving forward, the Bank of Canada has signaled tighter monetary conditions ahead in order to preserve the climate of low inflation. I doubt there will be any drama in terms of defending the currency now that it has broken to the 1.41 U.S. this past week . It is unlikely this is the beginning of any kind of run as we have seen in the past (most recently in late 1994 - early 1995) but I tend to think the C$ will not be much stronger a year from now - maybe 1.37 - 1.38 .
Next week brings on the key U.S. employment report with the usual risk of significant interest rate movement. This leads on to the November 12 , Fed meeting (FOMC) which is unlikely to result in a rate hike and I doubt the December meeting will result in higher rates either. For Canada , I believe the Bank of Canada will raise the Bank Rate by 25 basis points at least once by year end and possibly twice. All this, in my mind at least, is imminently positive for North American long bond prices and ultimately for the equity markets .
Friday , October 31 , 1997.
By Frank Hracs -FIRST QUARTILE ECONOMICS
FIRST QUARTILE ECONOMICS |
Back to Canadian Capital Markets Weekly
Back to Investors' Corner
Back to The Investment Strategy Page 
Return to The Homepage