FIRST QUARTILE ECONOMICS |
Initially, the Asian currency and equity market turmoil was not viewed with much alarm in terms of far reaching macro-economic consequences. However, the past week saw U.S. Federal Reserve Board Chairman, Allan Greenspan, indicate that the impact on the U.S. economy would not be negligible . While no one is talking about the U.S. economy losing more than 0.5 to 1.0 percent of GDP growth over the next year or so, this is enough of a slice to keep the threat of tighter monetary policy at bay well into 1998.
The November 12 FOMC meeting resulted in steady Fed policy but most still feel the next Fed move is a tightening. However, the word deflation has increased almost exponentially in usage of late ( in the wake of Asian currency devaluations) and there must be a favorable upcoming impact on the U.S. inflation structure through 1998. I have to believe there is now scope for the U.S. CPI to trend to the 1.5 percent area on a year over year basis by mid - 1998 and probably remain below 2 percent through the balance of the year. This is not an environment that demands higher short term interest rates even if the economy continues to grow faster than the so called sustainable growth rate of 2 to 2.5 percent.
A look at gold prices also suggests the inflation outlook has improved lately . With gold reaching $300 /oz on Friday (a 12 year low), this area has no great reason to hold as support . Certainly, the gold price weakness is related to other factors than inflationary expectations (such as looming central bank selling), but other commodities have been getting blown away as well. Despite the current uncertainty over Iraq, oil prices are widely feared to be headed for a decline as Asian demand ebbs over the next several quarters. For Canadian equity markets, in particular, all this is bad news.
The good news from a financial market perspective is that bonds look better and better . The flattening yield curve in the U.S. suggests an ever-growing belief in the sustainability of 2 percent inflation, even with the tightness in labor markets. Put another way, as real short rates drift higher because of declining inflation, maybe the Fed is tight enough and has been for a while. Perhaps the next Fed move is a course of easing !
For Canada, the imminent Bank Rate increase has been priced out of the market in recent days and this has pushed the C$ somewhat weaker. I doubt the Bank of Canada will end up tightening as much as they may have been thinking since we will certainly be affected by slower Asian growth and any slower activity in the U.S. All this bodes poorly for the Canadian trade surplus which has plunged over the past year and is an important factor in C$ softness versus the U.S.
Over the next several months, I expect U.S. 30 year Treasury yields will break below the current 6 percent resistance level and test the 1993 and 1995 lows of 5.75 percent . After that level breaks , virtually anything goes! .
For Canadian bonds, the impact will be an almost perfect correlation with U.S. bonds. Longer durations will continue to offer the best rewards for several more months. Remember, the federal government reported a $1.7 billion budget surplus in the first half of fiscal 97/98 . During the past year , Ottawa has "paid back" some $8 billion to the market in federal securities through a combination of a staggering $27 billion decline in the stock of Treasury Bills outstanding and net bond borrowings of about $20 billion. With a balanced budget already here and likely better numbers ahead, Ottawa will roughly keep the level of Canada bonds outstanding at near current levels. This means that the net supply of new Canada bonds over the next several quarters will head towards zero .
Friday, November 14, 1997.
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