One would think that bidding adieu to such a miserable year like 2008 would be a welcome event. However, turning the calendar to 2009 has not elicited a particularly enthusiastic response. The financial markets are still a mess, recession is plaguing nearly every corner of the globe, and in many countries official rates are at new historical lows. But to be fair, there has been some modest improvement in some credit metrics, such as LIBOR spreads, and it seems as though the market has braced itself for the worst. But banks are still not lending, which only exacerbates the stress. In short, the painful deleveraging process is not over yet.
Fed Steps Through the Looking Glass
The Fed made history at their last meeting of 2008 when they lowered the Fed funds rate to 0.00% - 0.25%. Not only was the size of the cut surprisingly large, but the fact that the Fed shifted away from a point target for the fed funds rate is a massive shift in thinking as traditional monetary policy becomes increasingly ineffectual. The shift to a target range for the fed funds rate was seen as a means to help focus investors' attention on the use of balance sheet policies as a way of providing further monetary policy stimulus. In the current context, the FOMC noted that given clear recessionary signals, economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.
The Fed also made another important announcement that the focus of the committee's policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve's balance sheet at a high level. The statement that the Fed will continue its exceptional measures ultimately forms the crux of a quantitative easing policy. Quantitative easing will now frame the basis of current monetary policy and will likely to remain in place until the Fed is convinced that it is no longer needed. Until such time that the Fed is convinced that the economy can stand on its own and that there has been sufficient financial market repair, the printing presses will remain operating full steam ahead. Therefore tools such as purchasing large quantities of agency debt and mortgage-backed securities, in addition to tentative plans to buy longer-term Treasuries will be increasingly used to facilitate liquidity in the market.
The Forecaster's Lament
Looking ahead, the length of time that monetary policy remains at these historical lows depends largely on how quickly the recessionary storm passes. And on that front the prognosis does not look good. Forecasts (including ours recently) have been slashed as it became increasingly clear as the end of 2008 rolled around that traditional policy measures were not getting any traction. So as the U.S. slips further into recession in 2009, so too will many of its trading partners. Global GDP growth is expected to be meager 0.5% in 2009 as the synchronized global recession takes grip. This recessionary episode is being compared to the early 80's recession, but there is a non trivial possibility that it will be the worst since the 1930's.
Aside from now using unorthodox monetary policy tools, President-elect Obama has indicated a desire to release the second portion of the TARP funds for homeowner relief. The mounting need for debt issuance raises several key questions, especially since Obama has indicated that the U.S. deficit would top $1 trillion and could remain that high for several years. With debt-to-GDP ratios expected to swell to rates once reserved for emerging markets, it appears that U.S. fundamentals suggest that both monetary policy and fiscal policy will remain loose through 2009.
The impact on U.S. financial markets will be notable. With such a dire economic backdrop, which in turn will play a role in the long term fundamentals for the U.S., investors are unlikely to find the dollar an attractive bet for quite some time. As such, we think the dollar will face a rather bearish environment until much later in 2009. As for the bond market's machinations, the fact that yields at short end of the curve are whisper thin and central banks are not expected to start the normalization process until mid 2010, suggests a protracted period where yields curve will be very low. Compounding the likelihood of a flat yield curve is the Fed's admission that it is willing to purchase longer dated Treasuries outright.
Contagion in Canada
The recessionary headwinds from the U.S. have now gripped Canada. The recent economic data has been uniformly disappointing and point to not only stress on the export sector but growing trouble in domestic sources of growth. A deterioration in housing starts, auto sales and consumer spending have all materialized recently and inflation, though recently hotter than expected is unlikely to remain so for very long as economic slack quickly builds.
The Bank of Canada acted decisively in early December with its 75bps easing in the overnight rate, leaving it at 1.50%.The statement that the Bank of Canada released was very dovish. The communiqué cited that the global recession will be broader and deeper than previously anticipated. And it also acknowledged that Canada's economy is now entering a recession as a result of the weakness in global economic activity. Not only is economic activity expected to be soft, but the Bank also painted the inflation outlook as weaker as well, thanks to the growing slack in the economy. However, there is a bit of a silver lining in that they mention that the depreciating Canadian dollar will continue to provide an important offset to the effects of weaker global demand and lower commodity prices.
Against this backdrop the Bank left the door open for further rate cuts, as most of the issues that it had highlighted in previous statements, including the U.S economic downturn, commodity prices and the credit crunch have only deteriorated since the last meeting.
We forecast the Bank of Canada to deliver another 50bps rate cut this month, leaving the overnight rate at 1.0%. The possibility for a top-up of another 50 bps rate cut in March is certainly in the cards especially considering the battering that Canada's export sector is likely to take from three main sources: soft commodity prices, the fact that Canada has one of the highest exposures to exports in the developed world, and that the lion's share of those exports are destined to the U.S. It is unlikely that rates will go lower than 0.50% given the numerous technical problems it will create in money markets and some financial instruments linked to the overnight rate.
Like the U.S. monetary policy will remain easy for some time and will be bolstered by looser fiscal policy, which will help with the heavy lifting in this recession. The government hands down a budget on January 27 which is expected to include a good dose of fiscal stimulus.
The fall out on Canada's financial markets will be palpable. Though the Canadian bond market never fully participated in the rally U.S. Treasuries saw, it could now play a bit of catch up. With another 100 basis points of easing expected, bond yields will head lower still, pushing the Canadian curve even flatter.
The global recession and consequent downward pressure on commodity prices as spare capacity continues to build will remain a key drag on the Canadian dollar, though the prospect of U.S. dollar weakness could allow the loonie to appreciate modestly into mid-2009.
U.S. FIXED INCOME
The past month has been an absolute rollercoaster ride for the U.S. Treasury bond market. The U.S. 10-year yield swung through an unbelievable 60 basis point range, with a massive rally in mid-December that was then partially unwound as the New Year began. Despite the latest tempering, the 10-year yield still fell by 22 basis points over the last month, and the 2-year yield declined by about 12 basis points. Bucking an earlier trend, the curve actually steepened slightly, though it remains unusually flat when one considers just how low bond yields are to begin with.
Indeed, the main market theme remains the tug-of-war between deflation fears plus possible Fed purchasing of Treasuries (both of which argue for lower long-dated yields), versus bond supply fears (which argue for higher long-dated yields). Both sets of forces are formidable.
Inflation expectations have plummeted to almost unprecedented lows, and deflation fears are very real. And the Fed has mused openly about possibly buying Treasuries in the open market in an effort to extend monetary stimulus further out the curve. The mantra don't fight the Fed comes to mind here, as the Fed technically has unlimited purchasing power given its ability to print money. But weighing in at more than $2 trillion in the opposite corner, there is an urgent need for the U.S. government to issue bonds given all of the major commitments made so far. It is far from clear how this war ends, though we remain on the side looking for longer-dated yields to remain low. After all, the Fed has conducted massive issuance over the span of the last several months, and the market has absorbed it handily so far.
Traditional monetary policy has been taken out of the bond market equation now that the fed funds rate is at 0.00-0.25% and likely to stay there for some time, which means that other considerations will dominate, with a particular emphasis on the ones cited above. The U.S. economic outlook remains grim, and the economy is likely to get worse before it gets better. In turn, TD does not believe that the rally in Treasuries is necessarily over. New lows may yet be reached.
The TD forecast calls for the U.S. 10-year yield to fall back close to 2.00%, and for a cautious selloff to be postponed until the second half of 2009. The yield curve can flatten further.
CANADIAN FIXED INCOME
In contrast to the U.S. Treasury market volatility, Canada's 10yr bond was relatively sleepy over the past month. But, on an absolute basis, it was still rather jumpy. The Canadian 10-year yield declined by 16 basis points over the past year, which masks a big 46 basis point range. Canada's 2-year bond had an even bigger swing, rallying by over 40 basis points on the month. As a consequence, the Canadian bond market outperformed the U.S. at the short end of the curve, but underperformed at the long end.
This steepening of the Canadian curve relative to the U.S. is actually somewhat puzzling, since Canada's bond supply needs for the future, though large, pale in comparison to the U.S. Similarly, Canada has a ready-made set of liability-driven investment buyers who should be helping to keep the Canadian long end well bid. This appears to be a mispricing by the market, and TD looks for Canadian longer-dated bonds to rally in the future.
The market currently prices in two further 50 basis point rate cuts by the Bank of Canada, and TD concurs with that view given the economic slowdown and financial market risks. Canada has been blindsided in particular by the U.S. correction and also by the sharp decline in commodity prices that has a subtle but powerful impact on Canada's terms of trade. Inflation, though currently a touch elevated, is almost certain to ease in the future. In turn, Canada's short-dated bonds are likely to remain well bid, though there is at best limited scope for any further rallying from current levels.
TD calls for a flatter Canadian yield curve as the long end remains unnaturally elevated relative to both the U.S. and common-sense. Longer-dated bonds can afford to rally from this point. Relative to the U.S., TD looks for Canada to begin outperforming at the long end of the curve. Overall, bond yields should remain quite low, though there is scope for them to begin rising in the second half of 2009 as the market begins to detect the scent of a nascent economic recovery.
Market conditions remain volatile though we remain of the opinion (expressed in the December edition of this report) that the USD rally evident in the second half of last year has run its course. Investors seem to be generally divided into two camps on the dollar at the moment; the dollar bulls expect aggressive monetary and fiscal policy easing to prompt a quicker (than elsewhere in the developed world) economic recovery in the US, which will support the greenback. The other (bearish) camp, where we reside, is concerned that these same stimulus efforts will work against the USD overall.
Data trends remain very weak and the minutes of the Federal Reserve's December meeting suggest that policy makers remain highly concerned about the growth outlook, even with the central bank pulling on all the usual - as well as a few unusual - policy levers. Beyond that, ultra low interest rates and the massive increase in Federal deficit in particular are a threat to the USD, we think. Over the past 20 years or so, the relative strength - or weakness - in the US fiscal position (government gross financial liabilities are nearing 80%/ GDP, according to the OECD) has tended to be reflected in the broader USD performance. The Congressional Budget Office estimates that the 2008/2009 budget deficit will reach USD1.2tn (about USD200bn higher than recent estimates - and the final tally may be significantly higher still). With foreign investors already holding substantial amounts of US debt, US yields at record lows and global savings glut in retreat, investors may be reticent about adding significantly to US Treasury investments without additional incentives (higher rates or a lower USD).
We do not expect an all out rout in the dollar as there are few, if any, compelling alternatives in the major currency space currently; rather, we think the dollar is likely to fall back towards the levels seen around the middle of last year as investors become a little more selective about where they put their money to work.
It looks like the third time is not the charm for USD/ CAD, since after three solid attempts at breaking through 1.30, it has now fallen back below 1.20 as the USD has lost ground. However, we're still expecting to see a little more weakness over the next couple of months, before recovering into the end of 2009.
The Canadian economy has been one of the last developed countries to show real economic weakness, as the boost to national income from higher commodity prices in the first half of 2008 has had a lingering effect. Aside from just a couple of data points (the latest employment and housing figures come to mind), the numbers have held up reasonably well thus far. However, we think that's going to change over the next few weeks as the November and December statistics trickle in, since the economy took a serious turn for the worse in the last quarter of the year. This should cause some CAD weakness, as markets adjust to the fact that Canada is indeed joining the rest of the developed world in recession territory. We're expecting to see USD/CAD peak in the first quarter of 2009 at around 1.25.
Looking to the rest of the year, we should see USD/ CAD head lower as the USD softens on the back of ultra- low interest rates and a ballooning federal deficit; by the end of the year, we expect to see USD/CAD fall to about 1.15. But it will probably be a bumpy ride with a lot of volatility, since there could certainly be some big surprises out of both Canada and the US this year, given the uncertain economic and financial climate.
After rising sharply last year, mainly due to the deleveraging process, we expect the JPY to ease modestly overall in the coming 12 months. While it seems unlikely to us that the confluence of factors - diverging interest rate trends, low volatility and strong risk appetite - that made the carry trade such a success (and pressured the JPY until the start of the credit crunch in 2007) will make a quick comeback, we do think the fundamental backdrop will keep the JPY on the defensive overall.
The data flow from Japan remains quite negative and the spillover effect of the global slowdown on the country's export sector remains highly apparent, with the trade balance now posting four consecutive monthly trade deficits, the worst performance since the early 1980s. Domestic economic data suggest a broad and deep slowdown; economic confidence measures are plumbing record lows while industrial production dropped 16.5% in the year through November. Note that Toyota recently announced its first operating loss ever and announced an 11-day halt to domestic production. Historically, we note a broad linkage between Japan's overall export performance and the USD/JPY exchange rate's evolution; the last time the trade performance was this weak, the USD/JPY exchange rate was rising by around 30% in year on year terms. We do not expect the USD to rise by such an extent over the course of the next 12 months but we do think the impact of the deterioration in the trade balance will be negative on the JPY.
The weak domestic economic outlook will likely leave industry - exporters, specifically in the auto manufacturing sector - and the authorities more sensitive to the exchange rate. We think the Japanese authorities will try and jaw-bone the JPY lower if USD/JPY returns to the JPY90 level while the risk of unilateral intervention may rise if the spot rate falls below the JPY80-85 region.
We have raised our end-2009 forecast for EUR/USD to $1.55, the very upper end of the current consensus. While the rebound in the EUR in the latter part of December reflected our view that the H2 2008 weakness had largely run its course and that a EUR-rebound was likely in 2009, the rally in the single currency reached our previous year-end 2009 forecast (of $1.40, which was also above consensus) about 12 months too soon. We remain concerned by the broader USD outlook, as noted above, and feel comfortable forecasting a return towards the EUR peaks seen just a few months ago as a result.
The stresses within the single currency block that we have mentioned in previous updates - the relative economic weakness of the peripheral economies and the clear credit differentiation between core and non-core sovereign debt to name two issues - have attracted a little more attention in the markets recently. While we remain concerned that the single currency area is facing some quite profound economic and financial challenges, we do not think these issues that will concern investors in 2009 (or perhaps even 2010), however. Asset and reserve managers are likely to view the EUR as the only realistic alternative to the USD for a while yet.
The European Central Bank (ECB) is expected to ease interest rates by a further 100bps over the course of the current quarter, taking the key repo rate down to 1.50%, safely above the (effectively zero) Fed funds target rate. We think inflation fighting credentials are deeply embedded in the central bank's DNA and there will be significant institutional resistance to following a policy path similar to the Fed; euro zone instruments should retain a decent interest rate premium over ultra low yields elsewhere for the foreseeable future. This should ensure a generally firm profile for the EUR on the crosses (with one or two exceptions) over the course of the coming year at least.
We were about as bearish on the GBP last year as we were bullish on the JPY. The tables are perhaps turning to an extent though we would hardly name the GBP as one of our favourite currencies for 2009. The UK economy remains weak, the housing sector (which tends to reflect the state of overall economic activity) continues to deteriorate and UK government borrowing is rising sharply. None of this looks especially palatable to the GBP though, to a large extent, the sharp sell off in the GBP in the latter part of last year suggests that a good deal of the bad news on the economy is factored into the exchange rate.
The Bank of England (BoE) has responded to prospect of a long and deep recession with aggressive interest rate cuts, taking the repo rate to 1.50% at its latest meeting - the lowest ever level for the BoE's benchmark interest rate in its 300-year plus history. Monetary policy may be relaxed a little more but policy makers gave little indication that they were considering deploying non-conventional policy measures, along the lines of the Fed at the moment. That may be modestly encouraging for the GBP in the short term.
Indeed, there are some tentative signs that the GBP is trying to claw its way back from the sharp sell off that characterized trading in the latter part of last year on a number of the key crosses - against the EUR, CHF and CAD notably. Valuation (the pound looks very cheap on a number of fronts from an historic point of view) rather than economic fundamentals appears to be the main support for the pound at the moment. We expect trading to remain choppy overall but we do think there are reasons to expect the pound's recent under performance to moderate at least from here.
The Australian dollar has staged a small rally since the start of the New Year thanks to a pick-up in some commodity price indices. But we are reticent to read too much into this. Fundamentally, we retain a view that the Australian dollar will ease against the USD in the first half of 2009. Official US interest rates have troughed while the RBA has further monetary easing ahead of it. This will narrow interest rate differentials. In addition, growth differentials will narrow as Australia has more economic hardship ahead of it; its terms of trade will decline in line with the downward adjustment of contract commodity prices and slower growth in its major Asian trading partners. Only in the second half of 2009 will the Australian dollar find a firmer footing against the USD, ending 2009 at about 66 cents US.
NEW ZEALAND DOLLAR
The New Zealand dollar has ridden on the bow wave of AUD to move higher against the USD since the start of the year, despite a severe recession that should continue into 2009. With the economic outlook very poor, the RBNZ will need to further unwind monetary policy to a highly expansionary level. TD looks for a further 225bps of easing, unwinding the remaining yield differential that New Zealand enjoys against US rates. Another downside driver for NZD is the unsustainable current account deficit, which stands at 8.6% of GDP; a weaker NZD will be one way of improving the external imbalance. However, an improvement in the NZD is likely toward the end of 2009 as the economy finally starts to recover, in line with expectations for an improvement in the global economy.
2009 is not looking like it's going to be a good year for the Swiss Franc, since Switzerland seems have several of the same difficulties as do the US and Japan. To start, Switzerland is essentially in ZIRP territory, with a target rate of only 0 to 0.50%. And, the SNB has already mentioned the possibility of moving to quantitative easing or buying long-term bonds to help ease rates. Furthermore, the SNB has also said that expansionary monetary possibility has weakened the Franc as intended, and that it could intervene in the FX market if necessary. Switzerland also has a large, gummed up financial sector, much like the US and the UK. And, it has a large reliance on its export sector, which is going to be hurting with the global nature of the recession, just like in Japan. Overall, we see CHF as being one of the underperformers this year, with EUR/CHF rising to 1.62 by the end of 2009.