By Benjamin Tal
CIBC WORLD MARKETS

There is little doubt that the focus at this point must be the US economy. In recent months we have argued that this recovery is going to be the most non-linear recovery in recent history. And currently we are in the non-linear portion of the recovery. After expanding very strongly in the first half of the year, the US economy is now losing momentum at a worrying pace. Consumer confidence is still at a recessionary level, the housing market is showing clear signs of double dip, with prices likely to fall in the coming six months, the labour market is softening rapidly and the inventory cycle is fading.

Given the important contribution of fiscal policy to the recovery, the question at this point is to what extent Obama will have the political courage to proceed with his planned fiscal austerity. My guess is that the President will not have the public and political support for such a move. The likelihood is that we might see a second wave of fiscal stimulus in the coming year, including the extension of the Bush tax cut that is supposed to expire at the end of the year.

From its perspective, the Fed is already revisiting its exit strategy. The fact that the Fed is now using the proceeds from its MBS holdings to buy treasuries suggests that it is keeping the level of its balance sheet unchanged. That is—the Fed is not ready to remove liquidity from the market. In fact, I will not be surprised if we will see another wave of quantitative easing in the coming quarters. (If you take a close look at the MBS holdings by the Fed, you will find that the Fed has already added to its position in recent months, despite the fact that officially this program has expired by the end of March 2010).

What might limit the degree of a second round of quantitative easing (QE2) is not the willingness of the Fed to do it, but rather doubts about its effectiveness. After all, even another trillion dollars of monetary stimulus can make little difference if banks are unwilling to lend. And that’s where the focus should be. Recent numbers clearly show that banks are more comfortable collecting the low interest rate on their reserves holdings with the Fed than lending it to firms and individuals.

The other focus of course must be the US labour market, and here the trend is getting worse with the unemployment rate still extremely elevated and the pace of job creation slowing notably. In fact, something interesting is happening in the American labour market. If you look at job openings in the US, you will find that there is in fact a V-shape recovery in this category. Job openings are rising much faster than job acceptance. It is easy to be cynical and say that many Americans are choosing unemployment benefits over available jobs on offer. I doubt that this is in fact the case. A more likely possibility is that firms are taking their time in the hiring process. Given the low bargaining power of labour, they can take their time and look for the best candidate with no sense of urgency.

This environment is of course inconsistent with the Fed raising rates any time soon. Look for the Fed to be on hold until 2012.   If you are the Bank of Canada, how do you deal with this situation? Yes, the Canadian economy is in a better shape, yes the output gap in Canada is much narrower and inflation is a bit higher. And yes, the inflation adjusted Bank Rate is still negative. But do you have the guts to continue raising rates in this uncertain environment? The market is currently discounting a 60% probability of a move in September and a zero probability of a move in October. Regardless, the Bank is very close to ending the first phase of its monetary tightening

The Bank of Montreal has warned the government against deficit cutting, which it sees as counteractive during times when world’s economy is so unstable.

The bank also advised against setting any hard deadline for ending its stimulus programs, and pointed out that the government should wait until the end of the global economic recovery is on sight.

BMO mentioned the  expansion of the Trans-Canada highway near Lake Louise, as an example of the type of public spending that will help fight the negative effects of recession.

Its advice didn’t stop at the Canadian government, recommending also that most industrialized nations should continue spending public money to support the global recovery.

To support its arguments, the bank tried to dispel what it calls myths about spending, including that bond markets are worried about high borrowing by governments. That would usually be indicated by high interest rates as lenders priced in the higher risk of default, but BMO said most government bond markets are showing no such concern this year.

“Quite the contrary,” said the report’s author, and the Bank’s deputy chief economist, Douglas Porter.

“Ten-year U.S. treasury yields have recently dropped to their lowest level since April 2009, when the economy was still mired in recession and losing more than 600,000 private sector jobs per month,” he said.

Porter said another myth is that the U.S. has committed itself to massive stimulus. The truth, he said, is that spending cuts by state and local governments have negated much of the spending by Washington.

In Canada, the commentary said, the reverse has happened, with provinces adding to federal stimulus.

“The direct impact of government spending and investment has added 1.6 percentage points to GDP growth in [the 12 months ending in March], compared with a typical annual addition of just under 0.6 percentage points over the past 30 years,” said Porter.

The bank published all these recommendations just a day after world financial markets fell amid concerns about the real strength of the global recovery.

By Benjamin Tal
CIBC WORLD MARKETS

There are already early signs that point to the non-linear nature of the current recovery in both Canada and the US.

• Excluding the one-off impact of census related hiring, overall employment growth in the US during May was very weak.
• Retail sales fell by 1.2% in May. Sales tumbled at building supply stores, reversing more than half the surge of the prior two months. As well, auto sales show a notable softening.
• Overall mortgage application volume, which includes loans for purchases and refinancing, dropped by more than 12% during the week ending June 4, compared with the previous week. Refinance volume tumbled 14.3%. This is the lowest level in more than 13 years—a clear sign that the housing market is struggling without government incentives.

These observations are consistent with our call that overall US growth in the second half of the year and early 2011 will be on the soft side. This suggests that the Fed will not touch rates until probably the second quarter of 2011.

Note that the temporary lift from the government has led to a reversal of the deleveraging process by American households in recent months. For example, the saving rate is now at 3.4%—down from 5.4% in the second quarter of 2009. Even more interesting is the difference in savings among income groups. The savings rate of Americans with income of more than $100,000 fell to the level seen before the recession. At the same time, those who earn less than $100,000 managed to increase their saving to a 20-year high. As well, credit is starting to rise, but even here we have to take a closer look. Total revolving credit (credit cards) was down by $8.5 billion while non-revolving loans (car and mobile homes) were up by $9.5 billion. This suggests that banks are very selective in their lending practices which, in turn, lead to some improvement in the quality of credit.

In Canada there are clear signs that the housing market is softening. Housing starts are slowing, while supply of existing houses is outpacing demand. This raises the issue of the quality of mortgage credit in Canada, and how significant will higher rates will be impacting the market as a whole.

Note that the vast majority of home owners in Canada regardless of their age have not experienced any worsening in affordability despite the rapid increase in prices. The only sub-group of households that have seen some deterioration in their affordability position is older Canadians with average income of less than $50,000. Zooming in on this group we find that on average they spend close to 60% of their gross income on mortgage payments, property taxes and electricity costs. This is three times the average ratio seen among households at the same age groups but with income of over $50,000. Note, however, that as opposed to the situation in the US and to a common misconception, the share of this vulnerable group in total mortgage holders in Canada is on the decline—currently accounting for Just over 13% of all mortgages in Canada, down from 19% five years ago. Also note that the share of the least vulnerable group (older/higher income) is on a clear upward trajectory. The practical implication of this finding is that the composition of the mortgage market in Canada has, in fact, improved over the past few years.

Interestingly, there is no significant difference in affordability between households with fixed rate mortgages and those with variable rate mortgages. While variable mortgage holders enjoy lower interest rates, the average mortgage they carry is 7% larger.

While one cannot ignore the risk of an outright decline in home prices in the coming 12-18 months, nothing in the data supports a market crash. As opposed to the US, the share of mortgage holders in Canada has in fact declined in recent years, while the increase in the average size of mortgage has not coincided with a significant worsening in affordability. While higher interest rates will clearly erode affordability, our detailed look at the distribution of mortgage payments as a share of income does not reveal major pockets of vulnerability. Accordingly, the most likely scenario is that higher interest rates will lead to a modest decline in prices (probably in the magnitude of 5%-10%) in the coming year or two. But given relatively modest rate hikes and the current balanced affordability position, the more significant adjustment will be in housing market fundamentals that are likely to catch up with prices in the coming years—paving the way for a healthier housing market by mid decade.