Big Change in Interest Rate Outlook

By Dr. Peter Andersen

The U.S. and Canadian economies are in a credit squeeze. Market psychology has soured and is not likely to improve anytime soon. The fall-out from the mortgage market debt crisis probably has a long way to go.
Mortgage defaults and foreclosures will continue to increase through the rest of this year and well into 2008. The impact on the financial industry will therefore be drawn-out and uncertain. The squeeze has spread to Europe and Asia. It has also spread to other debt markets. The commercial paper market is experiencing a sharply reduced availability of credit.
The U.S. and Canadian economies are still basically healthy despite what is happening in financial markets. In the U.S., real personal disposable income is growing at a three per cent rate; job growth over the past three months has averaged a decent 135,000; and the unemployment rate (4.6 per cent) is low. Credit is hard to come by in the U.S. housing sector but the economy at large is not in a full-blown credit crunch. Credit spreads are still below long-term averages and the banks are well capitalized.

A key indicator to watch will be U.S. consumer confidence. American consumers are more exposed to the stock market than in previous decades. The latest reading on August consumer sentiment shows a sharp decline to a one-year low but we are not forecasting a 2008 U.S. recession as a result of a credit crunch. However, the probability of a recession has now increased. We put it at about 25 per cent. There would have to be a number of other developments to provide a tipping point, such as a spike in oil prices, a big stock market crash and a refusal by the Fed to cut rates. For now, the world price of crude oil appears to be headed lower, not higher, along with other strategic commodities such as copper.

Real GDP Growth Stronger Than Expected
Canada's economy is being supported by strong personal income growth, robust consumer spending and big gains in resource-based business capital spending. Governments have also ramped up construction for infrastructure and institutional projects. Real GDP results for the second quarter, released on August 31, were expected to show a strong economy. Real GDP growth, measured from the previous quarter, is unofficially estimated to be around 3.5 per cent at annual rates. This is significantly stronger than what the Bank of Canada had been forecasting.
It will therefore be difficult for the Bank to cut rates in response to financial market problems, even if the Fed does cut. Nonetheless, the Canadian dollar has lost some of its appeal in currency markets. The CAD is looked on as a commodity currency and commodity prices are declining in response to the global financial uncertainties. We have always thought that the long-term equilibrium value for the CAD is around 91 cents (U.S.) and, as global risk premiums increase, it could move below this equilibrium level this fall. However, we are forecasting an accelerating U.S. economy in 2008 and this is likely to boost both the Canadian economy and the CAD.
Recent financial market developments have changed the interest rate outlook. The Bank of Canada will forget earlier plans to raise interest rates. We now don't expect the Fed or the Bank of Canada to be raising rates over the next 12 months. Mortgage rates have already begun to edge lower. As a result, the outlook for Canadian housing demand is still positive.

Starts to Decline Slightly
Housing starts are forecast to show only a small decline in Canada in 2007, to an annual total of 218,000 units from 227,400 in 2006. This is a decline of only four per cent. In contrast, housing starts in the U.S. are likely to show an annual decline this year of about 25 per cent. Housing starts in Canada averaged 226,300 units at annual rates in the second quarter. This was actually the highest level since the second quarter of 2006. We are forecasting a decline to an average annual rate of 212,000 starts in the third quarter.
July housing starts, at a 215,600 unit rate, were stronger than we expected. On a year-to-date basis for the first seven months of the year, some provinces are showing increases in urban area starts from last year: Newfoundland (7 per cent), Quebec (6 per cent), Manitoba (24 per cent) and Saskatchewan (69 per cent). In contrast, Ontario shows a 16 per cent decline. Based on July information from Canada's resale market, housing demand is still strong. The number of resale transactions is on target to set a new all-time record high. HB