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Financial Markets Monthly - January 2010

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Data over the past month largely produced upside surprises relative to market forecasts resulting in a sustained pickup in equity markets and a relatively sharp rise in government bond yields. Since our last publication on December 4, 2009, 10-year rates in the markets that we cover were up as much as 16-38 basis points. Yields retraced some ground in the first week of January but remain in the upper end of their 2009 trading range. The world equity market index posted a 2.1% gain during the month, managing to build on the very strong increases in the prior five-month period.

The improved tone in the economic reports led to upward revisions to projections for U.S. fourthquarter growth with the consensus shifting toward the economy growing at a faster pace than the 3% annualized quarterly rate forecasted in early December 2009. The slowing pace of decline in U.S. nonfarm payrolls in the fourth quarter likely helped the revival in consumer confidence for the month and, we expect, supported another monthly increase in retail sales activity. These reports along with improvements in the manufacturing and service sector point to more vigourous activity in the fourth-quarter 2009 than we previously expected. As a result, we revised up our fourthquarter 2009 U.S. real GDP forecast to 3.4% at an annualized quarterly rate from our previous projection of 2.6%. Our 2010 forecast has been boosted slightly, with the economy expected to grow at a 2.6% pace, stronger than the 2.5% rise we estimated earlier. Even with households and businesses continuing to repair their balance sheets, thereby weighing on the pace of the recovery, the passage of the worst for the financial crisis, the end of the housing recession and the steady stream of fiscal support are lessening the chances of the U.S. economy entering a double-dip recession.

Next week's inflation report is sure to be closely watched with the headline inflation rate forecasted to rise to 2.7% in December 2009, the fastest pace since October 2008. Unfavourable base effects, energy prices tanked in December 2008 but held up in December 2009, will take the steam out of concerns that an attack of broad-based inflation is underway. More attention will be paid to the core measure, which has proven to be much less volatile. RBC Economics forecasts the core rate edged up to 1.8% in December with 2009's average annual increase at 1.7%, down from 2.3% in 2008. We expect that the core inflation rate will continue to slide throughout 2010 as the large output gap generated throughout the recession keeps downward pressure on prices in the near term. The sharp increase in the unemployment rate, which averaged 9.3% in 2009 following 2008's low 5.8%, combined with the near-record low capacity utilization rate, highlights the amount of excess slack in the U.S. economy. Estimates suggest that our forecast of a 2.8% year-over-year increase in real GDP in the fourth-quarter 2010 will only trim 1.2 percentage points from the estimated 5.7 percentage point output gap, which is consistent with a limited decline in the unemployment rate.

Given this backdrop, inflation pressures in the US will remain muted with the core inflation rate forecasted to end 2010 at 1.0%. A stronger 3.4% expansion in real GDP in 2011 points to a more substantive decline in the unemployment rate, as the output gap narrows further and is consistent with the core inflation rate rising to 1.6%. As indicated above, the headline inflation will be volatile as the effects of movements in commodity prices produce a near-term rise in the headline inflation rate, which will fade out by year end. In 2011, the headline inflation rate is projected to average 1.8%, just a shade lower than 2010's 1.9% pace.

Our economic forecast supports the case for the Fed to move slowly away from its current level of policy accommodation. Initially, this will come through the termination of its nontraditional policy measures including the end of the security purchase programs. At its December 2009 meeting, the FOMC raised the possibility of expanding some of these programs should the economy weaken or conditions in the mortgage market deteriorate.

Our assumption that the economy will weather the termination of these programs means that, as the pace of economic growth accelerates and the trough in core inflation approaches, the Fed will be in position to take more direct action, and we expect that the Fed funds rate will be raised to 75 bps by year end. This will kick off a year of steady increases in the funds rate, as the economy returns to trend growth, the unemployment rate recedes and inflation rates start to rise. We revised up our forecast for the funds rate at the end of 2011 to 3.25% from 2.75%. On the fiscal front, the improving economy will lend support to government finances as tax revenues increase, although debt levels will remain high. We expect U.S. government bond yields to rise and have revised up our forecasts with twoyear bonds forecasted to end 2010 at 2.25% from our previous 1.85% projection. 10-year rates are also forecasted to end 2010 at a higher level of 4.5% (from 3.75%). Our 2011 forecasts now call for a 4.25% two-year yield and 4.5% 10-year yield at year end.

After the muted start to its recovery, Canada's economy showed signs of picking up pace in the final-quarter 2009. An increase in employment in the quarter spurred a rise in retail spending and likely helped the strong rally in the housing market. This increase in household activity reverberated throughout the economy with manufacturing and wholesale activity rising as well. We expect real GDP growth of 3.4% to be reported for the final quarter 2009 and boosted our forecast for growth in the first half of 2010. As a result, we look for Canada's economy to grow at a trend-like 2.8% this year accelerating further in 2011 with growth forecasted to average 3.9%.

The sharp rebound in Canada's housing market and improved labour market conditions indicate the economy entered 2010 on firm footing. We expect real GDP to increase at an average 3.7% in the first six months of 2010, stronger than our previous forecast of a 3.25% average pace. The gains in employment resulted in the unemployment rate averaging 8.5% in the fourth quarter, a shade lower than the third quarter's 8.6% average level. Stable labour market conditions and with record-low interest rates saw a staggering 7.4% increase in housing resales in the first two months of the final quarter of 2009 with prices hitting an all-time high. Robust housing sales in turn led to stronger construction activity with housing starts hitting their fastest pace in a year during the fourth-quarter 2009.

Our stronger growth profile for the first half of 2010 suggests that the bottom in Canada's core inflation rate will be higher than we previously forecasted, yet we still project it will remain in the lower half of the Bank of Canada's 1-3% target band. Similarly, recent data indicate that the peak in the unemployment rate will likely be lower than our previous forecast. Even with the upward revision to our 2010 growth forecast, the pace of growth will pale compared to previous recovery periods. This means that Canada's economy will continue to have an output gap but it is projected to narrow to 2.2 percentage points in 2010 from an estimated 3.5 percentage points at the end of 2009. With excess capacity still needing to be worked off, the unemployment rate is likely to remain above 8% throughout 2010, falling to 7.5% at the end of 2011. Canada's headline inflation rate will exhibit the volatility associated with movements in commodity prices but will likely retain an upward trajectory in 2011, which would be consistent with our expectation that the output gap will close by year end.

While we made upward tweaks to our forecast, our updated profile provides little incentive for us to change our call that the Bank of Canada will honour its conditional commitment to hold the policy rate at its current level until the end of the second-quarter 2010. Our assessment that the recovery will build momentum throughout 2010, however, supports the case for the Bank to initiate a program to start to remove the extraordinary amount of monetary policy stimulus mid-year 2010.

Our baseline forecast looks for the Bank to raise the policy rate by 100 basis points in the second-half 2010. Most likely the Bank will hike in 50 basis point increments because there will be little value in drawing out the process once conditions warrant less policy accommodation. Another 225 basis points in rate hikes are expected over 2011 with the policy rate expected to settle at 3.5%.

In keeping with the changes to our U.S. forecast, we raised the overall profile for Canadian yields with the two-year yield forecasted to end 2010 at 2.75% (from 2.6%) and the 10-year rate at 4.25% (from 3.8%). These upward revisions are more modest than the changes to our U.S. projections. In 2011, with the policy rate closer to its neutral level, we look for two-year rates to end the year at 4% with the 10-year yield holding at 4.25%.

Canada's currency gained 2.3% against the U.S. dollar for December with the effective exchange rate, excluding the U.S. dollar, up a larger 4.2%. Part of the currency's rally can be traced to oil prices hitting their highest level since October 2008 while non-energy prices recorded a 2.2% gain. Our expectation that Canada's economy will outperform the U.S. economy and that the Bank of Canada will raise rates sooner than the Fed means that there is still more upside for the Canadian dollar ahead. Our forecast is that Canada's currency will break through parity with the U.S. dollar mid-year and only start to weaken once the Fed moves into action late this year.

New Zealand's economy grew in the third-quarter 2009 matching the second quarter's modest gain. Recent data suggest that growth continued in the fourth-quarter 2009 and into 2010 backed by the housing market and consumer spending. RBC forecasts that New Zealand's economy will grow by 2.6% in 2010 and further accelerate to a 3.2% pace in 2011. Based on our forecasts for the New Zealand economy and our view that the annual inflation rate will accelerate to 3% in the second quarter of 2010 from 1.7% in the most recent report, we look for the RBNZ to hike rates in the second-quarter 2010. Our forecast remains that the OCR will rise to 4.00% by the end of 2010 with another another 150 basis points of tightening in 2011 bringing the rate to 5.50%.

Australian labour markets continued to improve as November saw 31,200 net new jobs created pushing the unemployment rate down one-tenth to 5.7%. Although third-quarter 2009 GDP fell short of expectations, it remained in positive territory marking a nine-month period of expansion. Indeed, while much of the world was mired in multiple quarters of output declines, over the past two years, Australia saw only one quarter of negative growth. With no meeting scheduled for January 2010, we look for the RBA to deliver a 25 bp rate hike at its next meeting in February bringing the Cash Rate to 4.00% and 100 bps from its recent low. Our forecast looks for the Bank raising rates to 5.00% by the end of 2010 and to 6.00% by the end of 2011.

In January, the VAT returned to 17.5% after being temporarily cut to 15%, which will affect the profile for growth and inflation in the near term. The annual pace of inflation rose to 1.9% in November 2009 on increases in the price of gasoline, and we forecast January's VAT hike to push annual CPI up to 3.1%. The BoE has said that it will look beyond this increase focusing instead on medium-term price stability. With respect to growth, third-quarter 2009 GDP saw a small upward revision, although it remained in negative territory. Growth in the fourth-quarter 2009 should enjoy a 0.5% quarterly bounce and then decelerate to 0.3%, because consumers likely brought purchases forward ahead of January's tax rise. Looking forward, we look for the U.K. economy to continue to expand although growth will likely be restrained by falling support from the government sector. The BoE is expected to hold the policy rate steady until the final quarter of 2010 with a 50 bps hike forecasted. As the recovery takes hold in 2011, we expect another 150 bps of tightening to bring rates to 2.50% by the end of that year.

The month of December saw survey data continue to improve. The German IFO survey increased with the expectations component rising to its highest level since January 2008. After five months in negative territory, November 2009 annual inflation posted a positive 0.5% reading as declines in year-ago energy prices fell out of the measure; however, it remains well below the ECB's target providing little impetus for immediate rate hikes. We expect the ECB to support growth by leaving its main refinancing rate unchanged until the third quarter 2010. Thereafter, we see rate hikes as the recovery becomes further entrenched, with the policy rate reaching 1.75% at the end of 2010 and 2.75% by the end of 2011.

RBC Financial Group

The statements and statistics contained herein have been prepared by the Economics Department of RBC Financial Group based on information from sources considered to be reliable. We make no representation or warranty, express or implied, as to its accuracy or completeness. This report is for the information of investors and business persons and does not constitute an offer to sell or a solicitation to buy securities.


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