Toronto, ON — Canadian and U.S. interest rates are headed in different directions in the near term, according to Global Insight Inc. The Bank of Canada reduced the overnight rate by 25 basis points on Jan. 20, 2004, to 2.50%, and its comments point to at least one more rate cut.
In contrast, the U.S. Federal Reserve (the Fed) started to prepare markets for an eventual tightening cycle in its statement following the Federal Open Market Committee meeting that ended on Jan. 28, 2004. Global Insight expects the Bank of Canada to reduce the overnight rate another quarter percentage point at the March 2 meeting, while it believes the Fed could raise interest rates as soon as June, possibly by 50 basis points.
Canadian and U.S. economic forecasts are diverging
Global Insight revised down the forecast of Canada’s GDP growth for 2004 from 3.6% in December to 3.4% in January. Meanwhile, its January forecast calls for the U.S. economy to expand 4.7% for the year, matching its December prediction.
The downgrade to the Canadian forecast was partly due to unexpected fiscal tightening by the federal government and in several provincial jurisdictions, including Ontario, and in Newfoundland and Labrador. In contrast, U.S. fiscal policy remains highly stimulative at the federal level, with a partial offset from fiscal consolidation by state and local governments.
Recent data on Canadian economic activity suggest downside risks to growth. A few more releases are still expected to come out for the fourth quarter of 2003, but what is already available suggests fourth-quarter GDP growth in a 3.5%-4.0% range, rather than the 4.3% rate anticipated in the January forecast. Retail sales lost momentum in the middle of the fourth quarter, dominated by a slide in motor-vehicle sales. While export volumes managed to rise in November, manufacturing data show a worrying decline in unfilled orders. Unfilled orders had been falling sharply since mid-2002, reaching the lowest level in over six years last November.
The exchange rate clouds Canada’s outlook
On an average annual basis, the Canadian dollar appreciated 12% relative to the U.S. dollar in 2003. This was the largest yearly appreciation in history, and forecasters are scrambling to come to grips with its impact on the economy.
The Bank of Canada made an about-face in its economic forecast for 2004 in January’s Monetary Policy Report: Update. Increased concern about the exchange rate’s impact on exports played a large role. The bank revised down its GDP growth forecast for 2004 from its previous 3.25% to 2.75%.
In early December 2003, the bank maintained its October Monetary Policy Report argument that higher commodity prices and a pickup in U.S. growth were helping to insulate Canada’s economy from the negative impacts of the rising Canadian dollar. But the Update noted “the stronger Canadian dollar appears to have begun to cut into the pace of economic activity in terms of weaker-than-expected export growth and signs of greater import penetration in the fourth quarter.”
Exchange rate likely to affect exports in 2004
Global Insight estimates that Canadian export volumes fell slightly in 2003. In contrast, U.S. export volumes are set to increase slightly. An estimated 12% depreciation of the U.S. dollar relative to a currency basket of the United States’ major trading partners was likely a factor, but it usually takes several years before a currency movement has its full impact on international trade and the economy. Consequently, the divergence in Canadian and U.S. exchange rates will likely have more impact on exports in 2004. Global Insight expects Canadian exports to rise 4%, while U.S. exports are forecasted to increase almost three times as fast.
The Canada/U.S. exchange rate reacted sharply to indications of divergence between the two countries’ monetary policies. The Canadian dollar fell almost one U.S. cent following the last rate cut by the Bank of Canada, and more than a cent after the Fed statement. After rising toward 79 U.S. cents in the first half of January, the Canadian dollar was dropping toward 75 U.S. cents late in the month. The Canadian dollar was not alone in its recent decline. The Norwegian krone also fell relative to the U.S. dollar, as the Norwegian central bank cut interest rates by 25 basis points and hinted that more cuts could follow.
Although the Fed’s statement provided broad-based support to the U.S. dollar, Global Insight believes current account considerations, which dominated U.S. dollar trading last year, will continue to exert significant downward pressure on the currency this year. Currencies of countries that maintain large current account surpluses, such as Canada, are expected to appreciate in order to bring the U.S. current account deficit to a more manageable level.
In the case of Canada, the merchandise trade surplus averaged $57 billion (annualized) in October-November 2003. This indicates that the fourth-quarter current account surplus likely fell to around $25 billion, down from $29 billion in the third quarter. Still, relative to nominal GDP, this implies a relatively large 2.0% surplus and contrasts with an estimated 4.9% U.S. deficit.
Look for an 80-cent dollar
The yield spread between Canadian and U.S. three-month T-bills narrowed to 130-140 basis points in late January 2004, from an average of 172 basis points in the fourth quarter. Global Insight expects the Canadian dollar to partly rebound in coming weeks and to rise to 80 U.S. cents by the end of 2004.
Meanwhile, the U.S. dollar is forecasted to fall 5-10%. This will keep Canadian and U.S. monetary policies on different courses in the first half of the year. Even when the Bank of Canada starts raising interest rates in late 2004, the pace is expected to be as cautious, if not more so, as in the United States. Consequently, the spread between Canadian and U.S. three-month T-bill rates is forecasted to stay in its recent range, with a risk of narrowing further.
Global Insight Inc.’s Canadian Service provides clients with analysis, data, and forecasts for the Canadian economy and the individual provinces. Its clients use the Canadian Service to assess economic, financial and investment risk, as well as business opportunities. The Canadian Service Forecasting Team has won a KPMG award for forecast accuracy three times over the past decade. For more information, visit www.globalinsight.com.