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Rate hikes around the globe to impact economic conditions and financial markets: TD Economics

4 minute read
By TD Bank Group
• Jun. 20, 2007
TORONTO, June 20 /CNW/ - Rising interest rates will temper global economic growth and will shape the performance of financial markets in the coming quarters. TD Bank's Chief Economist, Don Drummond, stated: "A global rebalancing in monetary policy is underway, and the Bank of Canada will join the fray this summer." The June issue of the TD Quarterly Economic Forecast predicts that the global economy will ride out the higher interest rate environment remarkably well, but financial markets could experience greater volatility as investors adjust to the new reality and equity markets are unlikely to replicate the double digit gains of the past few years. The report can be found at www.td.com/economics. Over the past five years, the global economy has been on a tear, but technological innovation and the disinflationary impact of globalization has kept inflation at bay. However, capacity constraints are increasingly being encountered. In some emerging markets, such as China, the impact is being felt in asset prices. In the case of developed nations, the result has been remarkably tight labour markets, even in countries experiencing sub-par growth, like the United States. "The good news is that monetary authorities are being proactive and are raising rates before inflation gets out of hand, reducing the risks of an economic downturn," said Don Drummond. In the months ahead, the European Central Bank, the Bank of Japan, the Bank of England, and the Bank of Canada - every G-7 central bank with the exception of the U.S. Federal Reserve - will increase their policy rates. And, while the Fed is likely to remain on hold, this is a tighter stance to policy than financial markets had expected until only a few weeks ago when rate cuts were anticipated. "However, while the global economic expansion will be dented by the rebalancing in monetary policy, it should not be thrown off the rails," said Drummond. The fallout from higher rates in the near term should be largely felt in the second half of 2008 and early 2009, with world real GDP slowing to a still robust 4%. In Canada, the Bank of Canada is clearly concerned about price pressures - and recent economic developments suggest that it should be. The economy was operating at full capacity at the end of last year and real GDP surged at a 3.7% annualized pace in the first quarter of 2007. The tracking for the second quarter is pointing to a gain of 3.3 %. As a result, a state of excess demand exists with capacity constraints being encountered, as latter reflected in a 33-year low in the unemployment rate and an upward drift in core inflation away from the Bank's 2% target. Given these conditions, the Bank is poised to raise rates, likely on July 10th and September 5th. The tightening in Canadian monetary policy will likely contribute to a Canadian dollar averaging 96 U.S. cents in the second half of this year. The one-two punch of higher interest rates and Canadian dollar will lead to a slower pace of economic growth and a 2.5% increase in real GDP in 2008. "This may look like a disappointing performance and it is likely to lead to many comments about how Canada is experiencing an economic slowdown. The reality is very different," said Drummond. The forecast is only marginally below the Bank's estimate of the non-inflationary potential growth of 2.8%. Moreover, given Canada's dismal productivity performance in recent years, there is a distinct possibility that potential growth is even slower. "As a result, 2.5% economic growth may be the best that Canada can do, and there is a risk that the Bank could be forced to engineer a weaker performance with even higher interest rates if Canadian productivity does not improve on a sustained basis," said Drummond. So, the global and Canadian economies are likely to weather the rebalancing of monetary policy, but the financial implications will be far reaching. The key financial themes include: - The return on cash products will rise in tandem with central bank rate hikes. - Higher short-term rates will boost bond yields, but the impact should be extremely limited since markets have already priced in much of the future policy tightening and inflation should remain tame. - Equity markets will be adversely affected in a number of ways. First, higher interest rates will make fixed income products more attractive, while also making equity valuations look more expensive. Second, higher interest rates will lead to softer corporate earnings growth. Third, commodity prices are expected to dip as global growth moderates, but tight supply should keep prices for energy and many other products at very profitable levels. Increased borrowing costs may also temper the recent explosive pace of mergers and acquisitions. "Overall, equity markets are expected to advance, but returns are likely to be in single digits and investors should be braced for increased volatility," said Drummond. For further information: Don Drummond, SVP & Chief Economist, TD Bank Financial Group, (416) 982-2556; Craig Alexander, VP & Deputy Chief Economist, TD Bank Financial Group, (416) 982-8064

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