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GDP Growth, Inflation, and the Yield Curve

Wednesday, August 29, 2007

GDP Growth, Inflation, and the Yield Curve

GDP Growth: Statistics Canada reported a rise of 2.8% in GDP annualized over 2006. The latest report available indicates an increase in GDP of 0.3% in May, 2007 after remaining nearly unchanged through April. Strong increases in retail and wholesale trade were present while a drop in oil and gas exploration constrained overall growth. GDP Growth is expected to remain strong through 2007 at an estimated 2.6% and subsequent 2.7 % in 2008.

Higher interest rates combined with an ease in housing starts and slowing profit growth will slow economic growth; however, a number of external factors, mainly a resurgence of the US economy, will keep the overall growth in the Canadian economy near 2.6% in 2007.

As a result of the anticipated growth remaining strong but constrained, the Bank of Canada is likely to hold off on interest rate hikes in the near term. As interest rates remain stable so too will consumption of capital investments as no higher rates will force consumers out of the market and no lower rates will attract new consumers. This policy will continue unless inflation increases, which would result in an increase in interest rates from the Bank of Canada to decrease consumption, or inflation decreases, which would result in a decrease in interest rates to revitalize consumption. Further, as a result of the continued moderate growth in GDP the yield curve has remained stable with a positive long term trend, the stock market although experiencing volatility has held gains through the year and the Canadian dollar has strengthened substantial against the green back and other major currencies throughout the year..

Inflation: Statistics Canada reported in July, 2007 a rise of 2.2% year over year in total CPI, which was identical to increases over the past 3 months. The Cost associated with owned accommodation was attributed for the fourth straight month to represent the most significant portion of the CPI rise. These price increases were offset by falling prices for gasoline, computer equipment and supplies, and natural gas.

Rising inflation due to a world wide economic expansion has caused many Nations to raise rates over the past few quarters in an attempt to ease inflation concerns. With the latest data placing inflation within the Bank of Canada’s target rate of between 1% and 3%, the case for a pause in interest rate policy remains strong. However, caution should be taken as a result of the latest interest rate movement in the US, a half percentage point decrease.

A pause in interest rates generally will not fane or dampen GDP growth and yield curves will remain stable. However, the market will normally predict a rate cut or increase before it is implemented by the Bank.

If the Bank of Canada decides GDP growth will decelerate too much without action, they will decrease interest rates at their September press release and many effects will ensue: the yield curve would steepen in a positive direction, increased consumer spending, yields on fixed income investments become less attractive than stock market gains, debt service costs decline, new equity becomes easier to place, equities rise on justified higher price/earning multiples, the expansion of the economy increases pace, unemployment falls, while inflation would likely increase pace.

Yield Curve: Long term yields on Government of Canada benchmark bonds have decreased recently as a result of market concerns of a pending rate cut in the future. As of August 22, 2007 the current yield was 4.49%. Yields on 3 month Treasury bills have also recently decreased but at a faster rate to 4.01% as of 21 August, 2007. This amounts to spread of 0.48% and implies a normal sloped yield curve that has recently steepened. This positive slope reflects investors expectations for GDP and inflation to grown in the future.

The TSX has experienced substantial gains over the past year while volatility has also been substantial. Under the current yield curve conditions the stock market still remains more attractive to investors than fixed income instruments and the outlook for the Canadian dollar is for further strengthening against the US dollar over the coming years.

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