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LOBAL OSITIONING TRATEGIES
March 17, 2011
Peter Buchanan Economics (416) 594-7354 email@example.com Warren Lovely Government Finance (416) 594-8041 firstname.lastname@example.org Katherine Spector Commodities (212) 885-4339 email@example.com Jeremy Stretch Foreign Exchange +44 (0) 207-234-7232 firstname.lastname@example.org Joanna Zapior, CFA Corporate Credit 416) 594-8498 email@example.com
Coping With Uncertainty
Economics (Buchanan): Risk aversion was on the rise due to higher oil prices, renewed euro debt fears and emerging market policy restraint, even before the still not fully clear effects of the earthquake in Japan. The markets’ reaction to events there reﬂects a general distaste for uncertainty. Solid domestic Q1 growth prospects support our view that the Bank of Canada will end its pause at the May meeting. Fragile recoveries and uncertainties will help keep major central banks elsewhere on hold (UK, US) or could see a delay in announced tightening plans (ECB). Foreign Exchange (Stretch): After a prolonged period of emergency monetary policy it seemed, at least ahead of the Japanese tragedy, that policymakers were gearing up for normalization; FX dynamics being determined by monetary policy set against risk appetite. If we do not face the worst case scenario in Japan then the prospect of an ending of QEII, heavily skewed market positioning versus the USD, a deceleration in global activity, led from Asia ex-Japan, points towards a broad based cyclical USD bounce in the upcoming quarter. Government Finance (Lovely): Budget season is in full ﬂight and there’s plenty to watch out for. External risks have mounted, and we examine regional implications from Japan’s disaster and high energy prices. In spite of global uncertainties, revised provincial growth forecasts show a further improvement vs. our earlier call, adding extra revenue to the ﬁscal plan and allowing some governments to more credibly trace a path back to balance. Credit (Zapior): We assess the strength of the spread rally of the last 10 months in Canada and the US in an historical context, as well as within the framework of our 2011 spread forecast. Spreads are tracking the tight end of the range in the second most optimistic forecast scenario, while key spread drivers are more closely ﬁtting the “meet expectations” scenario. Nevertheless, “priced for perfection” spreads should be sustainable, even with economic headwinds, if the strong demand for credit product continues.
Internet: http://research.cibcwm.com/ economic_public/download/ gps_mar11.pdf on Bloomberg: WGPS <GO>
Commodities (Spector): Most major crude grades—North American and otherwise— have rallied hard this year to date. The strength we have seen recently in Brent has been broadly reﬂected across sweet grades globally. But US benchmark West Texas Intermediate has lagged other crudes, and we see this disconnect continuing at least through the end of the year.
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if anything.7 1. than the consensus now believes before policy there edges back toward restraint.0 2. The Bank’s March 1st statement emphasized geopolitical uncertainties. there were signs that investors were starting to revisit some of their more optimistic assumptions about just how well things would turn out on the economic front in 2011.8 7. Moreover. Real GDP Growth (AR) Real Final Sales (AR) All Items CPI Inflation (Y/Y) Core CPI Inflation (Y/Y) Unemployment Rate (%) 10Q4A 2. and there are still good reasons why history may Table 1.7 1. No country is an island—least of all Canada.4 U.3 1.3 1.6 11Q1F 3. only to crash back to earth.0 11Q3F 1.1 9.March 17.8 1.CIBC WORLD MARKETS INC.4 1.7 12Q2F 3.4 1. That and still-contained inﬂation readings are a reason not to look for an April rate hike. It will be some time before the information is available to make a complete and accurate assessment of the implications of events there.6 1.4 2. Economic Update CANADA Real GDP Growth (AR) Real Final Domestic Demand (AR) All Items CPI Inflation (Y/Y) Core CPI Ex Indirect Taxes (Y/Y) Unemployment Rate (%) 10Q4A 3.5 11Q3F 2.0 1.5 2.S.0 2011F 2.2 1.0 1.1 1.3 12Q1F 2.2 2. central bankers in both the US and UK have also highlighted still fairly signiﬁcant risks to the recovery.8 12Q1F 2.2 9.5 2010A 3.9 1.7 9.4 1.7 8.8 1.8 2.9 7. Higher Oil Prices High on Global Worry List Nosebleed oil prices are one reason why growth this year may not match the barnburner pace some were predicting with arguably a touch too much conﬁdence earlier. although we still see the Bank pulling the rate trigger at its May setting. in the face of a number of developments.1 2012F 2.7 11Q1F 4.1 1.7 8.1 2010A 2. and there were hopes the momentum would carry fully over into the new year. It didn’t take long for those high.4 7.1 4. As we went to press.6 9.5 2.2 9.9 1. hampering growth as inﬂation tops ofﬁcial targets.5 2.9 1.8 3.7 1.3 2.1 1. 2011 ECONOMICS PETER BUCHANAN New Headwinds Give Central Banks Reason Not to Tighten Hastily Markets have regained a healthy respect for risk in recent weeks. Surging gasoline prices raise questions about whether US consumer spending can continue its healthier pace.2 1.0 11Q2F 2. Fears of a double-dip recession eased as 2010 wore on.8 7. While the ECB has struck a hawkish chord recently. markets were still trying to come to grips with the consequences of the horriﬁc tragedy in Japan.6 7.5 2.3 2.8 1.1 2.9 2 .3 4. GPS Monthly . hinting at a broad risk category. both for Japan itself and other nations. With the focus on containing red ink.8 1.3 0.9 2.0 7.9 1.7 11Q2F 2.0 2.7 2.5 1.0 9.7 2.7 7.1 1.8 6.3 12Q2F 2.7 9. reinforcing our view that it will be longer.7 2.6 11Q4F 1.7 9.7 1. but the (arguably) still relatively small chance of contagion laying low a top-tier OPEC producer like Saudi Arabia or Iran.5 2.0 2.9 7.3 2.8 7. Even before disaster hit that country.1 3. and in some cases overdone.0 1. governments in the industrialized world are reaching for the spending ax. Libya accounts for just 2% of global crude supply.3 2.6 2011F 2.0 9.9 1.2 11Q4F 1. but investors have been looking not just at events there.9 2. Oil has risen dramatically before.8 2.3 2.0 1. hopes to begin to fade.6 2012F 2.8 2. monetary policy in last year’s hot performers—the emerging markets—is poised to tighten further.
35 3.70 11.65 3.60 0.70 0.01 1.40 1.00 0. That’s not to say that the impact of the recent 2012 Sep 1.80 1.70 0.75 1.20 0.35 1.69 0.25 0.50 0.5 2.92 1.0 3. though.55 3.0 2.00 0.85 2.00 4.97 1.S.97 94 1.85 4.34 1.75 industrial economies.5 0.40 3.03 0.5 1.15 0.65 3.75 3. however.85 2.97 1.00 Jun 2.90 1.40 3.5 3.00 Sep 2. and the Saudi’s recent output hike suggest the cartel has at least some spare capacity.US 10-Year Bond Spread Canada Yield Curve (30-Year — 2-Year) US Yield Curve (30-Year — 2-Year) EXCHANGE RATES CADUSD USDCAD USDJPY EURUSD GBPUSD AUDUSD USDCHF USDBRL USDMXN 16-Mar 1.31 1.95 0.90 0. and over 4% in the second (Chart 1).15 0.85 3.80 4.20 0. later in the decade. A $10-15 pullback in oil prices isn’t implausable.20 0.99 89 1.95 4. But even if things don’t play out quite that way.10 1.45 4.85 Dec 2.11 3.10 1. Industrial-country inventories were adequate when the Middle Eastern political pot began bubbling. given this.00 1.50 3 .33 1. involved a much harder blow to the Table 2.00 4.March 17.98 92 1.70 0.64 0.20 0.03 1.85 0.96 1.62 12.29 1.15 0.50 4.99 1.CIBC WORLD MARKETS INC. that pricey oil was not the main reason growth ﬂoundered in a number of these cases.00 Mar 2.00 3.06 2.65 2.95 0.62 12. Oil Supply Shocks 4. Both of those episodes. GPS Monthly . not sky-high. Interest and Exchange Rate Forecast 2011 END OF PERIOD: CDA Overnight target rate 98-Day Treasury Bills 2-Year Gov't Bond 10-Year Gov't Bond 30-Year Gov't Bond U.20 1.15 0.85 -0.98 90 1.20 1.80 1. % of GDP repeat itself. The 2001 recession was arguably far more about the severe blow to investment spending and consumer conﬁdence from dot.04 Jun 1.02 0.62 11. than $1.0 Iranian Revolution 1973 OPEC Embargo Iraq's Kuwait Invasion Since Start of Recent Turmoil Rise in OECD countries' oil costs.95 4.99 1.15 0.25 1.50 3.99 88 1.85 1.25 3.01 0.01 0.85 2. based on the increase in costs to oil consumers in those countries.70 0.55 3.58 0.01 1.04 84 1.80 1.32 1.10 0.90 3.65 3.75 1.25 0.65 1.5 4.02 0. Federal Funds Rate 91-Day Treasury Bills 2-Year Gov't Note 10-Year Gov't Note 30-Year Gov't Bond Canada .10 1.35 3.98 1.75 0.65 3.67 12. moreover.55 4. The back-to-back recessions of the mid-1970s and early 1980s were clearly much more an oil story.60/gal gasoline.66 11.60 4.05 1.65 0.01 0.0 0. helped accentuate the US economy’s troubles in the early 1980s.67 0.94 0. Most observers would argue. in contrast to the situation when oil spiked three years ago.35 3.20 2.09 0.61 11.65 0.05 0.85 4.99 80 1. recession-inducing ones that crush oil demand.14 3.54 0.06 1.37 0.97 1. 2011 Chart 1.00 1. OPEC likes ﬁrm prices.65 3.85 3.01 87 1.00 1.61 0.20 0.60 3.20 0. the historical evidence suggests that they would probably have to climb a fair bit higher to undermine the recovery on their own.90 3. The Fed’s uber-hawkish stance.75 1.90 0.55 3.05 1.94 1. Given declining levels of oil intensity and other factors.55 1.39 1.15 0.20 0.85 Dec 2.20 4.99 0. Oil consumption costs rose by the equivalent of nearly 3% of GDP in the ﬁrst of these cases.US T-Bill Spread Canada .90 0.0 1.00 1. Oil prices did surge ahead of five of the last six US recessions.com implosion. oil prices would have to reach $160/bbl to match the ﬁrst of those two knockout punches and nearly $200 to match the second.25 1.60 1.50 3.96 1.58 3.10 1.15 0.97 1.80 1.90 3.00 1.25 3.90 2.32 1.81 1.30 4.63 12. and oil’s gyrations certainly didn’t blow up the US sub-prime mortgage market.
7 11.3 0.5 -0.3 Quarters from start of shock Quarters from start of shock 4 .3 -0. approximating the recent increase.2 0. The C$ followed crude north in the 2008 spike only until prices hit $100/bbl. and the provincial implications of oil prices have typically overshadowed the national macroeconomic ones. Canada is divided between an oil consuming east and producing west.2 -0.4 11. begin to increasingly outweigh producer rents once prices reach triple digits. A 25% rise. 2011 Chart 4.1 -0. CIBC calculations price run-up has been inconsequential.6 % chg.Jan-11 10 Feb11* Personal Disposable Income. SAAR Pre-shock = 100 100.1 -0. like weakness in trading partners and auto sales.5 1 2 3 4 5 6 7 Growth (L) Level (R ) 8 9 10 99. Chart 2. Canada is one of the world’s top dozen net exporters of oil and oil products (Chart 4).4 -0.3 Aug10 Sep. All signs are that the relationship between growth and oil prices is a non-linear one— meaning simply that some is good.7 99.4 99. Impact of a 25% Oil Price Shock on US Real GDP 0. Oil and the US Consumer 11.8 11.1 0. including the drag on key trading partners and Chart 3.March 17. That would seem to suggest that for Canada the negative effects of costlier oil. and key variables like the currency and rates. That suggests one shouldn’t take too much comfort from the recent resilience of energy-sensitive categories of demand like auto sales. Impact of a 25% Oil Price Shock on Canadian Real GDP 0. Beyond a couple of quarters.Oct-10 Nov10 10 *CIBC estimate Dec.0 -0.0 -0. We used a standard statistical modeling approach1 to get a better handle on the impact of oil price changes on the Canadian and US economies. $Tn SAAR GPS Monthly .CIBC WORLD MARKETS INC.6 99. the rise in food and gasoline prices since the start of the year has effectively offset most of the beneﬁt to consumers from the recent tax stimulus (Chart 2). SAAR Pre-shock = 100 100.5 99.7 99.6 1 2 3 4 5 6 7 Growth (L) Level (R ) 8 9 10 Source: CIBC Chart 5. As that might suggest. ordinarily lifts real GDP growth by a couple of ticks in each of the two following quarters.8 99.0 99. a lot bad. the negative effects (Chart 5).3 -0. In the US.2 -0.9 % chg. Our analysis suggests that it takes about a year for the US economy to feel the full pinch from an oil price shock (Chart 3).0 99. World's Largest Net Oil Exporters (2009) Russian Federation Saudi Arabia Iran United Arab Emirates Norway Kuwait Venezuela Algeria Kazakhstan Qatar Mexico C anada 0 2 4 MM Bbl/day 6 8 As reported Left over after costlier gasoline & food Source: US DOE.6 11.1 100. our analysis implies that in the near term higher crude prices are a modest plus for the economy.5 11.8 99.1 0.4 -0.9 99.
to this point.6 100. US Fiscal Outlook 120 100 80 60 40 20 0 *CBO Baseline with an extension of Bush tax cuts beyond 2012. Federal spending cuts have clearly moved to the front of the policy burner. After riding some strong tailwinds late last year.5 100. Our model is thus able to capture how a rise in oil prices impacts Canadian GDP directly and the induced effect from changes in the US economy’s performance. those developments have led to a scaling back of earlier optimism and an increase.3 100. That will cool performance in what. and involves regressing each of a number of variables (Canadian and US real GDP growth. Federal cuts come. growth simply won’t surprise to the upside the way it has in recent years. the global economy ﬁnds itself buffeted by new and. Chart 6. 1 The approach is known formally as a vector autoregression. have been some of the world’s hottest performers. just as state governments are also going on a ﬁscal diet. AMT indexation and const. and the exchange and interest rates. 5 18 20 20 20 00 . and on 10-Year GoC Yields (R) Pre-Shock = 100 100. after last year’s over-10% advance. completely unforeseen developments. Beyond four to ﬁve quarters. in risk aversion. the bad more than cancels the good. While the risk of outright recession would still appear to be quite low.5% pace this year. A third cloud on the global growth horizon is the fact that while inﬂation still looks fairly tame in most developed countries. Although rising debt levels (Chart 7) will result in dramatically higher interest payments over time.March 17. and the level of GDP is actually lower than it would otherwise have been.9% in February. for now at least. Publicly held debt without major policy changes (% of GDP*) C$ Appreciation 14 12 10 8 6 4 basis-point deviation from pre-shock C$ Depreciation 2 02 04 06 08 20 10 12 14 16 2 3 0 4 5 6 1 2 3 Quarters from start of shock 4 5 6 Fiscal Years auto sales begin to outweigh the positive.0 99.1 100.8% forecast for 2011 US GDP growth (Table 1). hurting GDP growth.CIBC WORLD MARKETS INC. Impact of a 25% Oil Price Shock on CADUSD (L). A further negative is the increasing drag from induced C$ appreciation on the country’s non-energy exports (Chart 6). While those economies are unlikely to sink into recession. The blow from front-load spending reduction is one reason we expected the US growth numbers to sport a two. The headwinds from ﬁscal restraint will intensify further in 2012 as measures like the $120 billion social security tax cut expire. Medicare rates after 2011. moreover.rather than three-handle moving into 2011. One is ﬁscal restraint. cutting spending sharply while the economy is still recuperating is not without risks. emerging markets are likely to have to tighten further to ensure long-term price stability.2 100.7 100. Oil price hikes and government cutbacks have also led us to pare a tick from our previous 2.4 100.8 100.9 1 Source: CIBC GPS Monthly . Spending Cuts Could Reverse Half of the Recent US Tax Stimulus Compounding the ill global growth consequences of pricier oil is the drag from a couple of other sources. CAD and 10-year government of Canada yields) on lagged values of each other. in some cases. 2011 Chart 7. Monetary tightening and other restraint measures there will help to cool GDP growth to an 8. particularly in the US. China’s inﬂation rate remained stubbornly high at 4.
The by-product of such trends is that one of the traditional dynamics of foreign exchange performance. While the end of US QEII is a potential pivotal event in Q2 it perhaps may not be the only changing dynamic from the US side of the monetary equation. led through current events. the next 2-3 month’s looks set to be a pivotal period. at least ahead of the tragic events in Japan. Continued positive but unspectacular US GDP growth. But it seems likely that the front end of the US curve is set to remain locked for a considerable period. up around US$280 bn since the start of Q4. not least when one considers the longer term ramiﬁcations of US ﬁscal imbalances. this as emergency settings are increasingly seen to be distorting behaviour.CIBC WORLD MARKETS INC. namely US QEII. USD Cumulative Net Shorts at All-time Highs * USD Basket 150 100 50 0 -50 -100 -150 -200 -250 -300 -350 Jan-09 Jul-09 Feb-10 Aug-10 90 88 86 84 82 80 78 76 74 72 70 Mar-11 Total Net Positions LHS DXY Index RHS Source: Bloomberg reveals cumulative USD net short positions at record levels and thus ripe for correction. allied to an end of cheap USD liquidity. But with little prospect of the Fed looking to tighten policy until 2012 at the earliest. It seems there is some dissent within the Fed as regards the perpetuation of the ‘extended period’ language in the Fed statement. the end of QEII is in sight as the US$600 bn target and June end date come into view.March 17.. points towards a trough in USD negativity. The balance sheet of the US Federal Reserve has ballooned over the last ﬁve months as the second round of quantitative easing has seen a plentiful supply of cheap USD ﬂood the market. Having seen the Fed’s balance sheet expand to more than US$2. this as factors such as the oil price have potentially signiﬁcant implications for the amount of USD to be re-cycled. While that is the case it could well be the ending of the one of the unconventional monetary policies. i.e. Central bankers in general are increasingly aware of the need to begin (ECB) or in some cases extend the normalization process (BoC). In terms of monetary policy direction. will see increased importance. The benign by-product of a deceleration in global demand. no longer seeing the USD perpetually used as a cheap funding currency. any USD reversal is likely to be relatively short lived. This should prove the case as structural risks in the eurozone remain prevalent into Q2. 2011 FOREIGN EXCHANGE JEREMY STRETCH Risk Dynamics and Policymakers Having endured a prolonged period of emergency monetary policy strategies it seemed. which has a profound impact on FX markets.5 trn. . the Fed keeping the front end locked indeﬁnitely. that policymakers and policy direction was increasingly being geared towards a degree of normalization. could be set for reassessment ahead of the culmination of QEII in June. namely interest rate spreads. due to the market not viewing signiﬁcant risks of the Fed looking to hike until at least well into 2012. GPS Monthly . that being an issue which is likely to become more evident as 2012 US Presidential race proceeds. It would seem that even though core inﬂation in the US remains well behaved and labour markets fragile the reference to keeping rates unchanged for an extended period. It is likely therefore that FX dynamics are set to be determined by a combination of changing monetary policy influences and the pace of global recovery being set against market risk appetite. especially banking related pressures. being a potential ease in commodity price inﬂation. But a market looking to anticipate an end in the ﬂood of ‘cheap’ USD into the end of Q2 could trigger a reversal of broad USD negativity. this as speculative positioning data into the start of March 6 Chart 1.
despite the risks to domestic growth or employment. With the authorities consistently having under estimated risks markets are likely to remain somewhat circumspect in terms of ofﬁcial estimates. which potentially provide an aggressive economic drag which could eventually prove more signiﬁcant than the Y10 trn impact in 1995. the answer to that will go some way to under writing EUR performance. allowing the exclusion of any write downs on sizeable peripheral debt holdings. But of course the human tragedy is far worse. The burden remains on individual states to stem the fiscal crisis through prolonged . hiking rates when economic conditions are ‘far from easy. Japanese Quake Concerns While global policymakers have been increasingly looking to normalize policy the horriﬁc events in Japan have for some proved to question the premise of the ability of policymakers to normalise the global monetary stance. economic weakness in the periphery. the credentials of the test remains questionable.CIBC WORLD MARKETS INC.’ It does seem that although the ECB has yet to cure the regions banks from their lending addiction they wish to signal an attempt towards normalization even if any move in April is more symbolic as opposed to the start of a series of hikes. notably in terms of Portugal likely facing pressure for a bailout in upcoming weeks. With Portugal set to be further pressured by tightening monetary policy the looming €4 bn bond redemption due on April 15 remains a major hurdle. Of course in the short term the market has attempted to draw parallels with the Kobe earthquake. taking the burden from the ECB. In terms of the banks. the ratings agencies or the central banks. Moreover. in contrast with 1995. US Twin Track Deﬁcit 1 0 -1 -2 -3 -4 -5 -6 -7 1980 1984 1988 1992 1996 2000 2004 2008 4 2 0 -2 -4 -6 -8 -10 -12 GPS Monthly . or in terms of the impending EU bank stress tests. The failure to agree to buy distressed bonds in the secondary market. CIBC Would any removal of the phrase mean any imminent move? The answer is no. But it is the prospect of nuclear fallout. but it may see the market looking to consider a pre-emptive bear ﬂattening of the US curve. impacting Japanese exports. the process does nothing to alleviate the crisis process being utilised. But in reality the comparisons are not obviously compelling. In terms of the parallels with Kobe monetary policy is already loose. the Kobe region accounted for around 12% of Japanese GDP. as a further slide in USD JPY 7 Current Account % GDP Fiscal Deficit % GDP Source: Bloomberg. But with no reference to the amount of assets held on lenders books. Any rise in US short end yields would be USD supportive.5% of GDP. the rating agencies at least €50 bn. any EUR short term interest rate support could prove temporary. Although the agreement following the March 11 summit to enhance the funding ability of the EFSF to the full €440 bn was encouraging. despite the apparent agreement at the March 11 informal summit. should external events prove to get in the way of the ECB. energy shortages and production shutdowns. The Bank of Spain estimates that the savings banks have a potential liquidity shortfall of €15.March 17. Banking sector pressures remain a key negative for the eurozone with the ratings agencies and the authorities seemingly having very different assumptions of capital shortfalls. equivalent to 2. Chart 2. prompting ratings agency Fitch to state the initiative materially enhances the crisis policy response.15 bn. the upcoming bank stress tests appear to be once again open to question as the economic criteria appear not as strong as those of last year. albeit the inclusion of an increase in short term funding costs to replicate a funding crisis is welcomed. not least as broad structural risks in Europe remain in terms of funding pressures. results of which are due in June. which on the basis of worst case scenarios could easily be double that. also remains a potential source of contention. Who is right. ECB Tunnel Vision In Europe it seems that despite an increasingly two speed economy the ECB is intent to repeat the monetary policy mistake of 2008. 2011 austerity measures. the current crisis zone accounts for around a quarter of the GDP of Kobe. In terms of the JPY it could be argued there is little room for the currency to appreciate against the USD. dissension amongst euro politicians. alongside banking sector liquidity issues this as markets speculate as to who is correct in terms of any euro bank capital shortfalls. in part as the markets attempt to front run an end in the ﬂow of cheap USD.
previously buying higher yielding currencies such as the AUD. not least against those currencies impacted by growth and or commodity valuations. while there could be some concerns over the unwinding of Japanese holdings of US Treasuries to fund reconstruction. In the short term we are likely to see JPY inﬂows.CIBC WORLD MARKETS INC. a deceleration in global activity. But in REER terms the JPY is not as strong as USD JPY would suggest. led from Asia ex-Japan (in the wake of monetary tightening policy).March 17. likely bringing forward an inﬂection point due to an aging population. Over the medium to longer run the parlous state of Japanese government ﬁnances is likely to prove a longer run drag upon the JPY. With national debt at 225% of GDP and with a ﬁscal deﬁcit of near 8% the ability of Japan to ﬁnance its debt mountain remains challenging. points towards a broad based cyclical bounce in the USD in the upcoming quarter. Thus it could be argued that current events while providing short term upside JPY impetus increase long run depreciation pressures. Japanese Debt Dynamics 2 1 0 -1 -2 -3 -4 -5 -6 -7 -8 Jun-90 Jun-95 Jun-00 Jun-05 Jun-10 300 250 200 150 100 50 0 Jun-15 Chart 3. which from a risk perspective would favour the USD and CHF. while Japanese corporates have outsourced a lot of productive capacity and exported currency risks down the price chain. especially as domestic investors reverse carry trades. Looking forward to Q2 it appeared likely that monetary policy determination would prove to be signiﬁcant inﬂuence. Thus we are likely to see short term JPY upside as positions are squared. such demand allowing Japan 8 Japanese Structural Balance as % of GDP IMF (RHS) Japanese Gross Govt Debt % GDP IMF Source: IMF. Chart 4. Until now Japan has ﬁnanced its debt almost exclusively through domestic debt purchases. . to run such deﬁcits without facing ratings pressures commensurate with nominal debt levels. the greater the risk that asset purchases are deemed to be monetising debt. thus we can expect the authorities to remain mindful of currency performance. CIBC Over recent weeks it has been risk appetite or risk aversion. heavily skewed market positioning versus the USD. Indeed it would suggest that uridashi demand is likely to be compromised with a potential reversal of ﬂows which has potentially negative implications for currencies such as the Rand where there has been much issuance. re-insurance ﬂows arrive or are anticipated. thus mitigating part of the impact of the external value of the JPY. although of course the scenario for the latter is confused by the aftermath of the earthquake and subsequent economic disruption. with the threat of ofﬁcial action where necessary. driven by exogenous geopolitical and commodity shocks which have been key drivers of currency performance. But any rebound has to be set against longer term structural ﬁscal negatives which are set to become increasingly problematic for the USD. risking long run JPY negativity. The perpetuation of such risks could prove to drive policy makers off course once more. USD JPY and Real Equilibrium Exchange Rates 160 150 140 130 120 110 100 90 80 70 60 Jan95 Jan97 Jan99 Jan01 Jan03 Jan05 Jan07 Jan09 Jan11 80 90 100 110 120 130 140 150 JAPANESE YEN REAL EFFECTIVE EXCHANGE RATE INDEX JPY USD (RH Scale) Source: Reuters Datastream In terms of risk aversion trades the traditional beneﬁciaries remain the USD. But in addition to rising geo-political risks in MENA we have to add a natural and a potential man-made disaster to the list of risk criteria. GPS Monthly . the more assets taken onto the BoJ’s balance sheet. Moreover. although that depends on the extent and duration of the negatives in Japan. CHF and JPY. a point highlighted by Moody’s. 2011 would further compromise Japanese exports. a factor which could impact USD sentiment. approximately 90% of JGB’s are held on shore. But if we are not faced with a worst case scenario in Japan then the prospect of an ending of QEII. this risks negatively pressuring the credit rating over time. Should the current crisis and restructuring lead to a reduction in domestic buying.
2011 GOVERNMENT FINANCE WARREN LOVELY Budgeting in an Age of Uncertainty It’s show time. Notably. global concerns over nuclear safety would negatively impact Saskatchewan’s uranium industry. lumber agricultural products infrastructure could temporarily delay shipments of Canadian wheat and other agricultural products. As we went to press. with ongoing uncertainty regarding efforts to stave off a nuclear catastrophe. Given geographic proximity. Of course. but the situation in a number of countries remains 9 . the situation is Japan remained ﬂuid.1 bn of long-term debt as of mid2010. Nor was there a notable exodus of Japanese capital from Canadian markets in the wake of the 1995 Kobe quake. Damage to Japan’s transportation Chart 1. equivalent to 2. A draw down of inventories and the substitution of non-Japanese models should limit the hit to auto sales. shutdowns in Japan’s auto industry will reverberate in North America. which is the world’s largest producer. but is the target for little more than 2% of Canadian exports. including added demand for provincial lumber. however. Meanwhile. Oil Remains a Threat NS PEI N&L Imports Turmoil in the Middle East and North Africa may have been bumped from the front page by Japan’s disaster. and others could follow. And while the government may still press ahead. Provincial exposure to Japan nonetheless varies. Japanese investors hold $44 billion of Canadian long-term debt. the 2011 budget season really gets rolling in the coming days and weeks. While it’s still early to judge. but for Canadian governments. While seeing a greater near-term hit to its trade. Canada looks to be much less impacted. As for the repatriation effect. And once again. with a number of external risks yet to be defused. Japan is British Columbia’s second largest export market. the overall impact on Canada looks to be limited. Japan's Share of Cdn International Trade. the most important policy document of the year is being drafted at a time of extreme uncertainty. Ontario has banked on a growing ﬂeet of nuclear reactors to meet its longterm energy needs. the view outside provincial or national borders is a little disheartening.CIBC WORLD MARKETS INC. recent developments signal greater public opposition. That’s one-third the relative exposure in the US (Chart 2). We’ve already had a couple of early movers. an expected surge in Japan LNG imports could incent development of North American shale gas deposits. machinery & equip.8% of GDP. % (2010) coal. copper. accounting for nearly 15% of provincial exports last year (Chart 1). The World’s a Scary Place For Canadian policy makers. disrupting global supply chains and temporarily crimping production at related plants in Ontario. resources Canada has in abundance. Japan may rank as Canada’s fourth largest export market. a shift away from nuclear power would translate into demand for thermal coal and natural gas. Indeed. For its part. with an added focus on safety translating into potential delays and added costs. where Japan held $1. Provincial Trade Exposure to Japan Varies 16 14 12 10 8 6 4 2 0 Cda BC Alta Sask Man Ont Qué NB Exports vehicles / parts. BC stands to beneﬁt from Japanese rebuilding efforts. but underlying demand for Canadian food products won’t go away.March 17. Switzerland and Germany have put the brakes on the nuclear industry. GPS Monthly .
8 8. As noted on pages 2-5. creating disproportionate wealth and triggering superior rates of real economic growth. the national growth pace is nearly a percentage point stronger than we once foresaw back in the fall.5 Japanese Holdings of US / Cdn Bonds (mid-2010) 15. elevated energy prices remain a risk for the global economy. compared to what was envisioned only a few months ago. as we’ve seen recently. Canada’s stronger economic backdrop is welcome news for Canadian ﬁnance ministers. with revised growth tallies presented in Table 1. but insulate against unwelcome 10 13 0 0 .CIBC WORLD MARKETS INC. % of GDP (2010) 15 There are other risks to be sure. External risks and some concerns on the domestic economy—including record household debt burden and currency-related pressures—argue for caution in 2011 budgets. Consistent with their strong energy trade surpluses. including sovereign debt crises and pronounced ﬁscal austerity across Europe. with the country’s full-year growth rate topping 3%. And while the Japan demand shock. Provincial Growth Forecasts Boosted In spite of external pressures. Y/Y % Energy rich provinces lead unsettled. Oil Rich Provinces Take Lead Once More 6 4 2 0 -2 -4 -6 2000 01 02 03 04 05 06 07 08 09 10E 11F 12F Rest of Canada Oil-Rich Provinces* * Alta. Canadian Bond Market Less Exposed to Japan 18 16 14 12 10 8 6 4 2 0 % of Foreign Owned Bonds % of GDP 2. 2011 Chart 4. has seen crude give back some ground. with more GDP translating into extra revenue.March 17. underlying credit quality in these provinces will continue to improve relative to most others. Provincial Trade in Oil 20 15 11 10 5 0 -5 -10 Qué NS BC Ont PEI Man NB N&L Sask Alta -1 -4 -4 Canada (2%) 0 2 Nominal Trade Surplus in Oil. The economy regained important momentum in the latter stages of 2010. Chart 3. At 2. And collectively. Next week’s federal budget will show Ottawa’s revenue on a stronger plane.8%. N&L Real GDP Growth.9 US Canada GPS Monthly . as well as emerging market tightening to cool overheated economies. Sask. Building more of a cushion into growth forecasts and spending assumptions would eat up some of the extra revenue. More investment dollars are ﬂowing into these regions and. Canada’s economy has strengthened of late.2 7. Saskatchewan and Newfoundland & Labrador will notably outstrip that in the rest of the country this year and next (Charts 3 and 4). growth in Alberta. with the hit to US consumer purchasing power and lagged impact on the auto industry chief concerns. But for a few Canadian provinces. Don’t expect extra federal or provincial revenue to be fully applied against the ﬁscal bottom line. and associated risk-off trade. we’ve upped our provincial forecasts to be consistent with the national pace. Chart 2. While acknowledging global economic risks. the provinces could take in an extra $5 billion or more in 2011/12. higher energy prices represent a positive terms-of-trade adjustment. A nice hand off and strong ﬁrst half have seen us up our 2011 real GDP forecast once more. higher energy prices are not the unambiguous plus for Canada that some might think.
.e. Stay tuned for our complete postbudget recap.3 -2 .8 3 .6 -0 . Still.0 -5 .6 2 .e.4 2 .9 2 .5 5 .3 2 .1 2 .5 2 . British Columbia remains the gold standard for ﬁscal prudence. layoffs.9 2 .8 -0 . with a high likelihood of a near-term federal election and ﬁve provincial elections scheduled for the fall. nominal GDP and other key indicators Where is economic growth coming from How has economic outlook changed vs.5 3 .2 3 .9 -2 . capital outlays.0 3 .e.0 1 .9 2 . Revised Provincial Real GDP Forecasts CIBC Forecasts Y/Y % Chg GPS Monthly .9 2 .7 2 . While elections loom in many corners.2 5 . revenue Pension funded status Drivers of net financing requirements (i.2 -0 . 2011 Table 2.1 2 . special pension payments.9 BC Alta Sas k Ma n Ont Qué NB NS PEI N &L Cda Outlook for real. but extra revenue would imply less aggressive cutbacks to meet a given ﬁscal target. 'Recovery' refers to three-year average annual growth rate for 2010 to 2012 Details of Fiscal Plan Own-source revenue growth vs.8 2 . other entities. attrition) Contribution from Crowns Are asset sales planned Changes to accounting methodology Other special items developments.0 -1 ..3 2 .4 2 ..3 3 .4 2 . slowing the growth in government debt and setting the stage for an important step lower on net government funding requirements—supportive for provincial spreads in today’s volatile environment.7 2. and look for others to emulate (to a degree) its cautious stance.8 2 . Debt/Borrowing Relationship between budget balance and net change in debt How is government debt defined Trajectory for debt-to-ratio Interest charges vs. There will be plenty to digest in the days and weeks ahead. After all.5 2 . stronger growth may not be sufﬁcient to eliminate structural deﬁcits. domestic vs. other adjustments) Role of pre-funding in reducing underlying funding requirements Refinancing requirements Availability of sinking funds Size and orientation of borrowing program (i.1 2011F 2 . as % of GDP or revenue) Change in balance vs. 'Recession' refers to two-year average annual growth rate for 2008 to 2009 3.7 2 .1 4 . On its own. MidYear Update) Change to timeline for deficit elimination. (a) trend and (b) nominal GDP projections Reliance on volatile resource revenues Changes in key tax rates or other revenue measures Federal transfer share of total revenue Expectation for federal transfers beyond 2013/14 How much extra revenue is consumed by incremental spending How does future pace of program spending compare to trend Is government counting on unidentified or unrealized savings How much of the budget is consumed by health care outlays Size of forecast allowance / contingency reserve Are other contingencies built into spending plan Scope of new spending measures Wage growth assumptions for future collective bargaining agreements Reductions in public sector headcount (i.8 2 . budget balance..5 3. 'Pre-Crisis' refers to five-year average annual growth rate for 2003 to 2007 2. Table 1.1 1 . if applicable Transfers to and from stabilization funds to address shortfalls 1. Risks are elevated and the political environment remains uncertain.3 2 .g.1 2 .5 4 .8 2012F Pre-Crisis Recession Recovery 3 .9 2 .3 -1..2 2 . (a) original plan and (b) latest estimates (e.2 -0 . credit ratings and spreads hinge on the credibility of ﬁscal projections.1 0 .1 2.8 3 . international) Reliance on short-term markets Interest rate reset risk Foreign currency exposure 11 .6 2 .CIBC WORLD MARKETS INC.5 2 .e. prior forecast Degree of prudence / buffer applied to consensus growth forecast Allowance for higher interest rates and associated fiscal sensitivities Key energy price assumptions and associated revenue sensitivities Trajectory for the C$ Assumed strength of global economy and implied demand for key exports Acknowledgement of risk factors Budget Balance Relative scale of budget balance (i.0 0 . 2011 should usher in important progress on Canadian ﬁscal healing. What to Watch For in 2011 Budgets Economy 3 2 Reference Periods 1 2010E 3 .9 2 .9 3 .5 2 .8 2.7 2 .2 1 .2 2 .3 4 .March 17. and a number of key elements to watch for in 2011 budgets (Table 2).8 2.2 3 . governments need to remain focused on restraint. That could add important credibility to long-term ﬁscal plans and lessen anxiety around the ability of governments to dramatically slow spending in the face of health-related spending pressures.2 3 .9 4 .
noteworthy that the bellweather investment grade US CDX index. however. have enjoyed a rally since June of last year (Chart 1). The high yield index spread has cut through that average late last year. Canadian cash bond spreads may at ﬁrst blush appear to lag. good corporate fudamentals. whether investment grade or high yield. Spread Rally in US Investment Grade (5-yr CDS index) 130 120 110 100 90 80 70 A pr-10 Spread (bps) Jun-10 A ug-10 Oc t-10 Dec -10 Feb-11 Spread Rally in US High Yield (5-yr CDS index) 700 650 600 550 500 450 400 350 A pr-10 Spread (bps) Jun-10 A ug-10 Oc t-10 Dec -10 Feb-11 Chart 1. This Has Been a Rally North American credit spreads. GPS Monthly . US high yield CDS generated best spread performance with its spread 44% tighter since June. albeit interrupted by a few bumps which were mostly driven by episodes of sovereign risk. Nor would we expect them to be. By and large. and strong demand for credit products. Against this performance. whether cash or CDS. However. 2011 CORPORATE CREDIT JOANNA ZAPIOR How Are We Tracking? North American credit spreads have enjoyed a rally since June of last year. 12 . Sustained Credit Rally Spread Rally In Canada (5-yr cash spread) 140 135 130 125 120 115 110 105 100 95 90 A pr-10 May -10 Jul-10 A ug-10 Oc t-10 Dec -10 Spread (bps) Putting the Rally in Its Historical Context From a historical perspective. as our Economics Team does on pages 2-5. current spread levels are not the tightest ever (Chart 2). It is. The tightest pre-crisis levels generally are not considered attainable. are just about equal to their respective average spread for the entire period since May 2006. Without a Doubt. US investment grade spread is 37% tighter. when we consider. as well as the Canadian investment grade spread.March 17. that headwinds have increased for the global economy. having tightened “only” 22%. This is ﬁne if the recovery is not interrupted and demand continues strong. the rally has been justiﬁed by the modestly improving economic outlook.CIBC WORLD MARKETS INC. we conclude that current spreads may have “priced to perfection”. when one excludes from calculations the deepest part of the ﬁnancial crisis (September 2008 – September 2009). pricing to perfection may come up for a test. So what now? When we analyze the spread rally in the context of both historical performance and the spread forecast that we had made for 2011 at the end of the previous year.
that the correlation between Canadian and US credit spreads since mid-2006 has exceeded 90% (with Canadian cash spreads 93% correlated with US investment grade CDX spreads in that period. The red & green c urv es delineate a 1 s tandard-dev iation “env elope” f or the “ex c eed ex pec tations ” s c enario. Chart 3. and their volatilities) have been more mixed and generally gravitated towards the “meet expectations” scenario. which we had dubbed “beat expectations”1 (Chart 3). equities. 2010). Still a Big Gap to the Tightest-Ever Spreads 240 Spread (bps) C$ Cas h Spread GPS Monthly . Chart 2. which would be justiﬁed only by continued upbeat economic news. However. though they have backed 13 At the end of November 2010. How Are We Tracking? A ug-08 Spread (bps) 210 CDX Investm ent Grade YTD 110 105 CDX IG spread in bps 160 A v erage s pread ex c luding the c ris is 110 100 95 90 A c tual CDX s pread (light line) is s how n as trac ked by our model s pread (dark line). Assuming the two markets remain highly correlated.CIBC WORLD MARKETS INC. if the currently strong demand for credit product continues. thus leaving itself less exposed to a potential correction. however. 60 Current 84 bps A v erage 100 bps (80 bps ex c ris is ) Max 131 bps Min 76 bps Jul-07 Feb-08 Sep-08 A pr-09 Nov -09 Jun-10 Jan-11 85 80 75 11/24/2010 CDX Obs erv ed CDX Model w ith ev ent adjus ted 12/19/2010 1/13/2011 2/7/2011 3/4/2011 10 May -06 Dec -06 Spread (bps) 950 850 750 650 550 450 350 250 A v erage s pread ex c luding the c ris is CDX High Yield LTM What Does This Mean for Canadian Credit Spreads? A relatively weaker spread rally in Canada compared to the US market suggests that the Canadian market has been pricing in the recovery more conservatively. credit spreads might have reached their lows for this part of the cycle. headwinds have increased for the global economy.March 17. Canadian spreads would also likely see a correction if US credit spreads correct. 2010 and available on the Macro Strategy website as “Corporate Credit 2011 Outlook”. as CIBC’s Economics Team argues. 2011 190 A v erage s pread ex c luding the c ris is 140 Current A v erage Max Min Feb-07 Nov -07 109 bps 156 bps (116 bps ex c ris is ) 455 bps 50 bps May -09 Feb-10 Nov -10 90 40 May -06 off the tights towards the median forecast spread. However. inputs into our spread model (namely rates. and their volatilities. even though the Canadian rally has not been as enthusiastic as that in the US credit markets. Scenario parameters and our forecast results are detailed in a report published on December 8. This suggests to us that spreads may be “priced to perfection”. spreads have been initially hugging the lower (tighter) boundary of the spread range in that scenario. Remember. 1 Current 405 bps A v erage 613 bps (471 bps ex c ris is ) Max 1925 bps Min 185 bps 150 May -06 Dec -06 Jul-07 Feb-08 Sep-08 A pr-09 Nov -09 Jun-10 Jan-11 Rally in the Context of Our Forecast: We Are Tracking Optimistic To put things in the context of our 2011 forecast. equity index returns. it will be offsetting any spread widening pressures. & the blue line s how s the median s pread antic ipated in that s c enario. Our forecast was probabilistic – we analyzed the spreads and their drivers in ﬁve possible scenarios. If. and included an adjustment for credit events. we produced a US CDS spread forecast for the following 250 trading days. as we wrote in this report on November 10. . CDS spreads so far has been tracking the secondmost optimistic scenario. We modeled the CDX index spread in relation to swap yields. In fact.
the spread between NYMEX gasoline and WTI has increased nearly $23 per barrel. GPS Monthly .59] [115. Can Ekofisk [113.19] [114. have now even ﬂattened the WTI curve signiﬁcantly. compared to margins earned by reﬁners running crudes that are not WTI-related.50-$2 WTI premium was typical).44] HLS Bonny [106. WTI has lagged most other crude grades with the exception of equally PADD 2-handicapped Western Canadian Blend.March 17. Chart 2.49] LLS Dated [116.94] CIBC Commodities Strategy NYMEX crack spreads give a similarly exaggerated view of broader reﬁnery economics. 14) 30% 25% 20% 15% 10% 5% 0% -5% WTI Cushing [80. the transatlantic spread is $11+ thanks to the deeper contango in WTI and comparatively ﬂat Brent structure. Chart 1. 2011 COMMODITIES KATHERINE SPECTOR West Texas Intermediate: Crude’s Odd Man Out Any casual observer of oil markets will have noticed the sharp divergence between US benchmark West Texas Intermediate and European benchmark Brent since the beginning of the year—Brent’s premium to WTI has recently narrowed to around $11/bbl. but not as much as Brent. whereas the NYMEX gasoline crack to Brent has increased by $10. M1 NYMEX WTI Minus Dated Brent $/bbl $10 $5 $$(5) $(10) $(15) $(20) '88 '90 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10 CIBC Commodities Strategy Chart 3.CIBC WORLD MARKETS INC. but had traded as wide as $20 in February (Chart 1). Comparing the term structures of WTI and Brent shows the stark contrast between the two crudes (Chart 3). Most major crude grades—North American and otherwise—have rallied hard this year to date. a $1.99] W. WTI & Brent Curves. 1 (Price Level on Mar. Today and Month Ago $/bbl $115 $110 $105 $100 $95 $90 $85 1 6 11 16 21 26 31 36 41 46 51 CIBC Commodities Strategy Brent Today WTI Today Brent Month Ago WTI Month Ago 14 .92] [115. Strengthening global crude fundamentals. particularly since the Libyan production outages. In fact. At the front of the curve. WTI currently trades at a $4+ discount to Brent (historically. Case in point. The strength we have seen recently in Brent has been broadly reﬂected across sweet grades globally (Chart 2).19] Dubai Tapis 56 [101.04] [116. In the long-dated part of the curve. The NYMEX heating oil crack to WTI is up over $26 but against Brent is just shy of $15 (Chart 4-5). Brent is not the outlier here. since the beginning of the year. Price Change Since Jan.
2011 Jul-10 Jan-11 As a trans-border pipeline. on the other hand. While TransCanada had initially given optimistic guidance on the timeline for the project. At the moment. NYMEX Heating Oil Crack (Left). but on average is not apt to increase in a signiﬁcant way going forward. while a decision one way or another is expected this calendar year. Chart 4. What the market is waiting for is the third (‘XL’) phase of TransCanada’s Keystone pipeline. Oklahoma—means that the crude trades on a very regionally specific set of supply/demand fundamentals. Limited infrastructure to move crude beyond Cushing. Some 10 million bbl of capacity was added in 2009-10. The contract’s landlocked physical delivery point —Cushing. and a second EIS has been submitted but no decisions have been made. from both Canada and North Dakota. Nebraska. Our expectation is that Keystone XL will ultimately move forward. CDU Planned Maintenance . Granted. Last year saw a particularly sizable annual increase in those volumes. and more than that is expected online this year. As such. Recent market events have strengthened crude markets globally. even so far as to move the lagging WTI curve into backwardation beyond this calendar year. But at the end of the day. The approval process has taken longer than most had anticipated. has increased in response to widening WTI spreads. Keystone XL requires State Department approval to proceed. Chart 5.Total PADD II kbd offline 700 600 500 400 300 200 100 0 Jan 2007 2008 2009 2010 2011 CIBC Commodities Strategy WTI’s structural problems as a benchmark are not news. As part of the Keystone XL project. to the US Gulf reﬁning centre. While Keystone XL may not solve the midcontinent dynamic completely. the second phase of TransCanada’s Keystone project—the Cushing extension—is bringing additional barrels into Cushing from Steele City. If geopolitics settle into a status quo.CIBC WORLD MARKETS INC. Reﬁner demand for barrels into PADD II increases and decreases in response to planned and unplanned maintenance and reﬁnery economics. incremental supply-side disruptions. operating reﬁning capacity in the Midwest has been largely unchanged for the past three years. Crude supply into Cushing (or PADD II more broadly) is on the rise. the State Department has been quite clear that. WTI spreads stand to weaken significantly—particularly in the Sep-Oct period when planned PADD II refinery maintenance looks heavy by historical standards (Chart 6). NYMEX Gasoline Crack (Right) $/bbl $35 $30 $25 $20 $15 $15 $10 $5 $0 Jan-10 $10 $5 $0 Jan-10 Jul-10 Jan-11 CIBC Commodities Strategy C rack to WTI C rack to Brent $/bbl $30 $25 $20 C rack to WTI C rack to Brent GPS Monthly . which will not only bring more barrels into the US from Canada. and virtually impossible to see it online this calendar year. Industrial Information Resources . we still see it as unlikely that the Dec’11 contract expires higher than the Dec’12 contract given the expected Keystone XL timeline. the initial Environmental Impact Statement for the project was deemed insufﬁcient. Short of severe. a more precise schedule for approval cannot be assumed. pipeline capacity additions are exacerbating the Cushing problem. Storage capacity at Cushing. At the same time. it is hard to see this capacity online before the middle of 2012. 15 Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec CIBC Commodities Strategy. but will also extend down from Cushing to Texas. the Cushing-Texas leg of the project is subject to the State Department approval even though that leg is not itself international. it will go some way in alleviating it. means that there are only so many moving parts in the WTI balance. Guidance from TransCanada confirms that construction of the Cushing-Texas line could take about nine months. Chart 6. a structural shift in WTI spreads is not likely to occur without additional infrastructure to move barrels beyond Cushing to the US Gulf.March 17. schedules are subject to revision—especially if economics at these reﬁneries are still disproportionately favourable come fall—but at the moment the data suggest heavy turnarounds.
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