Global Economic Research July 21, 2010 @ 07:30 EST

Daily Points
CAPITAL MARKETS RESEARCH
Derek Holt (416) 863-7707
derek_holt@scotiacapital.com
Gorica Djeric (416) 862-3080 — Tracking the numbers
gorica_djeric@scotiacapital.com

On Deck for Wednesday, July 21 BoC Events

Country Date ET Indicator Period BNS Consensus Latest BoC Overnight Lending Rate
CA 07/21 (08:30) Wholesale Trade (m/m) May 0.3 0.3 -0.3 Current Rate: 0.50%
US 07/21 (07:00) MBA Mortgage Applications (w/w) Jul. 16 -- -- 7.6 Next Move: September 8 @ 1.0%
US 07/21 (10:00) Bernanke Gives Monetary Policy Report to Senate Banking Panel Bias: Neutral

KEY POINTS:
 Bernanke's options are limited
 US mortgage purchase applications rise for second week in past eleven
 Canadian wholesale sales advanced in May?
Fed Events
 BoJ: upside and downside risks increased
 BoE debates further policy easing vs. rising inflation
Fed Funds Target Rate
Current Rate: 0-0.25%
CANADA Next Move: August 10 @ 0-0.25%
The Canadian wholesale sales (8:30amET) report for May will provide Bias: Dovish
some guidance for May’s retail sales figures, due out tomorrow. While the
Fed Chairman Bernanke will
headline may be swayed by lower import prices paid by wholesalers, partly deliver (2:00pmET) the semi-
due to a stronger Canadian dollar (relative to its U.S. counterpart) in May, annual monetary policy report to
volumes will be a better barometer of demand. Inventories are a key compo- the Senate Banking Committee.
nent of this report. Stockpiles expanded for the second time in the past three
months in April, a first since December 2008. Only half of the sectors re-
ported higher inventory levels, suggesting we could see a stronger rebound in
the months ahead. Some components of wholesale trade, like computers, act
as a partial leading view of retail sales in providing limited guidance. Other
limited guidance comes from StatsCan’s Survey of Large Retailers that en-
compass about 35% of non-auto related retail sales. That fell m/m in season-
ally adjusted terms in May, but historically offers poor guidance for the retail
sales report.

UNITED STATES
U.S. MBA Mortgage Applications Index rose 7.6% in the week ending July
16 to its highest reading in nine months. Gains were led by refinancing activ- Key International Events
ity -- which advanced by 8.6% to its highest level since May 2009 – but pur-
chase applications also moved up from a thirteen-year low. That’s only the
ECB
second week in the past eleven since the expiration of homebuyer incentives
Current Rate: 1.00%
on April 30th. Next Move: August 5 @ 1.00%
Bias: Dovish
The U.S. remains stuck in a liquidity trap and there is precious little the Fed
BoE
can do about it. Talking up the Fed's options could well be the focus of Fed-
Current Rate: 0.50%
eral Reserve Chairman Ben Bernanke's semi-annual testimony on mone- Next Move: August 5 @ 0.50%
tary policy to the U.S. senate today that used to be referred to as the Hum- Bias: Dovish
phrey Hawkins hearings (10:00amET). But those options are likely to be
BoJ
tragically ineffective.
Current Rate: 0.10%
Next Move: July 15 @ 0.10%
The core challenge is that the demand for money remains interest inelastic, or Bias: Dovish
insensitive to low rates. It's a very dangerous spot for a central bank to wind
…2

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Global Economic Research July 21, 2010

Daily Points

up. Cutting interest on reserves won't do a thing, as a quarter point difference on idle cash parked at the Fed won't do much to the
attractiveness of lending. We at least hope that a bank would expect to earn more on loans than a miserly quarter point alternative in
slipping it in the Fed’s mattress. It also won't force people to borrow. Ditto for buying more Treasuries, agencies or MBS, as an
extra modest reduction in longer rates will be shaken like water off a dog's back, assuming markets understand we’re in an environ-
ment with a zero inflation threat for years and don’t penalize such a policy shift through allowing inflation fears to push up the curve
on concerns the Fed is acting as the lender of last resort to Washington.

Extending the rate promise won't help either. With US 2s trading just over a paltry half point in yields and 5s at about 1.7%, even an
explicit message to markets that the Fed will not hike for years won’t materially impact rates. Thus, extending the “exceptionally
low” and “for an extended period” language won’t effectively add any further Fed influence up the curve than what is already baked
in.

After all, what don't we really get about the fact that US home prices are still 30% lower than their peak in the summer of 2006, and
US household net worth is still down US$11 trillion from its peak in 2007Q2? Sure, it has come back from the loss of US$17.6 tril-
lion that had been booked by 2009Q1, but that’s almost entirely due to higher stock prices that are focused upon the upper income
segments that hold the vast majority of stock wealth. More important to the mainstreet economy is that US$7.2 trillion in home eq-
uity has been lost, and that is showing no signs of coming back. If yesterday’s survey of over 100 economists by Robert Shiller is
any guide, US home prices might rise a cumulative 10% over the next five years. Yes, economists have been known to be wrong on
occasion (humour us…), but massive sidelined shadow inventories that have an all-time record high inventory overhang of unsold
listed and unlisted excess housing isn’t an environment within which to reasonably expect material house price appreciation. With
this as the operative backdrop for the Fed, you simply can't pay people to borrow. They’re worried about their retirement. About
footing the college bills for the boom-echo kids of the boomers. About the future status of their pensions. They spent too much in
the party years, and now the reckoning begins. So go ahead, inflate away. Would minus 5% real rates make you feel better about
borrowing more against your fallen retirement nest egg? Deeper negative real rates are likely to be even less influential now in an
aging population than in the past, given the harm that would be done to the fixed income cohorts that are about to blossom in a fun-
damentally different age structure of the US population than that which has existed in the past.

In fact, operating at the zero bound on rates is part of the problem in facilitating deleveraging. There is zero incentive for people to
spend when they can take enormous amounts of idle liquidity on household balance sheets that is earning zilch, and use it to pay
down high cost credit. Where else to put that liquidity when public mistrust of stock markets has been justified on a largely lost dec-
ade for such investments, and the bond market is offering stale peanuts in exchange for your paycheque assuming you have one? It
is also part of why banks are buying up massive lots of Treasuries. Banks' asset-liability choices have them skewed toward lending
for short- to medium-term horizons, and that earns them nothing after admin costs at today's low rates. So lend within a medium-
term horizon that doesn’t compensate for risk and transactions costs? Or lend for minimal risk further up the curve to at least pad
something into net interest income? Yes, ZIRP (zero interest rate policy) has backed central banks into a corner but it’s difficult to
see what else they could have done.

So what to do in order to counter weak growth that will feel close to a double dip to markets this year before the real possibility of
one arriving over the next two years arises at which point the US encounters European-style fiscal exit pains? Nothing. At least not
for the Fed. And fiscal policy won't help either. Surpluses were frittered away long before this crisis, adding more to deficit-
financed stimulus falls into three debating traps. One is that it may well create a temporarily higher peak in stimulus, only to fall
harder thereafter by 2012 and 2013 than what we’ve been writing about for much of this year. Two is debate over whether addi-
tional stimulus will work in the first place without crowding out private expenditures and without spooking bond markets that may
not fully comprehend what lies ahead. I’d love to see a head-to-head op-ed debate between Paul Krugman and Robert Barro, two of
the more significant lights in economic reasoning in a generation. One says throw everything including the kitchen sink at the prob-
lem (Krugman), the other put his stamp on the economics discipline with his seminal “Are Government Bonds Net Wealth” paper in
1974 that is core reading for any student of economics since. Barro’s assertion is that fiscal multipliers are well under one, perhaps
negative, such that deficit financed spending crowds out enough other activity such that it offers no net stimulus. He has been an
active editorialist in the WSJ pounding the table with such views during this crisis. The third dilemma for fiscal expansionists is that
the US already faces decades of deficits hard-wired into the fiscal landscape through the projected rise in interest payments as a share
of the economy (see this week’s Capital Points, “Is the US Facing a Debt Spiral Like Canada Once Did?, page1-3).

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Global Economic Research July 21, 2010

Daily Points

The last area for material public policy options is therefore regulatory policy. But it may well be heading in the opposite direction.
Easing capital and liquidity ratios may help, rather than talking them up in advance of tighter coming rules that risk continuing the
pro-cyclicality of regulatory policy (ease in good times, tighten in bad and beat up on bankers every imaginable way). But that still
encounters the demand-side obstacles to borrowing. So perhaps go back to Hilary Clinton's Presidential campaign suggestions to
dust off the Homeowners’ Loan Corporation of the 1930s and similar institutions. Or Brady bond the junk with one big bullet on it.
Sure there are moral hazard and adverse incentive problems, but pick your poison.

INTERNATIONAL
The Bank of Japan (BoJ) published minutes to its June 14-15 meeting, when the policy makers decided to keep the overnight rate at
0.1% to spur growth. Many board members thought that both upside and downside risks to a sustainable economic recovery had in-
creased since April’s Semi-Annual Outlook Report. Strong exports — supported by faster-than-expected recovery in emerging
economies — and capital investment by Japanese businesses remain the backbone of the economic recovery. The BOJ also revealed
further details of a lending program announced at the April 30 policy meeting. Separately, the BoJ Deputy Governor indicated that
the central bank was monitoring yen moves, but dismissed speculations that a yen increase past certain level would trigger additional
monetary policy easing. However, Deputy Governor did say that the central bank continues to look into measures that would spur
further economic growth.

The Bank of England (BoE) also released minutes to its July 8 meeting, when members decided to keep the key lending rate un-
changed for still some time, at the all-time low of 0.5%. While some members discussed further policy easing — as “the prospects
for GDP growth had probably deteriorated a little over the month” — Andrew Sentence remained the sole dissenter, continuing to
advocate raising the rate to 0.75%, on concerns over high inflation. Britain’s CPI currently sits at 3.2% y/y, above government’s
target of around 2%. Several members noted that the government’s decision to raise value-added tax to 20.0%, from 17.5%, would
contribute to higher inflation. However, “the margin of spare capacity was likely to bear down on inflation and bring it back to the
target in the medium term once the impact of temporary factors had worn off.”

Equities % change:
Fixed Income Government Yield Curves (%): Last Change 1 Day 1-w k 1-mo 1-yr
S&P/TSX 11629.88 86.41 0.7 -0.4 -2.6 10.6
2-YEAR 5-YEAR 10-YEAR 30-YEAR Dow 30 10229.96 75.53 0.7 -1.3 -2.0 14.7
S&P 500 1083.48 12.23 1.1 -1.1 -2.7 13.5
Last 1-day 1-w k Last 1-day 1-w k Last 1-day 1-w k Last 1-day 1-w k Nasdaq 2222.49 24.26 1.1 -0.9 -2.9 16.0
DAX 5225.79 86.33 1.7 -0.5 -1.4 16.6
U.S. 0.58 0.58 0.61 1.68 1.69 1.81 2.94 2.95 3.04 3.97 3.98 4.03
FTSE 6048.78 81.29 1.4 -2.6 -3.9 18.7
CANADA 1.57 1.52 1.72 2.39 2.38 2.55 3.19 3.16 3.27 3.76 3.74 3.78 Nikkei 9278.83 -21.63 -0.2 -2.7 -9.4 -3.9
Hang Seng 20487.23 222.64 1.1 -0.4 -2.0 5.1
GERMANY 0.73 0.78 0.77 1.62 1.64 1.61 2.65 2.64 2.66 3.35 3.33 3.33 CAC 3531.90 63.88 1.8 -2.8 -5.5 6.9
Commodities % change:
JAPAN 0.15 0.15 0.15 0.35 0.35 0.38 1.10 1.10 1.14 1.88 1.87 1.91 WTI Crude 77.94 0.36 0.5 1.2 0.2 20.4
Natural Gas 4.60 0.01 0.2 6.8 -5.7 24.1
U.K. 0.79 0.79 0.79 2.07 2.08 2.09 3.34 3.35 3.40 4.23 4.22 4.21 Gold 1183.00 2.00 0.2 -2.7 -5.8 24.2
Silver 17.55 0.00 0.0 -4.0 -9.4 29.8
Foreign - U.S. Spreads (bps): CRB Index 261.52 0.32 0.1 -0.1 -0.8 6.0
Currencies % change:
CANADA 99 94 111 71 69 75 25 21 22 -21 -24 -25 USDCAD 1.0372 -0.0064 -0.6 0.4 1.3 -6.0
EURUSD 1.2835 -0.0045 -0.3 0.7 4.2 -9.8
GERMANY 15 20 16 -6 -5 -20 -29 -31 -39 -62 -65 -70 USDJPY 87.0400 -0.4700 -0.5 -1.5 -4.5 -7.1
AUDUSD 0.8845 0.0006 0.1 -0.1 0.9 8.1
JAPAN -43 -43 -45 -133 -134 -143 -184 -185 -191 -209 -211 -212
GBPUSD 1.5279 0.0016 0.1 0.1 3.5 -7.2
USDCHF 1.0513 -0.0015 -0.1 -0.1 -5.5 -1.4
U.K. 21 21 19 39 40 28 40 40 35 26 24 18

Source: Bloomberg. All quotes reflect Bloomberg data as at the time of publishing.
While this source is believed to be reliable, Scotia Capital cannot guarantee its accuracy.