Friday, May 7, 2010

Dramatic Shift in Rate Hike Expectations


Ottawa -- The Greek crisis, together with Thursday's market chaos, has forced a "dramatic shift" in expectations of a Bank of Canada rate hike next month, a view reflected in a steep fall of the loonie on the belief that such increases are no longer in the offing as panic spreads about Europe.

Worries that the spillover in Greece may contract credit growth in Europe and threaten the global economic recovery rattled investors, with equity markets in North America sustaining deep losses and commodity prices falling.

And in a sign of concern reminiscent of the Lehman Brothers Holdings Inc. collapse, the London interbank offered rate - the cost of borrowing for banks from their peers - rose to its highest level since August, while the cost of protecting European bank debt against default surged to a 13-month high.

"Is Greece the canary in the coal mine that is going to lead to much greater economic troubles?" said Avery Shenfeld, chief economist at CIBC World Markets, in summarizing the top concern among market participants.

Markets were nervous from the onset after Jean-Claude Trichet, the European Central Bank president, suggested he was not prepared to take further measures to ensure the fiscal crisis didn't spread further.

Investors reacted by selling bonds in debt-laden European countries, with the yield on Portugal's 10-year notes surpassing the 6% level for the first time since the euro's introduction. Higher yields will make it increasingly difficult for countries such as Portugal, Spain and Italy to finance their debts.

It was only two weeks ago that traders had priced in a near 100% probability of a Bank of Canada rate increase in June after the central bank ditched its conditional pledge to keep its key policy rate low and suggested it was time to remove stimulus from the system.

Traders have now scaled back expectations by pricing in just a 50-50 chance of a pending rate, based on trading in the overnight index-swap market.

"The odds have dramatically shifted," said Mark Chandler, head of fixed-income and currency strategy at RBC Capital Markets.

That was evident in trading in the Canadian dollar, which fell as much as US4¢ in value before closing the day down US2.09¢ to US95.03¢. The dollar started the week in the US98¢ range. The currency's drop is attributed to a series of factors, including the Bank of Canada's appetite to raise rates.

Douglas Porter, deputy chief economist at BMO Capital Markets, said the potential fallout in Europe "has to be front and centre in the bank's decision. [The bank] would be much less willing to tighten if we are in the midst of a contagion fear that's sweeping through the markets."

Analysts say market volatility could prompt companies to delay decisions about investing and hiring workers until they figure out how events will unfold. Yesterday's activity on Bay and Wall streets provided no comfort.

Partly due to trading desk errors, the Dow Jones industrial average shed as much as 998 points before retracing losses and closing the session down 347.8 points, or 3.2%, to 10,520.32. The benchmark index in Toronto plunged as deep as 450 points, before rebounding to a 32.7-point loss, closing at 11,842.43.

All this unfolded even though Greece's parliament approved an austerity plan, which includes tax hikes and cuts to public-service perks and pay, demanded by the European Union and International Monetary Fund as a condition to secure a US$140-billion bailout. But concerns remain as to whether Greek legislators will implement the measures in the wake of the escalation of violent riots, which to date have claimed three lives.

In Ottawa yesterday, Finance Minister Jim Flaherty said Ottawa was "monitoring" the events in Europe. Meanwhile, officials with the U.S. Federal Reserve warned of repercussions to the U.S. economy if the feared contagion unfolds in Europe.

Financial Post,

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