The Weekly Bottom Line

HIGHLIGHTS

• Fed leaves rates at 2.00%
• Statement suggests extended pause, no near-term hike

In a week filled with second-tier economic indicators, the importance of words took center stage. In particular, the words of the FOMC's statement that accompanied their decision to leave U.S. rates at 2.00%. While June has been a central bank hawkfest, U.S. and European officials have recently had to back off. Central bankers are not blind automatons and a number of downside risks to economic growth - and yes inflation - remain. In the words this week of Mervin King, Governor of the Bank of England, "It's not sensible to bring inflation back to target in the next six months. That would lead to a deep recession and that would be silly." It remains to be seen whether the markets have a sense of humour.

The Inflation Scare

We do not really care about inflation. Those are the seven words the Federal Reserve can't say - or any other central bank for that matter. The seven words they can and did say, however, was that the "uncertainty about the inflation outlook remains high." U.S. import price inflation for every major category is now running faster than domestic inflation, which has the potential to intensify U.S. inflation. Moreover, oil prices have kept headline inflation stubbornly high.

So, while visions of stagflation dance in investors' heads, the Fed this week said that they continue to expect "inflation to moderate later this year and next year." In fact, total inflation for consumer goods in the PCE index was running 3.1% as of May, down from the 3.5% pace it ended 2007 with. The core PCE inflation measure that the Fed likes to look at was at 2.15% y/y as of December 2007 and 2.14% as of May 2008 - nary a smidgen of new inflationary pressures. And, the six month trend in core PCE inflation is now sitting at 1.99%, just inside the 1.5%-2.0% range the Fed is comfortable with. Importantly, the experience in the U.S. over the last decade is that headline inflation converges to the core rate, not the other way around. There is no evidence this dynamic has changed, but the Fed is right to be cautious.

The "Other" Risk

The worst may be yet to come - the seven words to describe our U.S. outlook. The Fed acknowledged that downside risks to growth have "diminished somewhat," and GDP growth for the first quarter was revised up this week to 1.0% q/q. In the second half of 2007, housing was the only component of U.S. GDP to contract. Data on home prices and new and existing sales this week confirm this is likely to continue through 2008; however, a nosedive in consumer confidence highlights the large downside risk for consumer spending. Moreover, there is a sizeable - and, in our opinion, too little discussed - risk that business investment will become increasingly weak as we move forward. Changes in core capital goods orders - a measure for business investment - have been reasonably good at predicting Fed interest rate moves. U.S. core capital goods orders fell 0.8% m/m in May, and while they are still up 2.6% on a year ago basis, the credit crunch has yet to fully make itself felt.

An increasing share of business investment has had to rely on borrowing from the financial sector. At nearly one-third of all capital expenditures right now, this dependence is close to the peaks seen in the previous two energy-induced recessions and the tech bust. Following each of these episodes, the pace of business investment slowed by 20-30 percentage points. From March 2007 to March 2008, the pace of business investment in the U.S. accelerated from 5% to 7%. This will be hard to sustain, as the U.S. financial sector's precarious situation only worsened through June. Over the last couple of weeks, the cost of funding for banks (LIBOR-OIS spreads) has risen by about 15%, the cost of insuring against default in U.S. investment grade corporate debt (CDS spreads) has risen by over 40%, and the Fed is looking to loosen restrictions for private equity groups to invest in banks to help replenish capital. There very well may be global opportunities that corporations could take advantage of if only they had the cash to invest, but he who controls capital, controls the economy.

Black Gold

Suffice it to say, oil rose again - the seven words you didn't need me to say. As of midday Friday, WTI crude prices had risen to 974 yuan - that's 142 U.S. dollars for those still tied to antiquated accounting methods. While the impact of the falling U.S. dollar has been well reported, the rapid rise in Chinese incomes is playing a role, as well. As the chart here shows, the average U.S. income will buy 70% less barrels of oil now than it could in 2002, double the decline in Chinese purchasing power. In fact, Chinese purchasing power is where it was in 1994, a far cry from the U.S. where it is near an all-time low. This week, a Chinese firm agreed to a 97% increase in the price of imported iron ore. Others have balked at such a price increase this year, though. It would not be that far off to say China is in a world of its own.

Oil remains behind the inflation scare sweeping the global economy. The Indian central bank provided its second surprise increase in two weeks to both interest rates and the level of reserves banks are forced to keep on hand as falling fuel subsidies drove inflation sharply higher. Meanwhile, ECB President Jean-Claude Trichet signaled a likely quarter-point rate increase next week to help ensure Eurozone inflation expectations stay grounded in the face of rising energy costs. The expectation remains that the ongoing decline in global economic activity will eventually bring oil prices and inflation lower. Until then, we will be forced to mutter a few choice words under our breath.

UPCOMING KEY ECONOMIC RELEASES

Canadian Real GDP - April

Release Date: June 30/08
March Result:-0.2% M/M
TD Forecast: +0.3% M/M
Consensus: +0.2% M/M

After posting two consecutive monthly declines in February and March, Canadian economic activity should bounce-back in April, with a fairly reasonable 0.3% M/M gain. The main drivers behind this turnaround in economic activity in April are the rather robust pace of retail and wholesale activity during the month, and the expansion in manufacturing shipments. The rebound in production in April will likely put the Canadian economy back on track for a positive print on GDP growth in Q2, following the contraction in domestic output in Q1 - which was the first quarterly decline in GDP since Q2 2003. However, with the U.S. economy continuing to struggle, we are unlikely to see any sustained upswing in Canadian economic activity in the near term. Note that if there is a risk to this forecast, it is likely to be to the upside.

U.S. ISM Manufacturing Report - June

Release Date: July 1/08
May Result: 49.6
TD Forecast: 48.0
Consensus: 49.0

The U.S. manufacturing sector continues to struggle under the weight of sluggish domestic demand and high input costs. And despite the important offset that the export sector continues to provide to these factors, we expect the deterioration in the U.S. manufacturing sector to continue in June. In particular, with the regional Fed manufacturing indices all pointing down during the month, the ISM will likely remain below the 50-threshold for the fifth consecutive month, with a 48.0 print (slightly down from 49.6 in May).

U.S. Nonfarm Payrolls - June

Release Date: July 3/08
May Result: -49K; unemployment rate 5.5%
TD Forecast: -75K; unemployment rate 5.4%
Consensus: -50K; unemployment rate 5.4%

With a slowing economy and rock-bottom consumer confidence, the U.S labour market continues to be weak as businesses conserve on their use of labour in response to the sluggish consumer demand for their products. However, despite the 324K jobs that have been lost since the economy started shedding jobs in January, the extent of job losses has been relatively mild compared to previous cycles. This is likely to change in the near term. We expect U.S. non-farm payrolls to decline for the sixth straight month, and for the deterioration to accelerate in June with a more profound -75K, compared to the -49K in May. And all indications are that the demise in the U.S. labour market will continue into the coming months. We expect to see the unemployment rate fallback modestly in June to 5.4%, following the surprising spike to 5.5% in May.

TD Bank Financial Group

The information contained in this report has been prepared for the information of our customers by TD Bank Financial Group. The information has been drawn from sources believed to be reliable, but the accuracy or completeness of the information is not guaranteed, nor in providing it does TD Bank Financial Group assume any responsibility or liability.