Economics – Page 19

Canada ends the fiscal year with $47 billion deficit

The 2009-2010 year-end fiscal monitor is finally released. I will make some year-to-year comparisons.

From April 1, 2008 to March 31, 2009 the government posted a $2.2 billion deficit. In 2009-2010, the government posted a $47.0 billion deficit.

Revenues were down about 5% year-to-year, mainly attributable to a decrease in personal income tax and corporate income tax collections. The corporate side would have been a lot worse if it wasn’t for a huge recovery in the later part of the 2010 fiscal year.

The one interesting item is that the proxy for general consumption in the country, the Goods and Services tax, had a decrease of 0.2% year-to-year in revenues, so this is virtually unchanged. Similar to corporate income taxes, there was a huge surge in collections in the last part of the fiscal year.

On the expense side, government expenses were up approximately 17%. The bulk of this is attributable to the “economic action plan”, i.e. the stimulus package. The stimulus package, as projected in the 2009 budget, was approximately $23 billion, so one can infer that if it weren’t for the stimulus, the deficit would have been around $24 billion – a fairly manageable number.

Most notable is the 35% increase in Employment Insurance premium payments – mainly a function of increased unemployment, but also factored into this were government legislative efforts to enhance EI benefits for those that paid into the EI program for a lengthy period of time (7 years or over) receiving an extended amount of benefits.

My quick guess for 2010-2011 is that we will continue to see significant growth in revenues from the three main sources – personal income tax, corporate tax and GST collections in the 2010-2011 fiscal year. On the spending side, we will continue to see spending as well, and probably see a posted deficit of around $35-40 billion. This cannot continue indefinitely, otherwise Canada might face its own entitlement crisis. Although relative to other countries we are in better shape, we should be returning our fiscal balance to a mild surplus position and save some capital for future rainy days – which is more than likely to occur for the duration of this decade and beyond as the baby boomer generation retires.

Flight to safety

The US held a 2-year treasury bond auction today and some $42 billion was awarded at a yield to maturity of 0.769%.

In Canada, the 2-year government note is trading at 1.69%.

I can’t think of a single rational reason why a retail investor (that has a lot less than $42 billion in the bank account) would want to purchase these types of securities when there are relatively risk-free alternatives (such as “near guarantee” GICs and corporate bonds of issuers that would only default in the event of an economic apocalypse).

Canadian Interest Rate Predictions

The last three weeks of market volatility have had a profound effect in driving demand for risk-free, liquid government investments. The Bank of Canada has been a recipient of some of this inflow, as demonstrated by the 5-year benchmark government bond rate:

Speculators would have made a fairly good gain had they bought around 3.1% and sold today at around 2.6%. Of course, the best trades are done in retrospect, so this is just like saying that I could have picked the last 6 digits of the lottery and won a million dollars. Whether the yield will go lower or not remains to be seen.

What this does mean, however, is that 5-year fixed rate mortgages are likely to drop from their existing levels of around 4.54% (at ING Direct) or 4.39% (a typical mortgage broker) to something down 25 basis points or so. I would expect the 5-year rate to be around 4.25% for most retail customers. I generally ignore the posted bank rates since they are always inflated and when negotiating, they usually have a standard rate that is a good percent and a bit below those rates. Competition has whittled that process down to a formality of just asking, but I am sure there are some financially uninformed people that believe the posted rate is the only one they can get.

The Bank of Canada will be raising the target (short term) rate on June 1. This is inevitable, but the question is whether they will be raising 50 basis points or 75 basis points. Right now the 3-month banker’s acceptance futures (the only short term interest futures instrument actively trading in Canada) is implying a June rate of 0.81%.

My prediction is that the Bank of Canada, on June 1st, will raise the overnight target rate 0.5% to 0.75%.

Since this is mostly baked into the markets, the effect this will have on longer-term rates is nil. However, for those that are on variable rate mortgages, they will be paying 0.5% more since the prime rate will go up a corresponding amount. On a $300,000 mortgage, this would mean $1,500/year in payments or about $125/month additional.

My projection for the end of December will be 1.5%, down from 1.75% as projected a month earlier. My prediction is that rates will go up another 0.25% on July 20, 0.25% on September 8, no change on October 19 and up 0.25% on December 7.

The Trillion Dollar Euro Bailout

The European Union Bank is effectively going “all-in” by pledging $1 trillion in collateral to shore up the economies in the Eurozone.

What people should be fully aware of is that while this might delay the financial issues concerning the countries in the Eurozone, this is not going to solve the underlying problems – too many entitlements promised to people and not enough money to pay the corresponding liabilities. The only solutions are to reduce the entitlements (which is difficult to achieve politically) or raise revenues.

Clearly by stalling for time, they are hoping something might happen that would alleviate themselves of the fiscal mess they are in, but by stalling any action that would clean up the mess, it will just make it worse in the future when the proverbial excrement hits the fan.

It is my market opinion that we have not seen the end of this by any means. How to play this profitably is difficult – increasing cash allocation and playing the risk aversion card seems to be wise until such a time it becomes evident that the markets have discounted sufficient risk to account for the soverign debt mess that is looming.

The United States is not immune to this, but economists do know that countries such as the United Kingdom, other European countries and Japan are more likely to face these big macroeconomic/demographic issues before the USA will.

Countries like Canada, relatively speaking, are in decent shape. While old age security payments and guaranteed income supplements will increase as the baby boomer generation retires, entitlement payments are relatively low and can be managed. Our pension plan (CPP) is solvent and funded by real assets generating real returns (although how those assets will perform in a global debt default remains to be seen). The big liability, accrued healthcare spending, is the big political hot potato. The Canadian economy seems poised to take advantage of one major trend, mainly that consumption of energy will continue to increase – our oil industry is going to boom assuming there is no massive deflation of debt and international trade.

I still have no idea whether the deflationary or inflationary theory will win out.

Canadian Interest Rate Projections – May 2010

I figure it would be helpful to see what the Canadian interest rate futures are doing and to make some projections as to what the market is saying about future rate increases:

Month / Strike	Bid Price	Ask Price	Settl. Price	Net Change	Vol.
+ 10 MA	0.000	0.000	99.375	0.000	0
+ 10 JN	99.150	99.160	99.250	-0.100	14740
+ 10 JL	0.000	0.000	99.365	0.000	0
+ 10 SE	98.730	98.740	98.820	-0.080	22075
+ 10 DE	98.340	98.350	98.410	-0.060	29381
+ 11 MR	98.050	98.060	98.100	-0.050	8873
+ 11 JN	97.740	97.770	97.810	-0.060	2777
+ 11 SE	97.440	97.480	97.550	-0.080	2076
+ 11 DE	97.220	97.270	97.310	-0.070	216
+ 12 MR	96.910	97.150	97.060	-0.250	1
+ 12 JN	96.550	96.930	96.860	0.000	0

My projection for the Bank of Canada overnight interest rate level is the following:

June 1, 2010 (+0.50% to 0.75%)
July 20, 2010 (+0.25% to 1.00%)
September 8, 2010 (+0.25% to 1.25%)
October 19, 2010 (+0.25% to 1.50%)
December 7, 2010 (+0.25% to 1.75%)

What has changed since my last projection is that the initial rate increase in June 1, 2010 will be 0.50% instead of 0.75%. I still see subsequent rate increases of 0.25% at each scheduled announcement. You can probably thank the European debt situation for this change.

Although Canada’s economy is much less linked to Europe than it is to the USA, it is enough to factor into the economic calculation. In particular, the Euro has dropped significantly and this will lessen the competitiveness of Canadian exports into the Euro market.

That said, relative to the US dollar, the Canadian dollar has slipped a little, but this probably isn’t enough to take into consideration other than “wait and see”.

Long-term rate projections, which is more relevant for mortgage pricing, has had rates drop over the past two weeks. 5-year bond rates are 2.74%, while the 10-year is at 3.47%, which is roughly the rates seen in the past three quarters. If the market stabilizes at the existing level, I would not be shocked to see a 5-year fixed mortgage rate offered at 4.00% in the next couple weeks.