Rate hikes around the globe to impact economic conditions and financial markets: TD Economics

    TORONTO, June 20 /CNW/ - Rising interest rates will temper global
economic growth and will shape the performance of financial markets in the
coming quarters. TD Bank's Chief Economist, Don Drummond, stated: "A global
rebalancing in monetary policy is underway, and the Bank of Canada will join
the fray this summer."
    The June issue of the TD Quarterly Economic Forecast predicts that the
global economy will ride out the higher interest rate environment remarkably
well, but financial markets could experience greater volatility as investors
adjust to the new reality and equity markets are unlikely to replicate the
double digit gains of the past few years. The report can be found at
    Over the past five years, the global economy has been on a tear, but
technological innovation and the disinflationary impact of globalization has
kept inflation at bay. However, capacity constraints are increasingly being
encountered. In some emerging markets, such as China, the impact is being felt
in asset prices. In the case of developed nations, the result has been
remarkably tight labour markets, even in countries experiencing sub-par
growth, like the United States. "The good news is that monetary authorities
are being proactive and are raising rates before inflation gets out of hand,
reducing the risks of an economic downturn," said Don Drummond.
    In the months ahead, the European Central Bank, the Bank of Japan, the
Bank of England, and the Bank of Canada - every G-7 central bank with the
exception of the U.S. Federal Reserve - will increase their policy rates. And,
while the Fed is likely to remain on hold, this is a tighter stance to policy
than financial markets had expected until only a few weeks ago when rate cuts
were anticipated.
    "However, while the global economic expansion will be dented by the
rebalancing in monetary policy, it should not be thrown off the rails," said
Drummond. The fallout from higher rates in the near term should be largely
felt in the second half of 2008 and early 2009, with world real GDP slowing to
a still robust 4%.
    In Canada, the Bank of Canada is clearly concerned about price pressures
- and recent economic developments suggest that it should be. The economy was
operating at full capacity at the end of last year and real GDP surged at a
3.7% annualized pace in the first quarter of 2007. The tracking for the second
quarter is pointing to a gain of 3.3 %. As a result, a state of excess demand
exists with capacity constraints being encountered, as latter reflected in a
33-year low in the unemployment rate and an upward drift in core inflation
away from the Bank's 2% target. Given these conditions, the Bank is poised to
raise rates, likely on July 10th and September 5th.
    The tightening in Canadian monetary policy will likely contribute to a
Canadian dollar averaging 96 U.S. cents in the second half of this year. The
one-two punch of higher interest rates and Canadian dollar will lead to a
slower pace of economic growth and a 2.5% increase in real GDP in 2008. "This
may look like a disappointing performance and it is likely to lead to many
comments about how Canada is experiencing an economic slowdown. The reality is
very different," said Drummond. The forecast is only marginally below the
Bank's estimate of the non-inflationary potential growth of 2.8%. Moreover,
given Canada's dismal productivity performance in recent years, there is a
distinct possibility that potential growth is even slower.
    "As a result, 2.5% economic growth may be the best that Canada can do,
and there is a risk that the Bank could be forced to engineer a weaker
performance with even higher interest rates if Canadian productivity does not
improve on a sustained basis," said Drummond.
    So, the global and Canadian economies are likely to weather the
rebalancing of monetary policy, but the financial implications will be far
reaching. The key financial themes include:

    -  The return on cash products will rise in tandem with central bank rate

    -  Higher short-term rates will boost bond yields, but the impact should
       be extremely limited since markets have already priced in much of the
       future policy tightening and inflation should remain tame.

    -  Equity markets will be adversely affected in a number of ways. First,
       higher interest rates will make fixed income products more attractive,
       while also making equity valuations look more expensive. Second,
       higher interest rates will lead to softer corporate earnings growth.
       Third, commodity prices are expected to dip as global growth
       moderates, but tight supply should keep prices for energy and many
       other products at very profitable levels. Increased borrowing costs
       may also temper the recent explosive pace of mergers and acquisitions.
       "Overall, equity markets are expected to advance, but returns are
       likely to be in single digits and investors should be braced for
       increased volatility," said Drummond.

For further information:

For further information: Don Drummond, SVP & Chief Economist, TD Bank
Financial Group, (416) 982-2556; Craig Alexander, VP & Deputy Chief Economist,
TD Bank Financial Group, (416) 982-8064

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