ScotiaBank JUL 21 Daily Points

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Scotia Economics

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sources believed reliable, neither the information nor the forecas

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On Deck for Wednesday, July 21

DailyPoints Tracking the numbers

Global Economic Research

CAPITAL MARKETS RESEARCH

Derek Holt (416) [email protected]

Gorica Djeric (416) [email protected]

July 21, 2010 @ 07:30 EST

KEY POINTS:

Bernanke's options are limited

US mortgage purchase applications rise for second week in past eleven

Canadian wholesale sales advanced in May?

BoJ: upside and downside risks increased

BoE debates further policy easing vs. rising inflation

CANADA

The Canadian wholesale sales (8:30amET) report for May will providesome guidance for Mays retail sales figures, due out tomorrow. While theheadline may be swayed by lower import prices paid by wholesalers, partlydue to a stronger Canadian dollar (relative to its U.S. counterpart) in May,volumes will be a better barometer of demand. Inventories are a key compo-nent of this report. Stockpiles expanded for the second time in the past threemonths in April, a first since December 2008. Only half of the sectors re-ported higher inventory levels, suggesting we could see a stronger rebound inthe months ahead. Some components of wholesale trade, like computers, actas a partial leading view of retail sales in providing limited guidance. Otherlimited guidance comes from StatsCans 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 retailsales report.

UNITED STATES

U.S. MBA Mortgage Applications Index rose 7.6% in the week ending July16 to its highest reading in nine months. Gains were led by refinancing activ-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. Thats only thesecond week in the past eleven since the expiration of homebuyer incentiveson April 30th.

The U.S. remains stuck in a liquidity trap and there is precious little the Fedcan do about it. Talking up the Fed's options could well be the focus ofFed-eral Reserve Chairman Ben Bernanke's semi-annual testimony on mone-tary policy to the U.S. senate today that used to be referred to as the Hum-phrey Hawkins hearings (10:00amET). But those options are likely to betragically ineffective.

The core challenge is that the demand for money remains interest inelastic, orinsensitive to low rates. It's a very dangerous spot for a central bank to wind

Fed Events

Fed Funds Target RateCurrent Rate: 0-0.25%Next Move: August 10 @ 0-0.25Bias: Dovish

Fed Chairman Bernanke willdeliver (2:00pmET) the semi-annual monetary policy report tothe Senate Banking Committee.

Key International Events

ECBCurrent Rate: 1.00%Next Move: August 5 @ 1.00%Bias: Dovish

BoE

Current Rate: 0.50%Next Move: August 5 @ 0.50%Bias: Dovish

BoJCurrent Rate: 0.10%Next Move: July 15 @ 0.10%Bias: Dovish

BoC Overnight Lending RateCurrent Rate: 0.50%Next Move: September 8 @ 1.0Bias: Neutral

BoC Events

Country Date ET Indicator Period BNS Consensus Latest

CA 07/21 (08:30) Wholesale Trade (m/m) May 0.3 0.3 -0.3

US 07/21 (07:00) MBA Mortgage Applications (w/w) Jul. 16 -- -- 7.6

US 07/21 (10:00) Bernanke Gives Monetary Policy Report to Senate Banking Panel


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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 theattractiveness of lending. We at least hope that a bank would expect to earn more on loans than a miserly quarter point alternative inslipping it in the Feds mattress. It also won't force people to borrow. Ditto for buying more Treasuries, agencies or MBS, as anextra modest reduction in longer rates will be shaken like water off a dog's back, assuming markets understand were in an environ-ment with a zero inflation threat for years and dont penalize such a policy shift through allowing inflation fears to push up the curveon 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 anexplicit message to markets that the Fed will not hike for years wont materially impact rates. Thus, extending the exceptionallylow and for an extended period language wont effectively add any further Fed influence up the curve than what is already bakedin.

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, andUS 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 thats almost entirely due to higher stock prices that are focused upon the upper incomesegments 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 yesterdays survey of over 100 economists by Robert Shiller isany guide, US home prices might rise a cumulative 10% over the next five years. Yes, economists have been known to be wrong onoccasion (humour us), but massive sidelined shadow inventories that have an all-time record high inventory overhang of unsoldlisted and unlisted excess housing isnt an environment within which to reasonably expect material house price appreciation. Withthis as the operative backdrop for the Fed, you simply can't pay people to borrow. Theyre worried about their retirement. Aboutfooting the college bills for the boom-echo kids of the boomers. About the future status of their pensions. They spent too much inthe party years, and now the reckoning begins. So go ahead, inflate away. Would minus 5% real rates make you feel better aboutborrowing more against your fallen retirement nest egg? Deeper negative real rates are likely to be even less influential now in anaging 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 tospend when they can take enormous amounts of idle liquidity on household balance sheets that is earning zilch, and use it to paydown 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? Itis also part of why banks are buying up massive lots of Treasuries. Banks' asset-liability choices have them skewed toward lendingfor 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 doesnt compensate for risk and transactions costs? Or lend for minimal risk further up the curve to at least padsomething into net interest income? Yes, ZIRP (zero interest rate policy) has backed central banks into a corner but its difficult tosee 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 ofone arriving over the next two years arises at which point the US encounters European-style fiscal exit pains? Nothing. At least notfor 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 fallharder thereafter by 2012 and 2013 than what weve 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 maynot fully comprehend what lies ahead. Id love to see a head-to-head op-ed debate between Paul Krugman and Robert Barro, two ofthe 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. Barros assertion is that fiscal multipliers are well under one, perhapsnegative, such that deficit financed spending crowds out enough other activity such that it offers no net stimulus. He has been anactive editorialist in the WSJ pounding the table with such views during this crisis. The third dilemma for fiscal expansionists is thatthe US already faces decades of deficits hard-wired into the fiscal landscape through the projected rise in interest payments as a shareof the economy (see this weeks Capital Points, Is the US Facing a Debt Spiral Like Canada Once Did?, page1-3).


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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 thepro-cyclicality of regulatory policy (ease in good times, tighten in bad and beat up on bankers every imaginable way). But that stillencounters the demand-side obstacles to borrowing. So perhaps go back to Hilary Clinton's Presidential campaign suggestions todust 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 at0.1% to spur growth. Many board members thought that both upside and downside risks to a sustainable economic recovery had in-creased since Aprils Semi-Annual Outlook Report. Strong exports supported by faster-than-expected recovery in emergingeconomies and capital investment by Japanese businesses remain the backbone of the economic recovery. The BOJ also revealedfurther details of a lending program announced at the April 30 policy meeting. Separately, the BoJ Deputy Governor indicated thatthe central bank was monitoring yen moves, but dismissed speculations that a yen increase past certain level would trigger additionalmonetary policy easing. However, Deputy Governor did say that the central bank continues to look into measures that would spurfurther 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 prospectsfor GDP growth had probably deteriorated a little over the month Andrew Sentence remained the sole dissenter, continuing toadvocate raising the rate to 0.75%, on concerns over high inflation. Britains CPI currently sits at 3.2% y/y, above governmentstarget of around 2%. Several members noted that the governments decision to raise value-added tax to 20.0%, from 17.5%, wouldcontribute to higher inflation. However, the margin of spare capacity was likely to bear down on inflation and bring it back to thetarget in the medium term once the impact of temporary factors had worn off.

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.

Fixed Income

Last 1-day 1-wk Last 1-day 1-wk Last 1-day 1-wk Last 1-day 1-w k

U.S. 0 .5 8 0.5 8 0 .61 1.68 1.69 1.8 1 2 .94 2 .95 3.0 4 3 .97 3.98 4 .0 3

CANADA 1.5 7 1.5 2 1.72 2 .39 2 .3 8 2.5 5 3 .19 3 .16 3.2 7 3 .76 3.74 3 .7 8

GERMANY 0 .7 3 0.7 8 0 .77 1.62 1.64 1.6 1 2 .65 2 .64 2.6 6 3 .35 3.33 3 .3 3

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

U.K. 0 .7 9 0.7 9 0 .79 2 .07 2 .0 8 2.0 9 3 .34 3 .35 3.4 0 4 .23 4.22 4.2 1

CANADA 99 94 111 71 69 75 25 21 22 -21 -24 -25

GERMANY 15 20 16 -6 -5 -20 -29 -31 -39 -62 -65 -70

JAPAN -43 -43 -45 -133 -134 -143 -184 -185 -191 - 209 -211 -212

U.K. 21 21 19 39 40 28 40 40 35 26 24 18

Governm ent Yield Curves (%):

Foreign - U.S. Spreads (bps ):

2-YEAR 5-YEAR 10-YEAR 30-YEAR

Equities

Last Change 1 Day 1-wk 1-mo 1-y

S&P/TSX 11629.88 86.41 0.7 -0.4 -2.6 10.6

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

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

FTSE 6048.78 81.29 1.4 -2.6 -3.9 18.7

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

CAC 3531.90 63.88 1.8 -2.8 -5.5 6.9

Commodities

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.

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

CRB Index 261.52 0.32 0.1 -0.1 -0.8 6.0Currencies

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

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

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

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ScotiaBank JUL 21 Daily Points