Financial markets are ready to ring in the New Year after 2010 was plagued with bouts of uncertainty as to whether the recovery
would be sustained. Recently, there were hints of a change in sentiment with investors appearing to have embraced the idea that the
global economy has built sufficient momentum to withstand the downward pressure emanating from Europe’s sovereign-debt crisis.
The global MSCI world stock index was 4.1% higher in November than October, on average, and the buying continued into the first
week of December especially after the U.S. Government reached a tentative tax deal that would put money into the hands of U.S.
consumers. Bond markets, conversely, lost ground with interest rates rising much more aggressively than we expected.
U.S. growth—prospects good for 2011
U.S. growth in the third quarter of 2010 was revised to a 2.5% annualized pace representing an improvement relative to the advanced
estimate of 2.0% as well as the 1.7% gain recorded in the second quarter. Unexpectedly, an upward revision in consumer spending
accounted for almost half of the upgrade to overall growth. Our forecast assumes that the recently announced tax package will be
passed by lawmakers thereby lending support to consumer spending with the incentives contained therein also spurring a pickup in
business investment. This tax cut package combined with very stimulative monetary policy and indications of improving consumer
confidence are expected to result in the U.S. economy posting stronger quarterly growth rates in 2011. Stable conditions in the
housing market means that this sector will no longer act as a drag on the economy; however, the inventory rebuilding that supported
the economy in the early days of the recovery will fade away in 2011 although the tax reform package will prevent fiscal stimulus
from turning negative. On balance, U.S. growth of 3.3% is forecast in 2011 with the pace accelerating to 3.6% in 2012.
Fed taking charge
The Federal Reserve faced down its critics regarding the decision to implement another round of quantitative easing in early
November. The decision reflected the Fed’s assessment that both the unemployment rate and inflation rate were at levels that were
inconsistent with achieving its mandate of price stability and full employment. Our updated forecast takes into account the sharp selloff
in the Treasury market in recent weeks, and we now look for the 10-year bond to exit 2010 at 3.15% (compared to 2.6% in our
November outlook). The thrust of our 2011 forecast remains the same, and we increased our year-end target for 10-year yields by 45
bps to 4.00%. We expect the Fed to hold the Funds target in its current range of 0.00% to 0.25% during 2011. Policy rate increases are
likely to begin in 2012 when the economy is growing at a stronger pace, the deleveraging process is over and financial market
conditions are back to “normal”. We forecast that the Funds target at 2.25% by the end of 2012 and the 10-year yield at 4.50%.
Canada sprinted out of recession, economy takes a breather
The Canadian economy slowed in the third quarter of 2010 with annualized GDP growth dropping to 1.0% following gains of 2.3% in
second quarter and 5.6% in the first quarter. Unlike the US, where the string of data reports have proven to be stronger than expected,
Canadian data have been disappointing of late. With that said, the sharp slowing in GDP output in the third quarter was largely the
result of big hit coming from the trade sector, which reduced real GDP growth by 3.5 percentage points. Domestic demand came in at
a respectable pace due to stronger than expected consumer activity and a solid increase in business fixed investment. We expect the
slowing in the pace of growth to be short lived with the economy forecasted to accelerate in the fourth quarter and throughout 2011.
The low interest rate environment will serve to limit the slowing in consumption activity and backstop the housing market, which is
likely to experience slower activity. Our forecast is that the economy will grow by 3.2% in 2011 and 3.1% in 2012.
The Bank of Canada temporarily called it quits on interest rate increases in October and December focusing on the downside risks to
the global and domestic economies and financial markets emanating from the European debt crisis. The combination of disappointing
growth and below-target core inflation will likely keep the Bank of Canada on the sidelines in the first quarter of 2011. Our
expectation that Canada’s economy will return to a faster growth track in the quarters ahead and that the U.S. economy will be able to
sustain upward momentum should be sufficiently evident by the second quarter of 2011 at which time we look for the Bank to resume
raising the policy rate. From today’s 1.0%, we forecast that the overnight rate will rise to 2% at the end of 2011. The combination of
sustained above-trend growth in Canada in 2012, and a steady acceleration in the U.S. economy will likely result in the Bank of
Canada working to reduce policy accommodation in 2012. The overnight rate is forecasted at 3.5% by year-end 2012 with 10-year
yields drifting higher during this horizon and ending 2011 at 3.80% and 2012 at 4.15%.

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