by Aaron Fennell

The first half of 2010 was quite volatile, but there are still many unanswered questions in regard to the global economic outlook that are likely to make the second half equally as volatile. Canada’s economy is growing, but the global economy is still not out of the woods yet. A double-dip recession remains a possibility. Let’s take a look at prospects for the markets during the second half of 2010.

The Stock Market and the VIX

The CBOE Market Volatility Index (VIX) has become a useful tool to gauge the fear in the stock market. This index is often called the “fear gauge” because it rises during times investors are distressed about the market’s prospects, and falls when they are complacent. The VIX calculates market volatility based on pricing of S&P 500 options. When more investors want to purchase options as a hedge against stock market declines, premiums spike because sellers will be exposed to more risk, and need to be compensated accordingly. When the sovereign debt crisis began to unfold in Europe in the second-quarter of this year, the VIX moved up toward 40. In contrast, when the financial crisis began to unfold in the U.S. in 2008, the VIX hit an all-time high of 70.

We have seen the VIX sell off this summer and I think it is likely to move into the low 20s. Summer tends to be a less volatile time for the market in general. Volatility and negativity tend to drop off during the summertime. Investors’ reaction to negative news tends to be a bit more muted in the summer than at other times of the year.

The following events dominated the first half of the year. I won’t go into detail about each of these events, as they have been widely covered by the press.

European debt crisis and debt downgrades
Canada dollar touching parity
BP Oil Spill
“Flash Crash”
Bank of Canada interest rate increases
Financial regulation discussions and proposals
G20 austerity discussions

Probably the biggest question mark to the global outlook right now stems from the sovereign debt crisis, which hasn’t been resolved. Some of these countries will find debt continue to accumulate until they either default, or are forced to reduce spending, which is difficult to do without causing a recession. There is still some reluctance in many countries facing sovereign debt issues to take the measures they need to take. How long can debt increase before it becomes uncontrollable? The problem of the miracle of compound interest is that it works both ways—it compounds to the investors’ benefit and also to the debtors’ detriment.

Canada Dollar and Interest Rate Outlook

The Bank of Canada met on July 21, and for the second month in a row, raised its benchmark short-term lending rate by 25 basis points. The rate stands now at 0.75 percent. The latest statements from the BOC were more cautious than in the previous policy report. Even though Canada’s economy is solid right now, GDP estimates for 2010 and 2011 were lowered as the unfolding European sovereign debt crisis caused concern about the global economic outlook.

The BOC is playing from a defensive or cautious position. They are leaving two doors open—raising rates or keeping them unchanged. We will have to listen carefully to see how that tone may change. If you didn’t look at any factors outside of Canada, you’d think an interest rate of 0.75 percent was crazy given the country’s job growth and GDP. Canada has added more than 400,000 jobs since this time last year, and its growth outlook is quite positive. The weaker outlook from the BOC and its maintenance of a low interest-rate environment is tied to the broader global outlook; how Canada’s trading partners fare economically.

The Canadian dollar hit parity with the U.S. dollar in April, and has not revisited it since. The dollar has been thwarted by the European debt crisis. While the BOC rate hike is supportive to the currency, I think the CDN is likely trade in a range for at least this quarter, and parity should hold as resistance.

One thing that’s positive for Canada is that its central bank is able to raise interest rates when other countries can’t do so. This generates a more lucrative investment environment, and drives foreign capital flow. However, Canadian interest rates are only 50 basis points ahead of the U.S., and that’s probably not enough to fuel major activity. If we do fall into a global double-dip recession, that could offset any gains in the Canadian economy tied to the interest rate differential.

I think the market is the best indicator of where interest rates are headed. One way to determine that is by taking a look at rates implied by bankers acceptance futures prices. These are contracts based on the benchmark three-month implied rate in Canada.

You can see a slow upward climb going to December 2012 before we even get to close to 3 percent in the benchmark short-term lending rate. Three percent is still very low from an historical context.

U.S. Interest Rate Expectations

The U.S. Federal Reserve continues to keep its target benchmark short-term lending rate (Fed funds) at 0 – 0.25 percent, and has indicated that’s likely to be the case for some time. To determine market expectations going forward, we can look at prices of the CME Group Fed funds futures contracts. If you go to CMEGroup.com/fedwatch, you can find the latest information online, re-calculated every 10 minutes as expectations change. Each contract month reflects a different expectation based on the upcoming FOMC meeting date.

Currently, the August Fed funds futures contract reflects a 74 percent likelihood interest rates will remain unchanged. Before year-end, there is a probability rates could be even cut further, to zero. It’s not until June 2011 that we see any probability of an interest rate hike. What that tells me is the market expects rates to stay low for a very long time in the U.S., while Canada’s rates slowly grind higher as long as there is strength in the economy. That should ultimately result in a slow grind higher in the Canadian currency.

One of the problems with prolonged low rates is that they can encourage consumers to overborrow and overspend, and not save enough for their future. So another problem that’s developing in the future is that pensions will fail if interest rates aren’t brought up. They aren’t generating enough income to meet their obligations. Growing debt, low interest rates and a generation without enough for retirement are a scary aspect of the global economy we haven’t seen talked about much yet.

Gold
The gold market has been interesting, and there are many reasons investors flock to gold. This market has been trading on psychology right now; it’s worth what the market thinks it should be worth, not supply and demand. When you look at copper, for example, consumption and use drive prices. Gold that was mined thousands of years ago is still in inventories. Gold’s price is determined largely by investor perception.

Gold has seen resistance at $1,200 an ounce, and I think if the market can’t break that level, many investors will get discouraged and abandon their bullish positions. We could see a fairly significant move lower as a result. At the end of 2009, when the market first broke $1,200, we saw a correction to $1,100, and many investors felt that was the bottom. However, the market headed as low as $1,050, which I felt was largely psychological. Many traders with large positions started to panic. Right now, we haven’t gotten to that stage where traders are abandoning positions, but it is a strong possibility.

I recommend keeping your powder dry. Wait for a bigger decline to buy gold and hold for the longer-term. I think the outlook for gold remains bullish long-term, as there are still many investors in the world who will lose confidence in paper assets, and look to diversify into hard assets to protect their wealth.

Turning to other metals, platinum and palladium are interesting markets to watch. These metals are used in automobile catalytic converters. Their supply is fairly restrictive—some 80 percent comes out of South Africa. These are a rare metals and it’s difficult to increase production when demand moves up. As a result, a small demand increase can result in a large increase in price, and a small decrease in demand will result in a dramatic decline in price.

Crude Oil

The price of crude oil for the second half of the year also depends on whether or not we get a second dip in the recession. I think betting on the upside in this market is a risky proposition right now; the better bet is probably to short crude oil and look for a move to a range of $60 - $50 a barrel. There just isn’t much incentive to buy right now, other than perhaps hurricane activity, which might create temporary spikes.

A longer-term factor to keep in mind is how the BP oil spill may lead to more incentives for alternative energy sources in North America. We still have a cleanup effort going on at the same time we have an active hurricane season. This could be a factor from a policy standpoint in that increases the case for a push toward natural gas and away from crude oil. As a result, I don’t think the outlook for crude is quite as strong on a very long-term basis as it is for natural gas, which is much cheaper and cleaner than crude oil.

As mentioned, hurricane activity is a big factor in the energy markets, and expectations are for above-normal activity this season. Natural gas is affected to a greater degree than crude oil, because it’s extremely difficult to transport natural gas on a global basis. A hurricane in the Gulf of Mexico will have a huge impact on the total North American supply for natural gas, but crude oil production that might be lost can be replaced by crude oil that is transported from other parts of the world. As a result, there tends to be more volatility in the natural gas market. An active hurricane season could create dramatic spikes in natural gas this summer and fall.

Aaron Fennell is a Senior Market Strategist based in Lind-Waldock’s Toronto office, and is serving clients in Canada. If you would like to learn more about futures trading you can contact him at 877-840-5333, or via email at afennell@lind-waldock.com.

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