Economic Insights

March 31, 2011

Inflated Fears
by Avery Shenfeld

Economics It seems like only yesterday that investors
were shaking in fear of deflation, but its
polar opposite is now the rising concern.
Across the globe, inflation readings have
Avery Shenfeld
(416) 594-7356
escalated as improving global demand and
avery.shenfeld@cibc.ca negative supply shocks combined to push
oil, food and some industrial commodities
Benjamin Tal
(416) 956-3698
through the roof.
benjamin.tal@cibc.ca
While inflation has already broken out
Peter Buchanan
(416) 594-7354 strongly to the upside in emerging markets,
peter.buchanan@cibc.ca most Western industrialized economies
Warren Lovely
have seen more limited pressure. Where
(416) 594-8041 the CPI goes from here will, of course,
warren.lovely@cibc.ca depend on the nearly unpredictable course
Krishen Rangasamy
of geopolitical events in North Africa and
(416) 956-3219 the Middle East. But assuming these don’t
krishen.rangasamy@cibc.ca get any worse, the inflation story will rest on
Emanuella Enenajor the transmission from a one-time food and
(416) 956-6527 energy shock to broader price levels.
emanuella.enenajor@cibc.ca
Central bankers and investors around the
world are coming to different conclusions on
that front. In Europe, the ECB appears poised
for a couple of rate hikes to demonstrate its
resolve, a move that replays its ill-advised
“Anyone holding 2008 hike. The now elevated euro, fiscal
RRBs should think restraint and a shaky banking system will
“textcashing
about text text”
in likely send the ECB back to the sidelines after
now.” 50 bps of hikes. The Bank of England is in a
civil war, with hawks voting to hike now, and
King’s majority camp trying to hold off in the
knowledge that the ballooning inflation rate
is all about oil and sales taxes, not excess
demand.
In North America, some benchmarks of
inflation expectations are heating up (Chart).
Stateside, the University of Michigan survey’s
five-year inflation outlook is at the top of
http://research.
cibcwm.com/res/Eco/
EcoResearch.html
its typical range, and fixed income investors
have also lifted the breakeven inflation rate
implied by the TIPS market.
But in wage rates, the key to any broadening
in inflation from oil/food to core, there’s
been absolutely dead calm. Indeed, US
consumption spending is being squeezed by
the failure of wages to keep up with CPI, a
trend that will put downward pressure on
retail prices in the core basket. There’s no
deflation risk to prompt a QE3, but neither
is there any threat of a Fed rate hike.
Canada’s real return bonds are pricing in an
even greater inflation threat, with the 10
year breakeven inflation rate topping 2.5%.
That seems overdone. Not only does the
Bank of Canada deserve credit for managing
inflation to its 2% target over the past 15
years, but wages on this side of the border
are also becalmed. Remember, the last core
inflation reading was only 0.9%. If energy
prices flatten out, so too will CPI. Anyone
holding RRBs should think about cashing in
now.
US Hourly
Earn yr/yr
US 10 Yr
Latest
TIPS Sep-2010
Breakeven
Inf
Cdn 10 yr
RRB
Breakeven
Inf
U-Mich 5-yr
Infl Exp
%
1 1.5 2 2.5 3 3.5

CIBC World Markets Inc. • PO Box 500, 161 Bay Street, Brookfield Place, Toronto, Canada M5J 2S8 • Bloomberg @ WGEC1 • (416) 594-7000
C I B C W o r l d M a r k e t s C o r p • 3 0 0 M a d i s o n A v e n u e , N e w Yo r k , N Y 1 0 0 1 7 • ( 2 1 2 ) 8 5 6 - 4 0 0 0 , ( 8 0 0 ) 9 9 9 - 6 7 2 6
CIBC World Markets Inc. Economic Insights - March 31, 2011

MARKET CALL
• We’ve extended the time period for oil to stay at lofty levels associated with geopolitical events. That will
keep the C$ trading stronger than parity for the next month or two, and we now see only a modest and
temporary dip to weaker levels if oil comes off the boil towards mid-year. The euro has climbed on the
prospect of ECB hikes ahead, but we see it giving back gains once the first hike is in the rear view mirror and
attention turns to lingering fiscal woes.

• Bonds reversed the flight to safety rally seen after Japan’s quake. The front end of the US curve remains
grounded by a stand pat Fed, but the long end could weaken as we approach the end of support from
QE2.

• Earlier this month, we pushed back the first Bank of Canada rate hike to July (from May), with surprisingly
tame core inflation and a stall in progress on the unemployment rate suggesting a higher estimate for the
economy’s non-inflationary potential. That also lowered our bond yield targets for June. Still, Q1 growth
will be well above the Bank’s last outlook, and we still see upward pressure on yields as the Bank hikes the
overnight rate to 2% by year end.

INTEREST & FOREIGN EXCHANGE RATES

2011 2012
END OF PERIOD: 30-Mar Jun Sep Dec Mar Jun Sep Dec
CDA Overnight target rate 1.00 1.00 1.50 2.00 2.00 2.00 2.00 2.25
98-Day Treasury Bills 0.93 1.00 1.55 1.90 1.85 1.85 1.85 1.90
2-Year Gov't Bond 1.78 2.00 2.15 2.50 2.40 2.75 2.85 3.00
10-Year Gov't Bond 3.32 3.50 3.55 3.50 3.60 3.85 3.95 4.00
30-Year Gov't Bond 3.75 3.80 3.90 3.85 4.00 4.10 4.25 4.25
U.S. Federal Funds Rate 0.15 0.20 0.20 0.20 0.20 0.20 0.20 0.20
91-Day Treasury Bills 0.10 0.15 0.15 0.15 0.15 0.15 0.15 0.20
2-Year Gov't Note 0.80 0.75 0.65 0.65 0.85 0.90 0.90 1.00
10-Year Gov't Note 3.47 3.55 3.50 3.40 3.50 3.80 3.85 3.95
30-Year Gov't Bond 4.54 4.60 4.55 4.40 4.65 4.75 4.80 4.80
Canada - US T-Bill Spread 0.83 0.85 1.40 1.75 1.70 1.70 1.70 1.70
Canada - US 10-Year Bond Spread -0.15 -0.05 0.05 0.10 0.10 0.05 0.10 0.05
Canada Yield Curve (30-Year — 2-Year) 1.97 1.80 1.75 1.35 1.60 1.35 1.40 1.25
US Yield Curve (30-Year — 2-Year) 3.74 3.85 3.90 3.75 3.80 3.85 3.90 3.80

EXCHANGE RATES CADUSD 1.03 0.98 1.00 1.01 1.01 1.02 1.02 1.03
USDCAD 0.97 1.02 1.00 0.99 0.99 0.98 0.98 0.97
USDJPY 83 84 86 89 88 90 92 94
EURUSD 1.41 1.35 1.32 1.33 1.34 1.35 1.34 1.32
GBPUSD 1.60 1.57 1.58 1.62 1.65 1.67 1.65 1.65
AUDUSD 1.03 0.96 0.95 0.98 1.01 1.03 1.01 1.00
USDCHF 0.93 0.94 0.96 0.98 0.99 1.01 1.03 1.06
USDBRL 1.64 1.67 1.65 1.63 1.62 1.62 1.61 1.62
USDMXN 11.99 11.85 11.90 12.00 12.00 11.85 11.75 11.50


CIBC World Markets Inc. Economic Insights - March 31, 2011

COMMODITIES OUTLOOK
Oil prices equal demand-supply dynamics plus geopolitical risk. The clear and present risk from a potentially
protracted Libyan conflict and a volatile Middle East political map have led us to hike our 2011 WTI price target
further to an average $97/bbl. Replacing shuttered nuclear generation in Japan will also provide a modest near-
term lift to demand. As reflected in our unchanged $90 target for 2012, fundamentals still point to a declining
path of least resistance for prices if and when Middle East tensions ease. OPEC has more spare capacity today
than during oil’s record-setting mid-2008 run. Efforts to contain inflation and trim budgetary gaps will slow
growth and oil demand in the world’s two largest markets, the US and China.

While de-emphasizing nuclear could provide support for natural gas prices down the road, transportation
constraints and ample shale gas supplies are likely to weigh on North American prices for now. Our target prices
for 2011 and 2012 imply that the fuel will continue to trade cheaply relative to oil in BTU terms.

Base metals prices have regained some or all of the Construction Demand for Base Metals
losses seen on the flight to quality after the disaster 60 % of total use
in Japan. Re-construction efforts there should help to
support prices and demand for steel and many base 50
metals over the next few years (see Chart). Rebuilding
will also require a range of forestry products, from 40

lumber and panelboards, to structural and oriented-

30
strand products.
20
Various unresolved crises—from the fighting in Libya
to eurozone sovereign and US budgetary and debt
10
woes—are constructive for gold. China has seen the
strongest growth in investment demand in recent years. 0
Inflation fears are likely to support hedging demand in Copper Zinc Aluminum
that country and other fast-growing markets like India. Source: Handbook of Commodity Investing
While QE3 looks like a non-starter, continued ultra-low
US rates are also constructive, with the Fed unlikely
to start lifting its target before 2013. These factors
continue to suggest a peak of around $1600/oz in the
next 12-18 months.

Spot Commodity Prices Average

29-Mar 2008 2009 2010 2011 (f) 2012 (f)

Oil (WTI) $/bbl 105 100 62 80 97 90

Natural Gas (Henry) $/Mn Btu 4.28 8.89 3.82 4.37 4.50 5.00
Gold $/troy oz 1418 870* 1088* 1406* 1600* 1600*
C opper $/lb 4.35 3.16 2.35 3.43 4.40 4.00
Aluminum $/lb 1.19 1.17 0.76 0.99 1.05 0.90
Nickel $/lb 12.08 9.57 6.69 9.91 12.50 10.00
Zinc $/lb 1.07 0.85 0.76 0.98 1.05 1.00
Lumber** $/'000 bd ft 280 252 221 245 270 300

* end of period **1st Futures


CIBC World Markets Inc. Economic Insights - March 31, 2011

Canada Goes to the Polls: What's at Stake?

Avery Shenfeld and Warren Lovely
Canadians will be trudging to the polls in early May, Chart 1
casting their votes in the fourth federal election in seven Polls Put Conservatives Out in Front
years. Party platforms are still taking shape, so we don’t Popular Support, % (3-Poll Moving Average)
yet know all of what’s at stake for the economy or 50

financial markets. But it’s still worth examining potential 45 Conservative Support (2008 Election)
performance in the lead up to the vote, and what the
40
implications might be of alternative political outcomes.
35
No Jitters
30

Thus far, markets have taken the election call in stride, 25

Liberal Support (2008 Election)
with no response in the exchange rate, the bond market
20
or equity performance that could be attributed to the Dec-08 Sep-09 Jun-10 Mar-11
events that led to the defeat of the Conservative minority C onservative Liberal
in the House. In part, that’s due to the fact that recent Source: Various polling agencies, CIBC
polls show the Conservatives headed for nothing worse
than another minority government (Chart 1), with a If anything, the period from the dissolution of parliament
steady-as-she-goes policy outlook as a result. to the day after the vote has been one in which Canadian
equities have fared well and outpaced those stateside,
Although the cliché is that markets abhor uncertainty, Canadian bond spreads have narrowed to Treasuries,
elections in the past few decades have not typically and the Canadian dollar has gained modestly. That’s
shaken market confidence. In contrast, sovereignty particularly evident if one strips out the 2008 election,
referendums have produced heightened volatility, even which had the misfortune of coinciding with the heights
as the ballots were counted in the case of the 1995 vote. of the US financial crisis (Table 1). While elections
But for elections, it’s generally been calmer waters. might not actually be good for markets, the governing
party tries to time the vote to match up with decent
economic trends. Nor is there evidence of a post-election
hangover, as judged by currency, bond and equity market
Table 1 performance in the weeks following a vote.
Market Performance During Past Elections
Election Winning Party / US$/C$ 10-Year Yields (Chg, bps)1 Equities (Chg, %)2
Date Type of Government (Chg, %) Goc UST Spread S&P TSX S&P500 Diff
8-Jul-74 Liberal M ajority -0.9 71 17 54 -10.8 -14.6 3.8
22-M ay -79 PC M inority 0.9 -14 -6 -8 1.5 -1.1 2.6
18-F eb-80 Liberal M ajority 1.2 172 232 -60 20.1 5.2 14.9
4-S ep-84 PC M ajority 1.9 -91 -81 -10 7.1 7.1 0.0
21-N ov-88 PC M ajority 1.2 -14 8 -22 -0.8 -1.7 1.0
25-O c t-93 Liberal M ajority 0.2 -18 17 -35 5.9 1.7 4.3
2-Jun-97 Liberal M ajority 1.6 -44 -32 -12 10.2 10.5 -0.2
27-N ov-00 Liberal M ajority -1.7 -3 -5 2 -14.9 -4.4 -10.5
28-Jun-04 Liberal M inority 2.2 17 -7 24 3.5 3.9 -0.4
23-Jan-06 C ons ervative M inority 1.5 6 -8 15 6.9 0.7 6.1
14-O c t-08 C ons ervative M inority -10.8 -3 25 -28 -27.3 -26.9 -0.3
Average -0.3 7 14 -7 0.1 -1.8 1.9
— Excluding 2008 Election 3 0.8 8 13 -5 2.9 0.7 2.1
Notes: Table shows change in key financial market variables FROM start of election (day Parliament dissolved) TO one day after election
1. For 1974 to 1988 elections, bond market yields based on weekly data
2. For 1974 election, equity market returns based on month-end data
3. Figures for 2008 election reflect financial market fallout from Lehman Brothers bankruptcy, which occurred in midst of campaign (15-Sep-08)

CIBC World Markets Inc. Economic Insights - March 31, 2011

Chart 2 Chart 3
Current Path for Federal Deficit Reduction Opposition forced Chg of Course in 2008-09
Federal Budget Balance, % of GDP Federal Budget Balance, $bn
3 10
Fcst
2 (2011 Budget,
0
not passed)
1

0 -10

-1 -20

-2
-30 2008 Fall Update
-3
2009 Budget
-4 -40
FY00 02 04 06 08 10 12 14 FY07 08 09 10 11 12 13

Is Deficit Reduction at Risk? between Liberal and Conservative parties, or between

For the bond market, the most important issue is whether
the election result could take Canada off its deficit
elimination track. The 2011 budget, which was never
voted on, hewed close to earlier plans to eliminate the
deficit by 2015/16 (Chart 2).
Note that fiscal policy in recent years has reflected the
give-and-take associated with a minority government.
That was most evident in what transpired two years
ago. In the fall of 2008, with evidence of a recession
mounting, the Conservative government initially planned
to trim spending in order to stay in balance. Opposition
threats to topple the government on that plan produced
a dramatic U-turn, with a major fiscal stimulus package
and a souring economic outlook dramatically increasing
the deficit in the 2009 budget (Chart 3).
But that reflected a Keynesian stimulus program that
virtually all other major western economies offered to
some degree. The Liberals can claim that in good times,
back in the 1990s, they too took dead aim against deficits
by running a tight fiscal ship. Two relatively costly items
on the Conservative agenda—fighter jets and prisons
required under a get-tough-on-crime program—are
likely to be reconsidered under the Liberals, although the
parties will debate about whether the cost for fighter jets
will end up any lower. Any savings on such items might
also be reallocated to other spending priorities in a Liberal
government, rather than to deficit reduction.
minority and majority governments (Chart 4). Moreover,
opposition parties haven’t come out strongly against
deficit reduction as an objective, with platforms diverging
largely on where the available fiscal room should be
allocated (e.g., tax cuts vs. spending).
What’s less clear is whether there would be a difference
in fiscal direction in a coalition government, as opposed
to a minority that did not include other parties in its
cabinet. There’s been only one formal Canadian coalition
government, way back during WWI. Still, in the UK,
a tight fiscal line has been taken by an equally rare
coalition.
The bond market might note that the Bloc Québecois
made some fairly expensive demands regarding support
for its home province as a pre-condition for supporting
the 2011 budget. These summed to $5 bn, comprising
compensation for earlier HST harmonization, richer
Chart 4
Budget Balances and Political Parties
Federal C yclically-Adjusted Balance, % of GDP
8
Lib Lib PC Lib
6
Major Major Majority Minority
4
2
'09
0

-2
Does the budget balance really hinge on the number PC Liberal Cons
-4
of seats a government holds? History does not show Minor Majority Minority
any consistent turns in fiscal direction—as measured by -6
the cyclically-adjusted budget balance—after changes 1975 80 85 90 95 00 05

Source: Haver Analytics, CIBC


CIBC World Markets Inc. Economic Insights - March 31, 2011

equalization and university funding, and other items. The campaign. Moreover, surprisingly-low core inflation gives
NDP was seeking more health care funding in addition to the Bank flexibility to delay a warning on rate hikes
the increases in support for the aged-poor and energy until May, with the next round of tightening looking to
retrofits that were included in the budget, although it commence with a quarter point hike in July.
opposed using fiscal room for corporate tax cuts.
Issues for Equity Markets
Still, both the Conservatives and Liberals have pledged
not to seek a formal coalition. Best bets are that Canada With the bond and currency markets largely sidelined,
will stay on a course of deficit reduction similar to the the greater focus on the election could come from equity
figures presented in the latest budget, regardless of the investors. Here the most notable divergence in platforms
election outcome. The Conservatives have pledged to thus far is the Conservative pledge to carry on with
achieve balance while still cutting corporate taxes, while corporate tax cuts (to 15% by 2012), against a Liberal
Liberal plans for a higher corporate rate would appear plan to return the rate to 18% (where it was in 2010)
to be devoted to funding health care spending and (Chart 5). Companies that might benefit from a quick
education tax cuts, rather than a faster track for deficit approval of the military’s jet program also have issues at
reduction. That approach might help relieve pressure stake.
on provincial governments that bear responsibility for
health/education. Environmental policies that could affect the energy sector
might also come into play. The Liberals are no longer
Once balance is achieved, it’s unlikely that Canada advocating the carbon tax that formed part of their
would aim for a return of large surpluses, given that the platform in 2008, and when in power, did not stringently
debt/GDP ratio will already be falling sharply even with a adhere to the Kyoto Accord despite signing on to it. Still,
balanced budget. Indeed, the Conservatives have already debates during the campaign may draw out differences
pledged to deliver a personal income tax cut for families among the parties on this front.
when the budget reaches balance.
More Votes to Come
Monetary Policy: Above the Fray
At the end of the day, if current polling holds up, this
Monetary policy, the other underpinning for the bond election could prove uneventful for financial markets.
market and the Canadian dollar, is also not likely to be But keep tuned to the political channel. Five provinces are
significantly affected by the election result. The Bank of scheduled to hold general elections this year. For the bond
Canada is not wholly divorced from the government, market, the greater concerns these days lie in deficits and
with its governor being a political appointee. And the financing requirements at that level of government. It’s
Bank’s 2% inflation target is up for renewal this year, with too early to get a read on opposition platforms for these
consideration having been given to a lower target, or a votes, but the debates over this week’s Ontario budget
switch to price-level targeting, under which a period of will provide some clues on that front for the country’s
higher than target inflation would have to be made up largest province.
with a below target period. Chart 5
Corporate Tax Cuts at Stake
But odds are that the Bank is on course for simply
Federal C orporate Income Tax Rate, %
reaffirming the existing policy arrangement. The 24
governing party of the day is likely to resist a lower target, 22.12*
22
given that it would entail a more stringent interest rate
regime, and one not matched by the US Fed. Carney has 20 19.5
19
sounded unenthusiastic about price-level targeting given 18
18
that the current system has worked well.
16 16.5
* Includes 1.12%
Nonetheless, the election may well affect the timing of 14 15
federal surtax
the next BoC hike. Of late, the Bank has typically signaled
a change in direction one rate-setting-date ahead. Were 12
2007 08 09 10 11 12
Carney thinking of a May hike, that would require him to
Legislated Path (C onservatives) Liberal Plan
warn of it in April—squarely in the midst of the election

CIBC World Markets Inc. Economic Insights - March 31, 2011
Oil Prices and the North American Economy
Peter Buchanan
An old and familiar spectre is haunting the global
economy these days—triple-digit oil prices. The recent
run-up comes nearly three years after oil’s last moon shot,
which saw the price hit a record $147/bbl in the face
of fast-rising emerging-market demand. Oil prices have
basically been on a gradual upswing since early 2009,
when the first green shoots of global recovery emerged.
Crude prices can rise for a variety of reasons. Some
like demand gains due to a stronger global economy
are essentially positive from an economic standpoint,
others like the OPEC disruptions that plunged the global
economy into recession in the 1970s and 1980s are a
clear negative. The Middle East and North Africa produce
nearly half of the world’s oil, and fears that another
producer could be poised to follow Libya into strife have
helped turn a not-so-disturbing demand-driven run-up
into a worrisome supply shockwave.
Although Libya’s output is approximately half as large
as Canada’s, its oil is prized for its high quality, and is
particularly well-suited for European diesel markets. The
prospects for a drawn out conflict there and risks in other
producers have led us to upgrade our WTI forecast to an
average $97/bbl this year, although we still expect prices
to settle back to $90/bbl in 2012 (see page 3), as supply
and demand fundamentals reassert themselves. Estimates
from a variety of sources suggest OPEC spare capacity
was ample before the crisis, and easing growth in China
will help to cool demand growth there.
Not Yet as Large as Recession-Inducing Shocks of
1970s and 1980s
Oil prices did surge ahead of five of the last six US
recessions. Most observers would argue, though, that
pricey oil was not the main reason growth floundered in a
number of these cases. The 2001 recession was arguably
far more about the shock from dot-com implosion, than
$1.60/gal gasoline, and oil’s gyrations certainly didn’t
blow up the US mortgage market later in the decade.
The back-to-back recessions of the mid-1970s and early
1980s were clearly much more an oil story. Both of those
episodes, however, involved a much harder blow to the
industrial economies, based on the rise in costs to those
nations as a percentage of GDP. That’s a good way of

looking at things, allowing for the global economy’s
declining oil intensity as well as the fact that the level of
oil prices before the shock matters. A doubling in prices
is more painful, in other words, from $50/bbl than when
the starting point is $10, a distinction that is lost when
looking only at percentage price changes.
Oil consumption costs rose by the equivalent of nearly
3% of GDP in the first 1973-75 supply shock, which came
after an OPEC embargo, and more than 4% in the second
(Chart 1) which came on the heels of the overthrow of
the government of Iran, the largest Middle Eastern crude
producer at the time.
Given declining levels of oil intensity and other factors, oil
prices would have to reach $160/bbl to match the first of
those two knockout punches and nearly $200 to match
the second. The Fed’s uber-hawkish stance, moreover,
helped accentuate the US economy’s troubles in the early
1980s. That’s not to say that the impact of the recent
price run-up has been inconsequential. In the US, the rise
in food and gasoline prices since the start of the year has
effectively offset most of the benefit to consumers from
the recent tax stimulus.
Lift to Canadian GDP Modest and Transitory
Canada is divided between an oi-consuming east and
a producing west, and the provincial implications of
Chart 1
Oil Supply Shocks
4.5 Rise in OECD countries' oil costs, % of GDP
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
Iranian 1973 OPEC Iraq's Kuwait Since Start of
Revolution Embargo Invasion Recent
Turmoil
Source: US DOE, CIBC
CIBC World Markets Inc. Economic Insights - March 31, 2011

oil prices have typically overshadowed the national Chart 3

macroeconomic ones. All signs are that the relationship Top Net Oil Exporters, 2009
between growth and oil prices is a non-linear one— Russian Federation
meaning simply that some is good, a lot bad. In 2008, Saudi Arabia
the C$ followed crude only until prices hit $100/bbl. The Iran
crossover point for Canada—where the negative effects United Arab Emirates
of pricier oil like weaker growth in the US and auto sales Norway
increasingly predominate—may not consequently be too Kuwait
much above that level. Venezuela
Algeria
Kazakhstan
We used a standard statistical modeling approach to 1
Qatar
get a better handle on the impact of oil price changes
Mexico
on the Canadian and US economies, and key variables C anada MM Bbl/day
like the currency and rates. Our analysis suggests that
0 2 4 6 8
it takes about a year for the US economy to feel the full
pinch from an oil price shock (Chart 2). That suggests Source: BP, CIBC
one shouldn’t take too much comfort from the recent
resilience of energy-sensitive categories of demand like performance at the national level. A 25% rise in wellhead
auto sales. prices, approximating the recent increase, ordinarily
lifts real GDP growth by a tick or two in each of the
Canada is one of the world’s top dozen net exporters of oil two following quarters. Beyond a couple of quarters,
and oil products (Chart 3). Higher prices are nonetheless the negative effects (Chart 5), including the drag on
something of a double-edge sword in that the country key trading partners and auto sales, begin to outweigh
trades heavily with an increasingly oil-import-dependent the positive, hurting GDP growth. Beyond four to five
US. Long transportation distances, a sizable auto sector quarters, the bad more than cancels the good, and the
and high levels of energy consumption in many of the level of GDP is actually lower than it would otherwise
country’s traditional industrial mainstays (Table 1) also have been. A further negative is the increasing drag from
mean that higher oil prices are not the unambiguous induced C$ appreciation on the country’s non-energy
benefit some might imagine. While Canada leads the G7 exports.
in per capita oil production, it is also the most intensive
user (Chart 4).
Table 1
Our analysis implies that in the very near term, higher oil Petroleum Use Per Unit of Output, 2009
prices result in a modest improvement in macroeconomic INDUSTRY SECTOR
TJ/$2002
mn.
E le ctricity G e n e ra tio n 6 9 .7 8
P a p e r Ma n u fa ctu rin g 1 9 .8 8
Chart 2 P rim a ry Me ta l Ma n u f. 1 7 .4 2
Impact of 25% Oil Price Shock on US GDP Min in g (n o t O il, G a s a n d C o a l) 1 0 .6 9
P e tro le u m a n d C o a l P ro d u cts Ma n u fa ctu rin g 1 0 .2 1
% chg, SAAR Pre-shock = 100 N o n Me ta llic Min e ra l P ro d u ct Ma n u fa ctu rin g 8 .3 1
0.1 100.0
C h e m ica l Ma n u fa ctu rin g 6 .3 6
W o o d P ro d u ct Ma n u fa ctu rin g 4 .8 9
0.0 99.9
To ta l a ll In d u s trie s In clu d in g Min in g 4 .4 7
To ta l All Ma n u fa ctu rin g In d u s trie s 4 .3 2
-0.1 99.8
Te xtile Mills 1 .9 0
P la s tics a n d R u b b e r P ro d u cts Ma n u fa ctu rin g 1 .6 8
-0.2 99.7
Fo o d Ma n u fa ctu rin g 1 .4 5
Fa b rica te d Me ta l P ro d u ct Ma n u fa ctu rin g 1 .3 4
-0.3 99.6
Fu rn itu re a n d R e la te d P ro d u ct Ma n u fa ctu rin g 1 .0 0
P rin tin g a n d R e la te d S u p p o rt Activitie s 0 .9 9
-0.4 99.5
Mis ce lla n e o u s Ma n u fa ctu rin g 0 .9 7
Growth (L) B e ve ra g e a n d To b a cco P ro d u ct Ma n u fa ctu rin g 0 .8 7
-0.5 99.4
E le ctrica l E q u ip , Ap p li & C o m p o n e n t Ma n u fa ctu rin g 0 .6 9
Level (R ) Ma ch in e ry Ma n u fa ctu rin g 0 .6 8
-0.6 99.3
C lo th in g Ma n u fa ctu rin g 0 .5 3
1 2 3 4 5 6 7 8 9 10 Tra n s p o rta tio n E q u ip m e n t Ma n u fa ctu rin g 0 .4 9
Quarters from start of shock C o n s tru ctio n , All s e cto rs 0 .2 8
C o m p u te r a n d E le ctro n ic P ro d u ct Ma n u fa ctu rin g 0 .2 2
Source: CIBC Source: Canadian Energy End-Use Data & Analysis Centre

CIBC World Markets Inc. Economic Insights - March 31, 2011

Chart 4 higher prices have historically had a widely varying effect

Canada a Heavy Oil User as Well as a Producer on a sector-by-sector basis. After the obvious example of
the energy sector, the TSX material group has traditionally
bbls of oil/Mn $ of GDP, 2010
600 been the largest beneficiary of costlier oil. Producers of
500 gold, whose price moves generally track oil, account for
half of the market cap of that sector. The sectors most
400
at risk from rising oil prices historically have been the
300 consumer groups, given the drag on spending power
200 from higher prices. The industrial sector, which contains
100 heavy users like the airlines and is closely tied to the
energy-dependent US economy, is another traditional
0
loser (Chart 6).
n
es

m
y
a

ce
al
an
ad

pa

do
at

an
It
n

m
Ja

Oil prices have risen dramatically recently. Although the

St

ng

Fr
Ca

er

Ki
d

G
te

run-up is causing pain for some sectors and will affect

d
ni

te
U

ni

the strength of growth and equity market performance,

U

Source: IMF, IEA
Equity Market Ramifications of Higher Oil Prices
Oil production is much more heavily weighted in the TSX
than in the Canadian economy. Estimates by the Canadian
Energy Research Institute suggest that the petroleum
sector accounts for about 11% of Canadian GDP. In
comparison, the energy sector, which is dominated by the
major oil and gas producers, accounts for over 27% of
the TSX’s market cap. That segment has also accounted
for as much as a fifth of index earnings in recent years,
second only to the financial group. While that arguably
suggests a larger upside for market performance from
rising oil prices than the economy, it is worth noting that
prices would in all probability have to rise further to kill
the recovery on their own. While not yet at recession-
inducing levels, the situation bears close watching given
the evolving picture in the Middle East. Looking at the
domestic implications, rising oil prices benefit some
sectors of Canada’s economy and regions, but are not the
unequivocal plus that is sometimes made out.
1
The approach is known formally as a vector autoregression, and
involves regressing each of a number of variables (Canadian and US
real GDP growth, CAD and 10-year government of Canada yields) on
lagged values of each other. Our model is thus able to capture how
a rise in oil prices impacts Canadian GDP directly and via induced
changes in the US economy’s performance, and the exchange and
interest rates.

Chart 5 Chart 6
Impact of 25% Oil Price Shock on Canadian GDP Impact of Oil Price Changes on TSX Groups
0.3 % chg, SAAR Pre-shock = 100 100.1
60 Outperform when oil strong or rising

0.2 40
100.0 Note: chart shows correlation between sector's relative strength
0.1 and WTI price, based on weekly data from 2002 - 11
20
0.0 99.9
0
-0.1
-0.2 99.8
-20

-0.3
Growth (L) 99.7 -40
-0.4
Level (R ) -60
Underperform market when oil strong
-0.5 99.6
1 2 3 4 5 6 7 8 9 10
h
s

ls
gy

ls

ls
ch

ap
cr
ie

lt

ia
ria

ia

ea

is
Te
er

it

St
co

tr
nc
ti l

D
e
En

Quarters from start of shock

us
at

le
fo

na

s
U

on
Te

on
d
M

In

Fi

In

C
C

Source: CIBC Source: CIBC, Bloomberg


CIBC World Markets Inc. Economic Insights - March 31, 2011

Oiling the Canadian Dollar Swings

Krishen Rangasamy

While it’s no secret that the Canadian dollar generally Chart 2

tends to benefit from higher oil prices, what’s less C$ Now More Responsive to Oil (L), Oil Now
obvious is the mechanism through which that relationship Main Driver in Canada's Energy Trade (R)
holds. The benefits to the currency of the associated C$ elasticity Oil/Petroleum products
improvement in oil export receipts are well understood, 0.25 (% chg. in US$/C$ when 70 trade surplus as a % of
but less so are non-trade factors which are often more oil price chgs 1%) total C anadian energy
trade surplus
crucial in determining the loonie’s trajectory. Those 0.20 60
factors have worked to keep the Canadian dollar in
1983-
overvalued territory over the last couple of years. But 0.15 50 2007
the recent run-up in oil prices past US$100/barrel has avg.
allowed for a better alignment between the loonie and 0.10 40
its fundamentals.
0.05 30
Amplifier Effects on the C$
0.00 20
What is now “conventional wisdom”, namely the positive 1983-2007 2008-2010 1983 1992 2001 2010
relationship between oil to C$, hasn’t always been so.
Source: Haver Analytics, CIBC
The correlation between the currency and oil prices was
in fact negative before 1983, when Canada was still a net
importer of oil. It was only when Canada began running problems, and that has been a major factor in keeping
petroleum trade surpluses on a sustained basis that trade both oil prices and the C$/US$ exchange rate at lofty
flows started to work in the loonie’s favour (Chart 1). levels.

In recent years, the elasticity of the C$/US$ exchange
rate to oil price movements seems to have risen (Chart 2,
left). While part of that increased responsiveness can be
explained by the much larger influence of oil in Canada’s
export revenues (Chart 2, right), there are factors other
than trade flows that are at least as important. For one,
US dollar weakness has gained momentum in recent
years with enhanced concerns about US fiscal and debt
Chart 1
Oil and C$ Positively Correlated After 1982
0.8 C$ correlation with WTI oil price
0.6
0.4
0.2
0
-0.2
Capital Flows Trump Trade Flows
Also, while trade flows are important, flows of capital
are becoming even more important in influencing the
Canadian dollar. According to the Bank of International
Settlements, the Canadian dollar’s share of the currency
market was around 5.3% in April 2010, which is
equivalent to volumes of around $2,500 bn/month. That
contrasts with total Canadian goods and services trade
of under $82 bn/month last year. In short, the bulk of
C$ trading can be impacted by perceptions rather than
fundamentals. And “conventional wisdom” tends to
affect perceptions, with investors pouring cash into a
perceived petrocurrency like the Canadian dollar when
oil prices rise and vice-versa. Speculative holdings have
tended to amplify the impacts of oil price movements in
the Canadian dollar. In March 2011, speculative longs
were at their highest since October/November 2007.

-0.4 Inflows of foreign cash related to oil prices haven’t been

-0.6 limited to trade. The run-up in oil prices in recent years
has also encouraged foreign direct investments (FDI)
-0.8
in the Canadian energy sector. So much so, that the
1973-1982 1983-2010
energy sector now accounts for a disproportionately high
Source: Haver Analytics, CIBC
10
CIBC World Markets Inc. Economic Insights - March 31, 2011

Chart 4
Chart 3 Oil Price Correlated With ex-Energy
More Inbound FDI Going to Energy Sector Commodity Prices
C orrelation coefficient:
120 US$/barrel % 24 1 BoC commodity price index vs. WTI oil price
22 0.9
100
0.8
20
80 0.7
18 0.6
60
16 0.5
40 0.4
14
0.3
20 12 0.2
0 10
0.1
0
1987 1998 2009
ex-Energy Metals Agriculture
WTI oil price (L)
C ontemporanous correlation
Energy sector's share of Direct Investment (R) C orrelation with oil lagged 9 months
Source: Haver Analytics, CIBC Source: Haver Analytics, CIBC

percentage of incoming FDI inflows. And the upward to the heady levels of the actual C$/US$ exchange rate
trend there hasn’t been interrupted despite the slump in (Chart 5). Simply put, the C$ had overshot fundamentals
oil prices during the 2008-2009 recession, suggesting that several years ago and the recent run-up in oil prices has
foreigners are investing in the resource sector for the long allowed fundamentals to now catch up to the currency.
haul (Chart 3). Those inflows serve to further amplify oil’s
impact on the currency. While the Canadian dollar is now reflecting resource and
interest rate fundamentals, that’s scant consolation for
Oil prices generally tend to affect prices of other non- non-resource producers, many of whom are feeling the
energy Canadian exports, perhaps because oil is often effects of the Dutch disease, particularly those who failed
used as an input, either directly or indirectly, in producing to make significant headway in improving productivity.
a range of products. Agricultural product prices soared While we expect oil to cool from current heights later this
in 2008 and again this year, not just because of higher year, it will remain elevated by historic standards, with
operating costs (e.g. higher fuel bills) but also partly further gains over the long term. The resulting persistent
because of fuel substitution, with corn (a key input in strength of the Canadian dollar, while not precluding
food production) being diverted away from the food growth in manufacturing, will continue to put pressure on
supply chain to produce oil-competing fuels like ethanol. Canada’s share of foreign markets in that sector.
The positive correlation between oil prices and ex-energy
commodity prices isn’t just contemporaneous but lingers Chart 5
for several months (Chart 4), which somewhat enhances C$ Now Fairly Valued Thanks to Oil's Ascent
the effect of oil prices on trade flows and hence the C$. C$/US$
1.35
Has the Canadian Dollar Overshot Fundamentals? 1.30
1.25
With the Canadian dollar hitting 0.97 C$/US$ in March, 1.20 Fair value
an obvious concern is whether the currency has overshot as per ECM
1.15
its fundamentals. A model similar to the Bank of Canada’s
error-correction model, taking into account interest rate 1.10
differentials between Canada and the US, and commodity 1.05
prices, has been showing a loonie straying in overvalued 1.00 Actual
territory over the last couple of years. But the sharp run- 0.95
up in oil prices in the first quarter this year means that 09Q1 10Q1 11Q1F
the Canadian dollar’s “fair value” has now caught up
Source: CIBC
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CIBC World Markets Inc. Economic Insights - March 31, 2011

ECONOMIC UPDATE
CANADA 10Q4A 11Q1F 11Q2F 11Q3F 11Q4F 12Q1F 12Q2F 2010A 2011F 2012F
Real GDP Growth (AR) 3.3 4.0 2.5 2.0 1.9 2.3 3.1 3.1 2.8 2.8
Real Final Domestic Demand (AR) 4.7 2.5 2.5 1.9 1.8 2.3 3.0 4.4 3.0 2.7
All Items CPI Inflation (Y/Y) 2.3 2.4 2.8 2.6 2.2 1.7 1.5 1.8 2.5 1.8
Core CPI Ex Indirect Taxes (Y/Y) 1.6 1.2 1.4 1.8 1.9 1.9 1.8 1.7 1.6 2.0
Unemployment Rate (%) 7.7 7.7 7.5 7.6 7.8 7.7 7.5 8.0 7.6 7.4

U.S. 10Q4A 11Q1F 11Q2F 11Q3F 11Q4F 12Q1F 12Q2F 2010A 2011F 2012F
Real GDP Growth (AR) 3.1 2.8 3.0 2.3 1.9 2.4 2.5 2.9 2.7 2.4
Real Final Sales (AR) 6.7 1.6 3.3 2.7 2.3 2.2 2.5 1.4 2.9 2.5
All Items CPI Inflation (Y/Y) 1.3 2.0 2.4 2.8 2.5 1.9 1.6 1.6 2.4 1.8
Core CPI Inflation (Y/Y) 0.7 1.1 1.2 1.3 1.4 1.6 1.6 1.0 1.3 1.7
Unemployment Rate (%) 9.6 9.0 9.0 9.2 9.3 9.3 9.1 9.6 9.1 8.9

CANADA
With energy prices set to stay lofty for longer, we’ve revised up our 2011 CPI call by three ticks to 2.5%,
although core should come in at a slightly tamer 1.6%, given its recent weakness. Growth is still on track
to hit 2.8% for 2011, helped by a strong start, as rebounding manufacturing activity looks to take the Q1
growth rate to 4%. But with fiscal drag and rate hikes on their way in the second half of the year, economic
growth should revert to a lower gear.

UNITED STATES
We’ve slashed our US first quarter growth rate to 2.8%, after having expected growth to top 4% a month ago,
prior to the deepening supply shock to oil prices. The downward revision is centred on consumption, where
weakness in wage gains, falling house prices and costly gasoline has put the squeeze on spending. Business
capital spending also looks to be coming up short. We expect even slower growth in the second half, in part
allowing for fiscal restraint that Republicans are pushing for. Our CPI targets are higher in the near term due
to the shock to gasoline.

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