U.S. slowdown could hit Canada, TD warns

While the opening months of 2006 have seen a rebound in both the U.S. and Canadian economies, the second half of the year could see a mid-cycle slowdown south of the border with ripples affecting Canada’s growth, according to a report from TD Economics.

While a deceleration in late 2005 was caused by isolated incidents, TD Bank Financial Group senior vice president and chief economist Don Drummond says there are now a number of risks to American growth looming on the horizon.

Current interest rates can no longer be considered “stimulative,” Drummond says, and he predicts only a single 25 point rate hike by both central banks before the credit cycle turns. That would mean an overnight rate of 4% from the Bank of Canada and a Fed rate of 4.75% in the U.S.

“Last summer, we noted that housing market strength and household indebtedness in the U.S. was simply unsustainable, and that it would give way to an economic slowdown in the second half of 2006,” says Drummond. “Evidence is mounting in support of this view.”

While new and existing home sales have slowed, construction has continued, creating an oversupply in the market. As house values fall, the so-called “wealth effect” is expected to evaporate, trimming consumer spending not only on housing related items, but in all non-essential sectors.

Since the U.S. is Canada’s largest export market, sagging consumer spending and slower GDP growth will have an impact north of the border. But the Canadian economy is generally in better shape, according to Drummond.

“Since Canada has neither the same degree of housing imbalances, nor as much tightness in monetary settings, it should fare slightly better than its U.S. counterpart,” he says.

Still, the TD Economics team is not predicting an outright recession in the U.S., with GDP growth remaining positive at around 2.3% through the 2006 and into 2007. That’s about 1% below its long-term trend rate. In Canada, the long term trend is lower at about 2.8% and the economy is expected to only slightly underperform.

“Virtually everything that matters in our forecast flows from two key assumptions,” Drummond says. “First, the U.S. experiences an economic slowdown; second, the economic weakness proves to be mild and relatively short-lived.”

So far, both central banks have managed to stave off inflation by raising rates in anticipation, rather than in reaction, to rising inflation. This gives both the Bank of Canada and the Fed room to cut rates rapidly should the respective economies hit a soft patch.