Financial Update

TSX slides as commodities tumble, central bank warns of recession

· TSX -455.60pts (Reuters)After big gains for TSX main index on Friday and Monday, investors returned to their selling ways
· Dow -231.77pts as mixed earnings reports persuaded investors to take some profits from Monday's big runup.
· Dollar -1.38c to $82.39US skidded to its lowest close in more than 3 years versus the U.S. dollar on Tuesday as BofC cut its key overnight interest rate and suggested more rate cuts may be needed. Lower oil prices often weigh on the Canadian dollar also because Canada is a key supplier of oil to the United States.
· Oil -3.36to $70.89US per barrel. Alarmed by the rapid slide, the Organization of the Petroleum Exporting Countries, which controls 40% of the world's oil supply, is holding an extraordinary meeting Friday in Vienna. OPEC's president, Chakib Khelil, said the group is planning to announce an output reduction that analysts believe could total at least one million barrels a day
· Gold +21.50 to $766.60US per ounce

Canadian bond prices all finished higher due to a sharp selloff in equities and the likelihood of more rate cuts in Canada "Some of the optimism we had seen on Friday and Monday is perhaps reversing and so money is flowing back into bonds," said Carlos Leitao, chief economist at Laurentian Bank of Canada. "

"In normal times, when you don't have a global credit crisis, you would tend to see . . . one-month rates, two-month rates, three-month rates, six-month rates, they would all decline big time," said economist Michael Gregory of BMO Capital Markets. "These are not normal times and those rates are not reacting in the same way."

Why the Bank of Canada pulled its punch

Jacqueline Thorpe, Financial Post While all about have been losing their heads, the Bank of Canada seemed determined to keep its Tuesday.

The central bank cut its benchmark lending rate a quarter of a percentage point to 2.25%, forgoing the more forceful half-point cut many Bay Street economists had pushed for amid signs the dramatic steps it has already taken to battle the credit crisis is beginning to bear fruit.

The clearest sign yet came Tuesday when Canada's commercial banks followed the central bank's move with a cut in their prime lending rate to 4%. Prime is the benchmark for consumer and mortgage loan rates across the country but banks had previously been hesitant to follow the Bank of Canada's cuts because the global financial crisis had driven up their own borrowing rates.

"TD Canada Trust's decision to lower its prime ... reflects [Tuesday's] Bank of Canada rate change, as well as the decrease in our cost of funds due to government actions and market forces, allowing us to pass the benefits on to customers," said Tim Hockey, president and CEO of TD Canada Trust, in a statement.

To be sure, the Bank of Canada is not suddenly predicting blue skies ahead. Its statement was, in fact, downright bleak, including the bold pronouncement the United States was "already in recession" - a word U.S. Ben Bernanke, the U.S. Federal Reserve chairman, has himself yet to utter.

The global economy too appears to be heading for a "mild recession" the bank said, as it drastically slashed its outlook for Canadian growth to 0.6% this year and next from much more optimistic forecasts of 1.0% and 2.3% respectively in July.

Indeed, its list of downside risks to the Canadian economy was long: weaker global growth will reduce demand for exports; sliding commodity prices which will depress the flow of income into Canada and in turn domestic demand, while the credit crisis is bound to restrain business and housing investment.

All will lead to "sluggish" growth through the first quarter of next year, though the bank stopped short of forecasting a recession for Canada. Growth is expected to eventually pick up in 2009 and the forecast is for a 3.4% burst of speed in 2010.

Derek Holt, one of the more bearish analysts on the Street, said the statement could have been written to accompany a 75-basis-point cut, let alone the 50-basis-point cut he advocated.

"It was the dead-on right statement but the wrong headline," said Mr. Holt, who says a Canadian recession is a foregone conclusion and predicts 50 basis points of cuts next time round in December.

And yet, the bank held back its heavy fire-power.

It highlighted three reasons. First the recent sizeable depreciation of the Canadian dollar will provide an "important offset" to slower global growth and commodity prices, the bank said.

The loonie sank another US1.38¢ Tuesday to US82.39¢, bringing it down 20% from July.

Secondly, the bank pointed out it has already meted out much assistance - 2.25 percentage points of rate cuts since last December, including a half-point emergency cut in co-ordination with other central banks on Oct. 8, a move it called "extraordinary."

Other "extraordinary" measures major economies have announced to stabilize the financial system - including capital injections directly into banks in some countries - will be pivotal to resuming the flow of credit and Canada's economy and "strong" financial system will benefit directly, the bank has said.

The Bank of Canada itself has injected billions of dollars of liquidity into Canadian money markets, and is now accepting a wider array of collateral from institutions for borrowing. The government, meanwhile, has announced a plan to buy up to $25-billion in mortgages to free up space on bank balance sheets for lending.

Ottawa Tuesday informed Bay Street it would step up the plan. The government said it will buy up $7-billion in mortgages Thursday, following strong demand from banks in the first round, which saw institutions sell $5-billion in mortgage-backed securities to the government.

All these measures have eased borrowing costs considerably for Canadian banks. The rate on overnight borrowing between banks has dropped to about 2.62% from a peak in early September of 4.83%.

Bay Street is also pushing for Ottawa to guarantee new bank borrowing to help them better compete for financing with institutions from other countries that are receiving more government support.

While the message from the Bank of Canada Tuesday was be patient, it did indicate it could easily drop interest rates further if conditions warrant, saying some "further monetary stimulus will likely be required."

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Information note:
The Bank of Canada's next scheduled date for announcing the overnight rate target is 9 December 2008.