May 31st, 2010 Paul Viera, Financial Post

The Canadian Economy posted better-than-expected growth in the first three months of 2010, marking the best quarterly performance in over a decade, Statistics Canada reported Monday – and all but cementing the likelihood of a Bank of Canada rate hike this week.

Strong domestic demand and a robust manufacturing sector helped the Canadian economy record annualized growth of 6.1% for the first quarter, the strongest three-month showing since 1999. This followed a stellar 2009 fourth-quarter performance, of 4.9% annualized (although revised down from 5%).

The expectation was for a 5.8% expansion for the first quarter. The 6.1% gain in output marks the third straight quarter of positive growth after the recession, which lasted three quarters. Further, the first-quarter result is just over double the growth the U.S. economy produced for the first three months of 2010, of 3%.

“While there are some questions on the sustainability of the rebound, there is simply no question that the early stages of Canada’s recovery exceeded even the most optimistic expectations,” said Douglas Porter, deputy chief economist at BMO Capital Markets.

Analysts suggest this pace of growth can’t last. However, they said the strong handoff from first quarter to second quarter likely means annualized growth of roughly 3.5% to 4% for the three-month period ending June 30th. The first-quarter bump was helped by a stronger-than-expected March result, of a gain of 0.6%.

In early trading, the Canadian dollar had gained nearly a cent, to trade in the US95.9ȼ range.

The consensus as of late last week was that the Bank of Canada would raise its key benchmark rate on Tuesday, by 25 basis points to 0.50%, given the stronger-than-expected domestic economy. The first-quarter result all but cements that view.

The solid gains over the fourth quarter of 2009 and the start of 2010 “provide strong evidence” and the near-zero interest rates, combined with a dollop of fiscal stimulus, “have helped pull the Canadian economy out of its recent recession,” said Paul Ferley, assistant chief economist at Royal Bank of Canada. “With the monthly numbers showing strong momentum late in the first quarter, the Bank of Canada will take reassurance that this strength is likely to be sustained near term. This suggests an environment where the Bank of Canada will continue to withdraw stimulus from the system.”

There was a belief the central bank could hike its target rate by 50 basis, but market uncertainty due to developments in Europe might cause the central bank to hold back.

Production grew faster in the first quarter of 2010 than in the fourth quarter of 2009, and inventory levels rose after being drawn down in all four quarters of 2009. Residential investment increased for a fourth consecutive quarter, as did consumer spending on goods and services. Export and import volumes rose for a third consecutive quarter, with growth in imports outpacing growth in exports in the first quarter.

First-quarter strength was broad-based with domestic demand at the top of the list. Consumer spending, up 4.4% annualized, and residential investment, up 23.6%, contributed the most to economic growth. Meanwhile, business investment grew by 0.9% following a 9.8% decline in the previous quarter, led by a 7.6% gain in investment in machinery and equipment. Economists at Toronto-Dominion Bank note that non-residential construction is one component of GDP yet to head down the road of recovery.

The goods –producing component of the economy expanded 2.7% in the first quarter, led by a 4.2% gain by manufacturing. The manufacturing sector was able to post this gain even though the Canadian dollar traded mostly above the US90ȼ mark in early 2010.

This is the latest in a string of Canadian economic data that have been consistently surprised to the upside. Job creation is in full swing, with a record of 109,000 workers added to payrolls in April; consumers are buying up goods at a healthy pace, tax credits or not; corporate profits are rebounding to pre-recession levels; and inflation is creeping closer to the central bank’s preferred 2% target.

The sterling fundamentals prompted the Bank of Canada last month to ditch its conditional commitment to keep its policy rate at a record low 0.25% until July.