Weaker economic growth should lead to interest rate cuts, which will in turn dictate financial markets’ performance in 2007, suggests TD Economics.

“The bottom line is that the U.S. and Canadian economies are in the midst of an economic slowdown, with the pace of expansion running well below their long-term potential rates of 3.3% and 2.8%, respectively,” it says. “As this continues over the next two to three quarters, the resulting accumulation of economic slack will diminish the price pressures present and cause financial markets to anticipate central bank rate cuts, which we believe will arrive in the spring.”

These cuts are unlikely to lead to a significant rally in the bond market, which has already priced in much of the forthcoming weakness, TD says.

“It is also not expected to spark a major correction in commodity prices, although crude oil and base metals could give up some of their gains in the near-term,” it says.

“Equity markets in both the U.S. and Canada may face headwinds from slowing profit growth, but they will be forward looking and should anticipate strong economic conditions, particularly when the central banks start telegraphing rate cuts,” TD concludes.