Highlights. Forecast dated January 5, United States. Canada. Paul-André Pinsonnault. January 2018

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1 Highlights January 1 Given our expectation of above-potential GDP growth in the U.S. and its already-low unemployment rate, we see CPI inflation ex food and energy accelerating to.3 in Q4 1. In our view, this scenario is consistent with three FOMC rate hikes this year, taking the target fed funds range to. by year end. We expect most of the hikes to come in the second half, when the recent softness of inflation will have proven mostly transitory, providing some tailwinds to long rates. In the longer portion of the yield curve, we see 1-year Treasuries trading just under 3. in Q4. In light of the strong performance of the Canadian labour market in 17 and given the lags in the effect of monetary policy on the economy and inflation, we think the data have moved outside the zone of inaction where the central bank can watch the incoming indicators without reacting to them. Given our forecast of. real GDP growth in 1, we see four Bank of Canada rate hikes this year, taking the overnight rate to from 1. With headline inflation slightly above in the second half of 1, the inflation-adjusted overnight rate would still be accommodative. That path would be consistent with 1-year Canadas trading at.7 by year end. Paul-André Pinsonnault Forecast dated January, 1 United States Quarters Fed Fund 3 Mth Bill YR YR 1YR 3YR 1// Q1/ Q Q Q Q1/ Q Q Q Canada Quarters Overnight 3 Mth Bill YR YR 1YR 3YR 1// Q1/ Q Q Q Q1/ Q Q Q

2 FOMC: On track for more rate hikes At the December FOMC meeting, most participants supported further policy normalization in 1. Six of the 1 participants thought it would be appropriate to raise the fed funds target range three times this year. Four saw a somewhat more aggressive path given their assessments of the economic outlook. Of the remaining six, four leaned to two or fewer hikes and one participant thought it would be appropriate to leave the current target policy range unchanged in 1 at The sixth, Chicago Fed president Charles Evans, thought the target range should have been left at In other words, while there was disagreement among FOMC members about the appropriate path, most thought economic conditions in 1 would warrant gradual increases in the federal funds rate. In our view, the economic indicators released in the first week of the new year were strong enough overall to comfort the 1 participants looking for three or more rate hikes in the next 1 months. True, the nonfarm payrolls report was weaker than expected, a net gain of 14, jobs, but the details were not that bad. The diffusion index of 4. showed broad-based improvement. Retail trade was the only major sector with a net loss of jobs (,3). Nonfarm payrolls: One-month diffusion index of industries reporting higher employment plus one-half of of industries reporting flat employment indicates an equal balance between industries with increasing employment and industries with decreasing employment Wages were up.3 on the month. Both the labour-force participation rate and the unemployment rate were stable at.7 and 4.1 respectively. The December ISM manufacturing index was up 1. points to 9.7, a level reached only three times since the last recession. No fewer than 1 of the 1 industry groups reported growth on the month. Further, the index remained solidly in expansion territory in 17, with the last five months printing above. Last time it was that strong was in 4. Adding to the good news were a multi-year high in the new orders index, up.4 points to 9. This is the strongest reading in 13 years and suggests solid momentum in manufacturing going into 1. ISM Manufacturing Survey: Continued strong expansion of new orders New Orders index at a 13-year high Index A New Orders Index above.3 is generally consistent over time with an increase in the Census Bureau s series on manufacturing orders (in constant dollars) Last but not least, a. monthly gain was reported for construction spending in November following a.9 gain in October good news for Q4 GDP growth. Not only is the underlying economic trend positive but the Republican Congress has just delivered tax cuts that are projected to modestly support GDP growth in 1 and 19 at a time when financial conditions remain accommodative. In fact financial conditions are easier now than they were in December 1 when the FOMC delivered its first rate hike of this cycle. Financial conditions have eased despite the FOMC s rate hikes NFCI shows financial conditions at year end 17 easier than in the period from 3 to Index The Chicago Fed s National Financial Conditions Index (NFCI) provides a comprehensive weekly update of U.S. financial conditions in money, debt and equity markets and in the traditional and shadow banking systems December 1: First FOMC rate hike Contributing to the accommodation are a 3. rise in the S&P between year end 1 and year end 17, a. depreciation of the USD against major world currencies and a narrowing of credit spreads. Yields to maturity on mid to long term corporate bonds consequently closed 17 lower than where they were two years ago. For example, BBB corporate bonds maturing in 7 to 1 years, which yielded 4. in December 1, ended 17 at 3.7. According to the Chicago Fed s National Financial Conditions Index (NFCI), which provides updates on financial conditions in

3 the U.S. money, debt and equity markets and the traditional and shadow banking systems, financial conditions at year end 17 were easier than in the period from 3 to. As of December 9, only four of the 1 indicators used to construct the NFCI were tighter than average, the remaining 11 being looser. In these circumstances, we project 1 U.S. GDP growth of.. With unemployment already low and growth expected to exceed potential, we see CPI inflation ex food and energy accelerating to.3 in Q4 1. In our view, this scenario is consistent with three more FOMC rate hikes this year, taking the fed funds target range to. by year end. This outlook of course depends very much on the path of inflation in the coming months, a point clearly made in the minutes of the December FOMC meeting. The flattening of the yield curve was also discussed by FOMC participants in December. While most agreed that the current flatness was not unusual by historical standards, several thought it would be important to continue monitoring the curve slope in the coming quarters. FOMC: Flatness of the yield curve not unusual by historical standards But several FOMC participants thought it should be monitored 3-year 4 1-year -year 3 Yield curve slope: 1-year minus -year yield Fed funds Basis points From that we conclude that several FOMC participants would be ill at ease if the yield curve were to flatten much from the current bps to 3 or bps for example. So most of the rate hikes that we expect this year are likely to be delivered in the second half, when the recent softness of inflation will have proven mostly transitory, providing some tailwinds to long rates. Further, the European Central Bank is likely to end its net asset purchase program in September, which in conjunction with the Fed s ongoing reduction of its balance sheet will further support higher rates in the longer portion of the yield curve, and by the same token create room for the Fed to normalize more without arousing fears of yieldcurve flattening or inversion. Bottom line: We see the FOMC delivering quarter-point rate hikes in March, September and December. In the longer portion of the yield curve, we see 1-year Treasuries trading around.9 in Q4. FOMC: More policy normalization in 1 Balancing of risks to financial stability, the economy and inflation calls for gradual policy normalization U.S. economic forecast Q4 17 Q1 1 Q 1 Q3 1 Q4 1 1 forecast forecast forecast forecast forecast forecast Real GDP growth (q/q chg. saar) CPI (y/y chg.) CPI ex. food and energy (y/y chg.) Unemployment rate () Fed Fund Target Rate Year Treasuries and in Canada We expect 1-year Treasuries, currently trading at.4, to be trading around.9 in Q4 1 The Canadian Labour Force Survey reported an employment surge of 79, in December, a 13th consecutive monthly gain, and an unemployment rate down two ticks to a 4-year low of.7. Employment was up in all provinces, a first in five years, with Quebec (+7,) and Alberta (+,) the top performers. The youth unemployment rate dropped half a point (chart). Canada: Perspective on labour-market slack Unemployment rate, youth unemployment rate and underemployment rate Includes discouraged workers, waiting groups and involuntary part-time NBF Economics and Strategy (data via Statistics Canada) Youth unemployment rate Underemployment rate* (all ages) Unemployment rate (total) The underemployment rate, which includes discouraged workers, waiting groups and involuntary part-time work, also fell to a historic low in December (as seasonally adjusted by us). Not surprisingly, tight labour markets are spurring wage inflation. Seasonally adjusted hourly earnings have risen 4.4 annualized over the last six months, the best showing in more than two years. As we expected, this has happened even before the minimum wage increases scheduled for 1 in Ontario (+.7), Alberta (+1.3) and Quebec (+4.4). 3

4 Canada: Average hourly earnings have boomed in the last six months NBF Economics and Strategy (data via Statistics Canada) -month change annualized On the inflation front, data for the month of November did show some acceleration of core inflation. Although 1-month CPI-Common inflation edged down, two other measures of core CPI inflation accelerated sharply. The resulting 1.7 average of the three measures followed by the Bank of Canada was the strongest in 13 months. Canada: Consumer Price Index inflation since 7 Change in total CPI and change in average of the three core measures preferred by the Bank of Canada y/y y/y change The Canadian dollar also reacted positively to the jobs report. We see it heading from the current US$. (1.41 CAD/USD) to US$.3 (1. CAD/USD) in the second quarter. Our own view is that with BoC policy decisions being guided by incoming data, the overnight rate will be adjusted upward in 1. The Bank will want to assess the economy s sensitivity to interest rates, the effect of the OSFI s B- mortgage rules on the housing market and the effect of a stronger currency on growth. But it will also be sensitive to the slope of the yield curve and its potential effect on financial intermediation. So, as south of the border, the rate increases we see in 1 will not be front-loaded. Given the strong performance of the Canadian labour market in 17 and our forecast of. real GDP growth in Canada this year, we see the Bank delivering four rate hikes in 1, taking the policy rate to from 1. With headline inflation slightly above in the second half of 1, the inflationadjusted overnight rate would still be accommodative. We see the Bank raising its overnight rate a quarter-point on January 17, pausing at the March and April rate-setting dates, resuming its normalization on May 3 (a non-mpr rate-setting date) and hiking further on July 11 and October 4. That path would be consistent with 1-year Canadas trading at.7 by year end Midpoint of BoC target range Total CPI (+.1) Average of core CPIs (+1.7) Canada: More policy normalization in 1 Balancing of risks to financial stability, economy and inflation calls for gradual policy normalization We expect 1-year GoCs, currently trading at.1, to be trading around.7 in Q NBF Economics and Strategy (data via Statistics Canada) By our in-house replication, the CPI-Trim and CPI-Median indexes have both inflated. annualized over the last six months, suggesting that the inflation-adjusted target overnight rate fell deeper into negative territory in Q4. In real terms, monetary policy is turning more accommodative with the unemployment rate at a record low. In light of all this, and given the lags in the effect of monetary policy on the economy and inflation, we think the data have moved outside the zone of inaction where the central bank can watch the incoming indicators without reacting to them. Until recently, financial markets were skeptical of a Bank move in early 1, putting the odds of a January rate hike at 43. This view has changed drastically. In reaction to the latest jobs report, the OIS market now puts the odds of that outcome at Canada economic forecast Q4 17 Q1 1 Q 1 Q3 1 Q4 1 1 forecast forecast forecast forecast forecast forecast Real GDP growth (q/q chg. saar) CPI (y/y chg.) CPI ex. food and energy (y/y chg.) Unemployment rate () Boc`s overnight rate Year Gov. of Canada

5 Canadian bond market total returns Total Returns 1//1 Since Since Since Since 1//17 1//17 7/7/17 1//17 Cash Canada Short Mid Long Universe Provincial Municipal Corporate AA A BBB Universe Total S&P/TSX NBF Economics and Strategy (data via Datastream) U.S. interest rates Last observation January, 1 Canadian interest rates Weekly, last observation January, Long corporate 7 7 Long corporate A Target fed funds 3-year mortgage U.S. 1-year U.S. -year BoC overnight target Long provincial Canada -year Canada 1-year Bond Market - Canada Close-on 1//1 1//17 1//17 7/7/17 1//17 Interest Rates 9-day (B/A's) years years years years Spreads 9 d - years years years years Currencies CAD / USD EUR / CAD Source:

6 Economics and Strategy Montreal Office Toronto Office Stéfane Marion Marc Pinsonneault Kyle Dahms Warren Lovely Chief Economist and Strategist Senior Economist Economist MD, Public Sector Research and Strategy Paul-André Pinsonnault Matthieu Arseneau Jocelyn Paquet Senior Fixed Income Economist Senior Economist Economist Krishen Rangasamy Senior Economist Angelo Katsoras Geopolitical Analyst General This Report was prepared by National Bank Financial, Inc. (NBF), (a Canadian investment dealer, member of IIROC), an indirect wholly owned subsidiary of National Bank of Canada. National Bank of Canada is a public company listed on the Toronto Stock Exchange. The particulars contained herein were obtained from sources which we believe to be reliable but are not guaranteed by us and may be incomplete and may be subject to change without notice. The information is current as of the date of this document. Neither the author nor NBF assumes any obligation to update the information or advise on further developments relating to the topics or securities discussed. The opinions expressed are based upon the author(s) analysis and interpretation of these particulars and are not to be construed as a solicitation or offer to buy or sell the securities mentioned herein, and nothing in this Report constitutes a representation that any investment strategy or recommendation contained herein is suitable or appropriate to a recipient s individual circumstances. In all cases, investors should conduct their own investigation and analysis of such information before taking or omitting to take any action in relation to securities or markets that are analyzed in this Report. The Report alone is not intended to form the basis for an investment decision, or to replace any due diligence or analytical work required by you in making an investment decision. This Report is for distribution only under such circumstances as may be permitted by applicable law. This Report is not directed at you if NBF or any affiliate distributing this Report is prohibited or restricted by any legislation or regulation in any jurisdiction from making it available to you. You should satisfy yourself before reading it that NBF is permitted to provide this Report to you under relevant legislation and regulations. National Bank of Canada Financial Markets is a trade name used by National Bank Financial and National Bank of Canada Financial Inc. National Bank Financial Inc. or an affiliate thereof, owns or controls an equity interest in TMX Group Limited ( TMX Group ) and has a nominee director serving on the TMX Group s board of directors. As such, each such investment dealer may be considered to have an economic interest in the listing of securities on any exchange owned or operated by TMX Group, including the Toronto Stock Exchange, the TSX Venture Exchange and the Alpha Exchange. No person or company is required to obtain products or services from TMX Group or its affiliates as a condition of any such dealer supplying or continuing to supply a product or service. Canadian Residents NBF or its affiliates may engage in any trading strategies described herein for their own account or on a discretionary basis on behalf of certain clients and as market conditions change, may amend or change investment strategy including full and complete divestment. The trading interests of NBF and its affiliates may also be contrary to any opinions expressed in this Report. NBF or its affiliates often act as financial advisor, agent or underwriter for certain issuers mentioned herein and may receive remuneration for its services. As well NBF and its affiliates and/or their officers, directors, representatives, associates, may have a position in the securities mentioned herein and may make purchases and/or sales of these securities from time to time in the open market or otherwise. NBF and its affiliates may make a market in securities mentioned in this Report. This Report may not be independent of the proprietary interests of NBF and its affiliates. This Report is not considered a research product under Canadian law and regulation, and consequently is not governed by Canadian rules applicable to the publication and distribution of research Reports, including relevant restrictions or disclosures required to be included in research Reports.

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