Q1/16

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1 Highlights May 1 We see U.S. economic growth accelerating to -plus in the second half of the year. Given that outlook, we continue to believe that by mid-september the FOMC will be confident enough of fulfilling its dual mandate over time to embark on a gradual recalibration of its policy stance. The target fed funds range, in our view, will be..7 by year end, up basis points from the current zero.. Though the market still puts the odds of a further Bank of Canada rate cut this year at slightly more than, we think the combination of improving growth and sticky core inflation will be enough to negate the need for additional easing. In our base case scenario, the BoC stays on the sidelines until Q 1. Paul-André Pinsonnault Forecast dated April, 1 United States Quarters Fed Fund Mth Bill YR YR 1YR YR /17/ Q Q Q Q1/ Q Q Q Q1/ Canada Quarters Overnight Mth Bill YR YR 1YR YR /17/ Q Q Q Q1/ Q Q Q Q1/

2 The euro zone gaining momentum While indicators of the global economy disappointed in Q1, those of the euro zone were better than expected. From a low of 7. in October, the euro-zone economic surprise index bounced back significantly to +. as of April 17. While some green shoots from the ECB initiatives are apparent, it is of course too early to talk about tapering of euro-zone QE. ECB president Mario Draghi has been clear that the asset purchase programme (APP) must be fully implemented in order to work. By showing its resolve, the ECB has pushed euro-zone long rates down further. Euro zone economic surprise index NBF Economics and Strategy (data via Bloomberg) Eurozone: ECB intends to fully implement its APP Ten-year yields driven down by the asset purchase programme (APP) 7 1 DEU NBF Economics & Strategy (data via Bloomberg) ITA FRA ESP The hope that the euro zone is gaining momentum is further supported by the ECB s bank lending survey. It shows not only banks easing their credit conditions to businesses in Q1, but a record net percentage of banks expecting that business demand for loans or credit lines will strengthen in the coming three months. Euro zone: net of banks expecting increased demand for business loans NBF Economics and Strategy (data via Bloomberg) Almost half of euro-zone banks reported that the ECB asset purchase program was having positive effects on their financing conditions, effects that they expect will translate into a further easing of credit standards for lending to corporations over the next six months. All this is good news, but the zone must still deal with Greece. With its deposit facility charging negative interest and a large APP under way, the ECB has two feet in uncharted waters. A Greek default would create even touchier new uncertainties for the European economy. On that point, Mr. Draghi said the zone was better equipped now to deal with a Greek crisis. Fed liftoff receding? Going into the first quarter, the futures market was pricing the fed funds rate to average basis points over the month of October. Since then the market expectation has drifted down, postponing the arrival of that monthly average rate level by five months to next March. Not only do market expectations for liftoff date and the pace of normalization seem to have been unmoored by slow economic growth in Q1, but some Fed officials now see little urgency for a first rate hike. Among them, Atlanta Fed president Dennis Lockhart, speaking to reporters after an April 1 speech, said June might still be on the table but he would prefer a later date. Even Federal Reserve vicechair Stanley Fischer, in a recent interview, showed no eagerness for early liftoff, though he made the point that the market cannot expect the Fed to remain accommodative forever.

3 Fed funds futures: A slower pace of normalization NBF Economics and Strategy (data via Bloomberg) Dec. 1 April 1 Adding to the uncertainty about the timing of normalization are headwinds to economic growth and inflation resulting from the strength of the greenback. More-expensive exports and more-competitive imports could brake U.S. economic growth (other factors equal) by about. percentage points, according to estimates by New York Fed staff. Hardly a comforting prospect for those who fear that premature rate hikes could undermine the expansion all by themselves. The pace at which slack in the labour market and in other resources is taken up in the coming months, together with the outlook for inflation, will be key to Fed confidence about when to pull the trigger. At some point the economic indicators will support a hike in the target fed funds rate. The pace of normalization and the ultimate level of short-term rates will then take centre stage as objects of prognostication for market participants and as influences on the shape of the yield curve. The predictability of Fed actions and the coherence of its communications will be key to avoidance of market turbulence. Though bad weather, the hit to capital spending from the energy-price slide, and drag from net exports made for a soft patch in the first quarter, we remain upbeat about U.S. GDP growth this year. Rising real incomes and supportive financial conditions will help the economy regain momentum. We see growth accelerating to -plus in the second half of the year. Given that outlook, we continue to believe that by mid-september the FOMC will be confident enough of fulfilling its dual mandate over time to embark on a gradual recalibration of its policy stance. The target fed funds range, in our view, will be..7 by year end, up basis points from the current zero.. The Fed s balance sheet Total $. trillion, including $. trillion in Treasuries at market value,,,,,,,, 1, 1, Billion $ NBF Economics and Strategy (data via Bloomberg) Further down the road, the normalization of U.S. monetary policy may be complicated by the path of the greenback This will be especially true if financial-stability considerations call for a more aggressive policy stance. Raising the fed funds rate significantly at a time when other central banks were still deploying further stimulus in support of their respective economies would create further upward pressure on the U.S. dollar. The unwelcome consequences for U.S. exporters and those competing with imports in the domestic market would be politically unacceptable. In such a pass, it cannot be excluded that the FOMC, somewhat constrained in its action at the front end of the yield curve but needing tighter financial conditions, would wish for the return of a larger term premium on long Treasuries. Treasuries: Term premium of 1-year zero-coupon Fisher equation: R = real rate + E(inflation) + premium year term premium 1-year nominal Term premium: median 1., maximum.9, minimum., latest NBF Economics and Strategy (data via New York Fed) In other words, the Fed might want financial conditions to be tightened by higher long rates while it kept short rates unchanged. It could trigger such a bear steepening of the yield curve by selling some of its long-term assets. Again, coherence and clarity of communications would be critical

4 to the achievement of such an outcome in a fairly orderly manner. At this writing, with risks to financial stability perceived as still muted, a Fed-engineered bear steepening of the curve remains food for thought. As time goes by and rates remain low and stable, the odds of such an outcome will slowly creep up. But that s more of a story for later in 1. U.S. interest rates Weekly observations and quarter-end forecasts Target fed funds upper bound Interest rate forecast /17/1 Q Q Q Q1/1 Q Q Q Q1/17 F.F. - upper bound YR YR Forward 1-yr rate NBF Economics and Strategy (data via Bloomberg) With data from the U.S. Energy Information Administration showing that the recent plunge in oil rigs is finally starting to crimp U.S. crude oil output, spot WTI appears to have bottomed. Since this development helps stabilize longerterm inflation expectations and since we think economic growth will accelerate to above trend in coming months, we continue to see 1-year Treasuries trading slightly above. in late and in Canada U.S. 1-year U.S. -year The Bank of Canada now projects annualized GDP growth rates of zero in Q1, 1. in Q,. in Q and. in Q. Despite the projected strong growth in the second half of the year, the market still puts the odds of a further rate cut this year at slightly more than. Canada bonds maturing in years are trading at., 1 basis points below the Bank s overnight rate. Obviously not everyone is convinced the Bank is right in its assessment that the effect on growth of the oil price shock was not larger than anticipated, just more front-loaded. Time will tell. But even if the transition from a very weak first quarter to growth well above trend proves somewhat slower than the Bank projects, we think the combination of improving growth and sticky core inflation will be enough to negate the need for additional rate cuts. Moreover, federal fiscal stimulus looks to amount to roughly. of GDP in 1-1. That will go far to offset planned and prospective provincial belt-tightening. In our base case scenario, the Canadian economy expands in 1. That rate is at the upper bound of the Bank s projection for the growth of Canadian potential output (1. to.). As long as the Canadian economy has excess capacity to absorb and foreign exchange markets are adjusting to implementation of the ECB asset purchase program, we do not see the Bank having any appetite for a higher overnight rate. Our base case scenario is still one in which the Bank lags the Fed in rate hikes. Our year end forecast for both the overnight and 1-year rates are unchanged from last month. Canadian interest rates Weekly observations and quarter-end forecasts BoC overnight target Canada -year NBF Economics and Strategy (data via Bloomberg) Canada 1-year Interest rate forecast /17/1 Q Q Q Q1/1 Q Q Q Q1/17 Overnight YR YR Forward 1-yr rate On a rolling 1-week basis, mid-term provincial bonds total returns are 1 basis points larger than those of Canadas. This compares to a basis points value added for mid corporates. However, the provincial out performance was concentrated in the last weeks of January and first week of February. Mid term: added value relative to Canadas Total returns mid corporates and mid provincials minus mid Canadas Rolling 1-week excess return Weekly excess return Mid Term Provincials Q 1Q 1Q Mid Term Corporates 1Q1 1Q... Weekly excess return Rolling 1-week excess return Q 1Q 1Q 1Q1 1Q NBF Economics and Strategy (data via Datastream) 1--17

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

6 ECONOMICS AND STRATEGY Montreal Office Toronto Office Stéfane Marion Chief Economist & Strategist Paul-André Pinsonnault Senior Fixed Income Economist Krishen Rangasamy Senior Economist Marc Pinsonneault Senior Economist Matthieu Arseneau Senior Economist Warren Lovely MD, Public Sector Research and Strategy General: National Bank Financial Markets is a business undertaken by National Bank Financial Inc. ( NBF ), an indirect wholly owned subsidiary of National Bank of Canada, and a division of National Bank of Canada. This research has been produced by NBF. National Bank of Canada is a public company listed on Canadian stock exchanges. The particulars contained herein were obtained from sources which we believe to be reliable but are not guaranteed by us and may be incomplete. The opinions expressed are based upon our 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. 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