Rates Scenario. Forecast Summary (averages) U.S. Rates

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1 An outlook on key interest and foreign exchange rates October 11, 2016 Michael Gregory, CFA, Deputy Chief Economist Jennifer Lee, Senior Economist Benjamin Reitzes, Senior Economist Carl Campus, Economist Forecast Summary (averages) Actual Forecasts Sep Oct Nov Dec Jan Feb Mar Apr Q2 Q3 Q4 BoC overnight yr Canadas Fed funds yr Treasuries C$ per US$ US$/ US$/ /US$ U.S. Rates Fed policy: Signalling strongly the potential for a rate hike this year, the September 21 FOMC Statement said: the case for an increase in the federal funds rate has strengthened, echoing Chair Yellen s Jackson Hole speech at the end of August. More tellingly, the FOMC included a net risk assessment for the first time this year: Near-term risks to the economic outlook appear roughly balanced. This was similar to the language ( nearly balanced ) last used before December s lift-off. Of course, the next meeting (without a presser or fresh set of projections) comes just six days before the November 8 election, so this was probably a signal for December 14, despite Yellen s assertion that November s meeting was live. Nevertheless, with 30% of voting members wanting to hike rates immediately and 82% of all participants pushing for at least one rate hike this year, November can t be ruled out. In the Summary of Economic Projections (SEP), the median calls are now for two rate hikes in 2017 (down from three before), and three hikes in 2018 (same as before). Importantly, the longer-run projection was snipped by 12.5 bps to 2.875% (we re at 2.75%, for the record), reflecting the fact that longer-run real GDP growth was revised down to 1.8% from 2.0%. With respect to our call, we were already ing one Fed rate hike for this year and two for next year, which leaves 2016-end and 2017-end fed funds at 0.625% and 1.125%, respectively. In 2018, we now look for just a pair of rate hikes to 1.625% (vs. four before), with the tightening cadence increasing to three in However, by this time (July 2019, specifically), the U.S. economic expansion will be trekking in record-long territory, and one wonders whether we might see an episode of easing before policy rates are finally fully normalized. Fed signals rate hike ahead, but along an even flatter profile Treasury yields uptrend ratcheted by Fed expectations and global bothers Greenback grinding stronger United States (% : as of October 11, 2016) 10-Year Treasury (rhs) Fed Funds (lhs) A publication of BMO Capital Markets Economic Research Douglas Porter, CFA, Chief Economist economics.bmocapitalmarkets.com Year-end 10-yr Fed Funds Current Sources: FRB, U.S. Treasury, Haver Analytics, BMO Economics s

2 Page 2 of 10 October 11, 2016 Treasuries: During the first week of July, Treasury yields hit multiyear or record lows along the curve (the latter for 10s and 30s), pulled down by the combination of falling Fed expectations and rising global fears. The former was prodded by the FOMC s June SEP, which revealed fading conviction for a couple rate hikes this year (even KC Fed President George pulled her dissent) and only a trio of hikes in each of 2016 and 2017 (which was down from at least four before). The latter was prodded by the U.K. referendum outcome in favour of Brexit. Shortly after, a strong U.S. employment report started re-pumping Fed expectations, as did another 200k+ payroll print in early August. The July FOMC Statement was sandwiched in between with its assertion, near-term risks to the economic outlook have diminished, and Fed President George reinstituting her dissent. Meanwhile, markets were getting over their immediate case of the Brexit blues. After Fed Chair Yellen took the podium at Jackson Hole on August 26, Treasury yields had closed up some 20 to 30 bps from their early-july lows. Subsequently, the Treasury yield trend turned choppy, reflecting two key factors. First, the data flow during September showed the U.S. economy succumbing to the second largest amount of precipitation for an August in 95 years of data (applying downward pressure on yields). However, so far during October, the data flow is showing the economy is bouncing back (applying upward pressure). Second, global yields were getting whipsawed by Bank of Japan and European Central Bank policy expectations, particularly at the long end. At Jackson Hole, Governor Kuroda said the BoJ was prepared to ease further without hesitation (which helped counter Yellen s comments). This stoked expectations for comparable comforting words from the ECB (on September 8), but markets were disappointed by Governor Draghi s lack of verbiage. Then, market speculation intensified about the BoJ s next easing effort, including measures designed to steepen the yield curve (selling the long end or buying much less of it). The market breathed a sigh of relief when the BoJ announced (September 21) that it was now going to target a zero 10-year yield (thus, both buying and selling) amid more flexible QE purchases. Market speculation intensified about the ECB extending its QE program past March 2017 in a tapered manner, but the ECB quashed it. Although a choppy trend, Treasury yields still drifted up along the curve, by as much as 15 bps at the long end (from August 26). We look for a similar, ratcheting, upward trend to continue in the quarters ahead, but this time with a flattening bias, as the Fed tightens. However, we don t expect to see 10-year Treasury yields breach 2% before the second half of next year. Greenback: The greenback has moved sideways this summer, gaining ground on augmented Fed tightening prospects (July/September FOMC) and in the immediate wake of the Brexit vote, only to lose ground on diminished Fed prospects (June FOMC) and eventual ebbing Brexit concerns. While we can t foresee the next global risk flare-up, against the background of major central banks either continuing to ease policy (with some considering upping the ante), or hunkering down for a long hold at current levels of accommodation, we judge prospective Fed tightening will become a U.S. Broad Trade-Weighted Dollar (January 1997 = 100 : as of September 30, 2016) Sources: FRB, Haver Analytics, BMO Economics s

3 Page 3 of 10 October 11, 2016 more consistent driver of U.S. dollar strength. But with tightening prospects having dimmed meaningfully from where they stood amid lift-off, we doubt the greenback will revisit January s peak anytime soon. Canadian Rates BoC policy: The Bank of Canada s September 7 policy announcement was more dovish than anticipated. The Bank stated that inflation risks have tilted somewhat to the downside since July, owing to weaker U.S. growth and Canadian exports. The exports alert was telling, in that it was as recently as July s Monetary Policy Report that Governor Poloz was trumpeting their improvement. The recession-like 16.7% annualized contraction in real exports during Q2 was shocking. The Bank noted: Exports disappointed even after accounting for weaker business and residential investment in the United States, adjustments in the resource sector, and cutbacks in auto production. With GDP growth hopes having been pinned on exports and, eventually, exportrelated capex, the Bank was likely feeling a little easing itch. The partial recovery in export volumes through July and August may have eased the itch a bit, but it still persists (Senior Deputy Governor Wilkins said uncertainty lingers regarding the prospects for noncommodity exports despite recent data, in a October 6 speech). Ever since January s close call to not cut rates, the Bank has dealt with this itch by counting on fiscal stimulus to tide the economy over 0.0 (Canada Child Benefit payments and federal infrastructure spending). Then there s the additional boost coming from rebounding oil production and reconstruction after the Alberta wildfires, and the fact that global financial conditions have become more accommodative. Moreover, the policy easing bar has probably been raised since January because financial vulnerabilities associated with household imbalances remain elevated and continue to rise. These all point to the Bank of Canada sitting on its hands (not scratching), waiting to see how all of these things (including Fed policy) pan out. Importantly, we can t rule out another rate cut during the quarters ahead if fiscal stimulus and export performance fail to impress. Given the longevity of this easing bias, we pulled our BoC rate hike call that was pencilled-in for 2017Q4 (so it s 0.50% until 2018). Two additional developments bolster this bias. The latest CPI report showed core inflation slipping to 1.8% y/y, the slowest rate in more than two years, as exchange rate pass-through pressures fade. More significantly, the federal government (along with British Columbia and Vancouver authorities) are taking steps to deal with the heated housing markets in (and around) Vancouver and Toronto. In her recent speech, Wilkins said these measures will help mitigate the risks to the financial system posed by household imbalances. In turn, these reduced risks to price and financial stability afford the Bank a bit more wiggle room. Canadas: Treasuries trends and BoC policy expectations continue driving Canada bonds. As Treasury yields were hitting multi-year or record lows along the curve during early July, Canada yields were also hitting record lows from the 7-year node BoC bides time, waiting for fiscal stimulus to kick in Canadas outperform Treasuries, as choppy yields grind higher A weaker flight path for the loonie as we approach a Fed rate hike Canada (% : as of October 11, 2016) BoC Overnight Rate (lhs) 10-Year GoC (rhs) Year-end 10-yr Overnight Current Sources: Bank of Canada, Haver Analytics, BMO Economics s

4 Page 4 of 10 October 11, 2016 onwards. Yields declined along the remainder of the Canada curve as well, but not to levels that prevailed early in the year when the market smelled a Bank of Canada rate cut (2-, 3- and 5-year yields hit record lows then). Also, as Treasury yields were bottoming this summer, most Canada-U.S. yield spreads were hitting their wides (least negatives) of the year (the 7- and 10-year nodes did so during the spring but still were relatively wide in early July as well). As Treasury yields subsequently moved higher, Canadian yields followed suit but outperformed, as is typical. From their relative summer wides, Canada-U.S. yield spreads narrowed, ranging from 10-to-15 bps (5s, 7s, 30s) to 20-to-25 bps (2s, 3s, 10s). Looking ahead, as Treasury yields drift up and the Bank of Canada stands pat amid Fed rate hikes, Canada-U.S. yield spreads should continue compressing. But, they should still stay far away from the multi-year (for 2s and 3s) or record tights (from the 5-year node onwards) hit around the turn of the year unless the market starts smelling a BoC rate cut again. Canadian Dollar (C$/US$ : as of October 11, 2016) Loonie: The Canadian dollar soared more than 16% by May 2 to close at (from 13-year lows in January), as the Bank of Canada backed away from further easing, oil prices recovered (from nearly US$26 to the mid-$40s) and the greenback was broadly weaker on fading Fed expectations. The Alberta wildfires were a catalyst for the currency to re-embark on a very gradual and choppy weakening trend, as the negative economic ramifications overwhelmed the positive oil price implications. Along the way, the currency was nudged weaker by Fed tightening expectations (Yellen s May comment rate hikes probably in the coming months along with the July/September FOMCs) only to be nudged stronger when these expectations waned (June FOMC). When Fed expectations have not been at the fore, the loonie was tossed around by the tone of Canadian data and consequent recalibrations of BoC rate cut risk. The currency closed at a 6½-month low on October 7 (4½ cents below its May peak), despite decent Canadian data (strong September job growth and an upbeat BoC Business Outlook Survey) and $50 oil, as the U.S. employment report failed to fade Fed tightening expectations. These latter prospects appear destined to drive the currency weaker through December s FOMC. But once the market comes to terms with the inevitability of very gradual Fed tightening, the combination of firming oil prices and ebbing BoC rate cut risk (as fiscal stimulus and export performance do, in fact, impress), the loonie should stabilize if not strengthen a little Sources: FRB, Haver Analytics, Bloomberg, BMO Economics s

5 Page 5 of 10 October 11, 2016 Euro The Euro Area economy continues to expand, although the ECB sees slightly less momentum than earlier this summer, leaving it apparently less open to further easing. At the last meeting in September, President Draghi disappointed markets by providing no hints to when or what the next move would be. The press conference was tighter than usual, with the President giving, at times, very short and cryptic responses to media questions. For example, when asked about extending the QE program, he replied We discussed the projections and the assessment. Nothing else. Meantime, other council members have cautioned on the risks of more stimulus and President Draghi has also warned that negative rates have side consequences. A rumour in October about how the ECB had formed an informal consensus on tapering sent the euro higher, but the gains were erased after Vice President Constancio firmly shot down the speculation days later. The current plan for bond buying ( 80 bln/month) ends in March 2017, though it is still possible that the timeframe could be extended again, depending on the outlook for the economy and inflation. The minutes to the September meeting gave no indication of any discussion about ending QE. Plus, we could be in for another political quake with the upcoming referendum in Italy. The common currency is likely to remain soft over the next 12 months, trading, on average, below $1.09 until the middle of U.K. Pound Financial markets were jolted back to reality in early October. Prime Minister May s announcement that the Conservatives will invoke Article 50 no later than the end of March of next year sent the British pound spiralling to 31-year lows, and 5-year lows versus the euro. This can be likened to a rude awakening. It had been three months since the referendum and the data have suggested that the U.K. economy was no worse for wear. For example, PMIs for manufacturing and construction reached 2-year and 6-month highs, respectively, in September. But it was only a matter of time before the U.K. began official proceedings to leave the European Union, which is when the hard work really begins. Now a date has been set and negotiators on both sides are girding for a fight. ECB in no rush Economic growth will be hurt by the likely messy breakup. The longer the uncertainty, the less likely capital investment will be made. The 1.20 BoE already lowered rates and boosted QE in August. And, a majority of members expected to support a further cut in Bank Rate to 1.00 its effective lower bound at one of the MPC s forthcoming meetings during the course of the year. Indeed, the BoE would respond with more stimulus if the second half of 2016 is as weak as the August Inflation Report expects. We are of the view that the BoE will keep its powder dry for the rest of the year, and save their ammunition for when it is really needed: during the talks. However, given the currency s deeply sour reaction to the Article 50 Upcoming Italian referendum a risk Euro (US$/ : as of October 11, 2016) Sources: FRB, Haver Analytics, Bloomberg, BMO Economics s Article 50 to be triggered no later than March Flash Crash doesn t help the GBP British Pound (US$/ : as of October 11, 2016) Sources: FRB, Haver Analytics, Bloomberg, BMO Economics s

6 Page 6 of 10 October 11, 2016 announcement, and the hard Brexit stance that both sides seem to be taking, Governor Carney may be unable to act again. In fact, there have been some indications that the BoE may begin to back off the QE program and a continued currency rout could even force some reversal of the earlier easing moves. Japanese Yen The Japanese yen continues to defy logic. It rallies not only when there BoJ targeting interest rate levels is a flight from risk, but also when the BoJ eases. The September Yen defies logic, but will weaken announcement was a step away from the traditional easing policy. Japanese Yen Instead of taking policy rates lower (further below zero), and targeting the monetary base, the central bank embarked on a new direction, ( /US$ : as of October 11, 2016) called QQE with Yield Control. The new tool that Governor Kuroda 130 introduced aims to control the yield curve by keeping 10-year JGB yields at zero, with the goal of steepening the curve to help banks and 120 pension funds. The ultimate goal continues to be meeting the 2% inflation target, and even that timeline was dropped and replaced with 110 at the earliest possible time. These actions (still buying bonds but targeting the yield curve instead of a set amount of purchases), along 100 with the message that negative rates could be cut further if needed, suggests that this is one central bank that will remain accommodative 90 for longer. Still, there may be more battles ahead as policymakers are not unified in their views. One BoJ member opposed the inflationovershooting commitment, calling it unrealistic and suggesting that it 80 would not be effective. In any event, under the forces of easy domestic monetary policy and a stronger greenback, we look for the yen to finally weaken, to as low as 105 by year end (or sooner), and nearing 108 over the next 12 months. Australian Dollar The Reserve Bank of Australia held its benchmark cash rate steady at a record-low 1.50% for the second straight month in October the first meeting with newly appointed RBA Governor Philip Lowe at the helm. Despite a changing of the guard, the script remained largely the same. Australia s domestic economy is humming along at a moderate pace as the large decline in mining investment is being offset by growth in other areas, including residential construction, public demand and exports. Nevertheless, labour market indicators have been somewhat mixed, while subdued inflation has largely justified the current path of monetary policy accommodation. The RBA noted in its most recent Statement on Monetary Policy that there has been little change to the that underlying inflation will remain around 1½ per cent in year-ended terms over 2016 and pick up to around 1½ 2½ per cent by the end of the period. That should keep the RBA side-lined for the remainder of the year; however, if upcoming Q3 inflation decelerates, the odds of another rate cut this year will likely rise alongside an upward move in Australian bond yields and the AUD. Indeed, the RBA retained its cautious view on the currency, noting that while the depreciation Sources: FRB, Haver Analytics, Bloomberg, BMO Economics s RBA on hold in October following 2nd cut this year in August Philip Lowe takes over as RBA Governor Australian Dollar (US$/A$ : as of October 11, 2016) Sources: FRB, Haver Analytics, Bloomberg, BMO Economics s

7 Page 7 of 10 October 11, 2016 since 2013 has been supportive of economic rebalancing toward non-resource sectors, further appreciation like we ve seen over the past year could complicate the necessary economic adjustments. Ultimately, the RBA still has room to lower policy rates if necessary given the subdued inflation outlook and ebbing concerns of an overheating housing market but, outside of a major external shock or downside surprise to Q3 CPI, we don t see the Committee cutting rates again this year. Chinese Yuan The latest run of economic data out of China suggests that growth has levelled out for now. Retail sales, industrial production, fixed investment and lending growth were all healthy in August, pointing to GDP growth of around 6.7% y/y for a third straight quarter in Q3. These data are particularly encouraging as there s no shortage of hard landing fears for China s economy. That backdrop has enabled the PBoC to hold policy rates steady (reserve requirements and interest rates), saving their ammunition for when it s really needed. Don t be surprised to see more easing in 2017, as policymakers do their utmost to engineer gently decelerating growth to hit the 6.5%-to-7% target. The growing debt burden is a concern, but policymakers have sufficient firepower to ensure conditions don t destabilize in the near term. After touching a 5-year low in July, the yuan gained modestly in 6.2 August, and held relatively steady through September. Current levels are the weakest since 2010, as the government tries to manage the 6.0 transition toward a more domestically-oriented growth model while still growing at a fast enough pace to ensure unemployment doesn t rise meaningfully. China s massive trade surplus suggests the currency is undervalued, but there s a large and persistent capital outflow that we don t see in the data, countering the inflows from trade. Look for pressure on the yuan to continue through 2017 amid persistent economic uncertainty, financial outflows, and a rising US$. Economic growth stabilizing Yuan steady in September Chinese Yuan (CNY/US$ : as of October 11, 2016) Sources: FRB, Haver Analytics, Bloomberg, BMO Economics s

8 Page 8 of 10 October 11, 2016 Foreign Exchange Forecasts Local Currency per U.S. Dollar (averages) Actual Forecasts Sep Oct Nov Dec Jan Feb Mar Apr Q2 Q3 Q4 Canadian Dollar C$ per US$ US$ per C$ Trade-weighted U.S. Dollar Trade-weighted¹ European Currencies Euro² Danish Krone Norwegian Krone Swedish Krone Swiss Franc U.K. Pound² Asian Currencies Chinese Yuan Japanese Yen Korean Won 1,108 1,110 1,105 1,105 1,110 1,115 1,120 1,125 1,130 1,145 1,155 Indian Rupee Singapore Dollar Malaysian Ringgit Thai Baht Philippine Peso Taiwan Dollar Indonesian Rupiah 13,112 13,100 13,085 13,070 13,110 13,150 13,190 13,235 13,275 13,395 13,520 Other Currencies Australian Dollar² New Zealand Dollar² Mexican Peso Brazilian Real Russian Ruble South African Rand Cross Rates Versus Canadian Dollar Euro (C$/ ) U.K. Pound (C$/ ) Japanese Yen ( /C$) Australian Dollar (C$/A$) Versus Euro U.K. Pound ( / ) Japanese Yen ( / ) ¹ Federal Reserve Broad Index ² (US$ per local currency)

9 Page 9 of 10 October 11, 2016 Interest Rate Forecasts Percent (averages) Actual Forecasts Sep Oct Nov Dec Jan Feb Mar Apr Q2 Q3 Q4 Cdn. Yield Curve Overnight month month year year year year year year year m BA m BA m BA m BA Prime Rate U.S. Yield Curve Fed funds month month year year year year year year year m LIBOR m LIBOR m LIBOR m LIBOR Prime Rate Other G7 Yields ECB Refi yr Bund BoE Repo yr Gilt BoJ O/N yr JGB

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