Cyclical USD weakness

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Darren Morgan
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May 215 Cyclical USD weakness The trade-weighted US dollar s impressive run ended with a nearly 2% decline in April, the worst monthly performance since September 213.

1 May 215 Cyclical USD weakness The trade-weighted US dollar s impressive run ended with a nearly 2% decline in April, the worst monthly performance since September 213. Weaker than expected US economic data in the first quarter of the year had markets pare back expectations of Fed rate hikes. But the US economy is stronger than what s depicted by Q1 results, the latter being impacted by temporary factors such as bad weather and port strikes. So, growth and hence rate expectations should bounce back as those factors dissipate. EURUSD has benefitted from the combination of weak US results and improving economic data on the old continent, gaining more than % in April, the best performance in four years. As we suggested last month, a move closer to 1.15 shouldn t be ruled out over the near term given that momentum could be sustained by the reversal of massive speculative net short positions on the euro. That said, we remain of the view that the euro is heading lower against USD over the longer term on the back of diverging monetary policies. Our end-of-215 target for EURUSD remains at 1.5. The Canadian dollar just had its best month since 211. Higher oil prices and a less dovish Bank of Canada gave the currency a boost in April. While the loonie could remain strong over the near term, we continue to expect it to head back towards 1.3 in the second half of the year, coinciding with the US economy returning to strong growth. Stéfane Marion/Krishen Rangasamy NBF Currency Outlook* Current 215Q2 215Q3 215Q 216Q1 216Q2 1-M ay-15 USDCAD US cents per CAD EURUSD USDJPY AUDUSD GBPUSD USDCNY AUDCAD * forecasts for end of period Source: NBF Economics and Strategy

2 Short-term USD weakness All good things eventually come to an end. The tradeweighted US dollar s impressive run ended with a nearly 2% decline in April, the worst monthly performance since September 213. USD hammered in April Trade-weighted US dollar 3.5 m/m % chg Jul 13 Oct 13 Jan 1 Apr 1 Jul 1 Oct 1 Jan 15 Apr 15 As we had warned last month, the USD s uptrend could only last as long as there are no hints the Fed will delay rate hikes. Unfortunately for those long USD, there were several such hints during April courtesy of ugly economic reports from the prior quarter. Non-farm payrolls for March showed the smallest increase in employment since 213, March industrial production saw the sharpest contraction since 212, and the Q1 GDP report was simply awful. First quarter growth ended up a measly.2% according to the advance estimate of the Bureau of Economic Analysis, the worst performance since the same quarter last year. Trade was a drag on the economy due to contracting exports. Domestic demand was very soft with weak growth for consumption and residential investment (both worst since Q1 last year), a sharp contraction of business investment in structures (the worst since Q1 of 211), and another quarterly drag from government. There was further bad news considering the massive inventory build during the quarter, which should restrain production later. The string of weak data unmoored market expectations for rate hikes at one point the futures market was pricing the fed funds rate to average only 5 basis points in March 216 which largely explains the USD s April woes. Not wanting to push even further out expectations of tightening, the Fed decided at its April meeting to move away from its date-based guidance and not pre-commit about the timing of policy change. By doing so, it reminded markets that monetary policy is entirely datadependent and that rate hikes remain a possibility this year. To be sure, the US economy is stronger than what s depicted by Q1 results. The latter were weak largely due to temporary factors such as bad weather (which affected consumption and construction) and port strikes on the West Coast (which hurt exports). So, growth should bounce back as those factors dissipate. Note that outside of recessions, a weak performance such as in Q1 is followed, often with a lag, by solid growth sometimes with a -5% handle. but sharp rebound is coming Real GDP q/q % chg. saar 8 6 U.S.: Q1 GDP results worse than expected Real GDP contributions 215Q1 21Q 21Q3 GDP Q1 Consumption Business investm. Equip./Intell Business investm. Struct Residential investm Government Domestic Demand Shaded areas represent recessions Exports Imports Trade Final sales Inventories Given the inventory build in the prior quarter, it s unlikely Q2 growth will hit those heights. But such a growth spurt is entirely possible in the second half of the year after inventories have been downsized. Indeed, economic fundamentals remain very strong, particularly for consumption, e.g. low gasoline prices, 2

3 healthy income gains from a solid labour market, a high savings rate, and easy credit. Record corporate profits should also help boost business investment the earlier USD surge has made it cheaper for firms to import machinery from say Germany or Japan. All told, domestic demand should strengthen further and offset any drag from trade, the latter remaining under pressure from the strong dollar. While the Q1 disappointment prompted us to trim by three ticks our 215 US growth forecast to 2.6%, the latter nonetheless remains well above potential and consistent with the start of monetary tightening by the Fed. We continue to expect the first rate hike to come late Q3, something which should allow USD to resume its upward trend in the second half of the year. Over the near term, however, the greenback remains vulnerable to soft data, courtesy of the earlier inventory build, as well as improving data on the other side of the Atlantic. Improving economy boosts euro The Eurozone is indeed showing encouraging signs. The economy is on the mend based on recent data on trade and domestic demand. Construction is slowly coming back, and so is consumption as evidenced by higher retail volumes, the latter on track to grow in Q1 at the fastest pace since The improvement in labour and credit markets is clearly helping. Unprecedented stimulus by the European Central Bank seems to be having the desire effects given that household and business loans both grew in Q1 at the fastest pace in years. Eurozone: Has deleveraging finally come to an end? MFI loans to Non-financial corporations and Households 18 q/q % chg. saar 16 1 Non-financial 12 corporations Households Q Eurozone: Inflation expectations bounce back Inflation expectations measured by 2-yr inflation swaps 2.2 % NBF Economics and Strategy (data via Bloomberg) EURUSD has benefitted from those developments, gaining more than % in April, the best performance in four years. As we suggested last month, a move closer to 1.15 shouldn t be ruled out over the near term given that momentum could be sustained by the reversal of massive speculative net short positions on the euro. But longer term, we remain of the view that the euro is heading lower against USD on the back of diverging monetary policies. The ECB is unlikely to abandon its QE program so soon after it began, based on Mario Draghi s own comments. A potential Greek default also threatens the common currency, particularly with massive repayments due to creditors in the summer. So, while the euro could remain strong over the near term, we expect it to resume its earlier downtrend in the second half of the year. Our end-of-215 target for EURUSD remains at 1.5. Loonie has done well lately The Canadian dollar gained over % against the USD in April registering its best performance since October 211. The loonie s surge was facilitated by speculators who cut their net short positions for the first time since December last year. Speculators reduced C$ shorts in April Net long non-commercial positions on Canadian dollar 2, contracts 1, -1, -2, -3, The cheaper euro resulting from the ECB s ultraloose policies is not only giving a lift to exports, but also helping support imported inflation as well as inflation expectations. -, -5, -6, -7, Jan 1 Feb 1 Mar 1 Apr 1 May 1 Jun 1 Jul 1 Aug 1 Sep 1 Oct 1 Nov 1 Dec 1 Jan 15 Feb 15 Mar 15 Apr 15 NBF Economics and Strategy (data via Bloomberg) 3

4 Favourable oil prices also gave a boost to the Canadian dollar. While the US$ price of WTI oil was up 2% in April, that of Western Canada Select soared 39% courtesy of narrowing spreads with WTI the WCS discount on WTI is now the smallest since September of 212. Smaller discount and cheap loonie have helped energy producers US$ WCS spread with WTI Lowest discount since 212 on Canadian oil versus WTI Q3 12Q 13Q1 13Q2 13Q3 13Q 1Q1 1Q2 1Q3 1Q 15Q1 WCS oil price 92 C$/barrel and cheap loonie, 76 helping cushion the 72 blow for energy 68 producers Aug 1 Sep 1 Oct 1 Nov 1 Dec 1 Jan 15 Feb 15 Mar 15 Apr 15 A less dovish Bank of Canada also helped the loonie. While the central bank lowered, in April s Monetary Policy Report, its 215 Canadian growth forecast a notch to 1.9% due to downgrades to Q1, it was quite positive about the rest of the year, even seeing a hot growth rate of 2.7% on average in the second half. That, together with a one-tick downgrade to potential GDP growth to 1.8% left the timeline for the closure of the output gap unchanged at around the end of 216. Governor Poloz said the impact of the oil shock on the economy was more front-loaded than initially thought, but not larger over the forecast horizon, which explains why he didn t feel the need to provide additional stimulus. He saw the silver-lining in the front-loaded impact by saying that Canada would also recover sooner. but weakness likely to resume We have doubts about the front-loaded story. The Q1 disappointment was partly due to extraordinary circumstances. The atypically harsh winter had a clear negative impact on consumer spending, while weakness in manufacturing and exports can be attributed to closures of auto assembly lines in Ontario for retooling. Those temporary factors will dissipate in the second quarter. Another reason why we think the impact of the oil shock isn t as frontloaded as advertised is the resilience in Alberta and Saskatchewan with regards to employment and investment spending. If the oil collapse of 28 is any guide, one can expect the impact on investment to be somewhat delayed rather than front-loaded. Impact of oil shock: Not so front loaded this time Employment and Real commercial & industrial non-residential building investment in Alberta and Saskatchewan after oil shock: 28/9 versus Current shock Employment, q/q chg. thousands Current 28/9 Investment, q/q % chg. saar T = oil shock T+1 T+2 T+3 T+ T+5 T+6 NBF Economics and Strategy (data via Statistics Canada) That suggests there may be some downside risks to the BoC s call for above-potential growth in the second half of the year. If that s the case, the Canadian dollar could struggle a bit later this year as softer-than-expected data get markets to start pricing in some probability of a Bank of Canada rate cut. Another potential negative for the loonie is the oil price which, after April s surge, now seems to have limited upside. As we ve seen in the recent past, when the loonie makes a move, it tends to do so quickly. Part of the reason is Canada s large current account deficit (2.8% of GDP in Q last year) and hence the dependence on capital inflows. Unfortunately, the latter have been of the short-term type lately. In the final quarter last year the current account deficit was financed not by stable Foreign Direct Investment the oil price collapse has made it more difficult to attract such flows into the energy patch but rather by other flows such as loans, currency and deposits which are unstable given the potential to quickly reverse. All told, while the loonie could remain strong over the near term, we expect it to head back towards 1.3 in the second half of the year, coinciding with the US economy returning to strong growth.

5 Annex 1.7 Euro 1.1 Canadian dollar Japanese yen British pound Australian dollar Chinese yuan

ECONOMICS AND STRATEGY Montreal Office Toronto Office 5179-2529 1669598 Stéfane Marion Chief Economist & Strategist stefane.marion@nbc.

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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A rate hike for Christmas

December 215 A rate hike for Christmas A December interest rate hike isn t fully priced-in by markets and as such there is upside potential for the USD if the FOMC delivers on its repeated warnings that