Can the greenback repeat the feat in 2015?

January 215 Can the greenback repeat the feat in 215? The U.S. dollar just had its best year since 1997 after appreciating nearly 9% in trade-weighted terms. The end of QE by the Fed clearly helped, but so did a further loosening of monetary policy into unchartered territory by central banks in Europe and Japan, which hammered the euro and yen respectively relative to the greenback. Such a divergence of monetary policy will extend through 215, suggesting further upside for USD, although we expect the overall appreciation to be more modest than last year. A stabilization of oil prices and a patient Fed could restrain somewhat the otherwise soaring greenback. Facing the threat of deflation amidst the ongoing deleveraging cycle which is restraining growth and hence prices, the European Central Bank finds itself with little choice other than follow its purchases of covered bond and asset-backed securities with outright quantitative easing. Adding to the euro s woes is the comeback of political uncertainty thanks to Greece, yet again. EURUSD is still on track to drop to 1.15 by the end of 215. After the recent Japanese elections gave him a new majority government, Prime Minister Shinzo Abe may press ahead with necessary structural reforms. The cheap currency policy will continue as the Bank of Japan ramps up the printing press, allowing the yen to depreciate against the USD to levels not seen since 22. We remain comfortable with our forecast for USDJPY to reach 128 by the end of 215. We have revised down our projections for WTI oil prices to an average of $7/barrel in 215 (versus roughly $9 in our previous forecast). The resulting downgrade to both our inflation and growth forecasts explains why we now expect the Bank of Canada to delay interest rate hikes to 216. We have, accordingly, adjusted our targets, expecting the Canadian dollar (versus USD) to reach 1.2 by the end of 215. Over the near term, however, the loonie could hold its own against the greenback as oil prices stabilize. Stéfane Marion/Krishen Rangasamy NBF Currency Outlook* Current 215Q1 215Q2 215Q3 215Q 216Q1 2-Jan-15 USDCAD 1.18 1.16 1.16 1.18 1.2 1.19 US cents per CAD.85.86.87.85.83.8 EURUSD 1.2 1.2 1.19 1.17 1.15 1.1 USDJPY 12 122 12 126 128 129 AUDUSD.81.82.81.79.8.82 GBPUSD 1.53 1.5 1.52 1.51 1.5 1.52 USDCNY 6.21 6.2 6.17 6.1 6.1 6.8 AUDCAD.95.95.9.93.96.98 * forecasts for end of period Source: NBF Economics and Strategy

Can the greenback repeat the feat? The U.S. dollar just had its best year since 1997. The near 9% appreciation of the trade-weighted dollar in 21 was made possible by the Fed s decision to end QE, although the greenback also got a helping hand from further loosening of monetary policy into unchartered territory by central banks in Europe and Japan. Commodity currencies were also hammered as the stronger USD capped prices of commodities. Banner year for U.S. dollar in 21 % 15 1 5-5 -1 Annual appreciation of trade-weighted U.S. dollar 1997 1998 1999 2 21 22 23 2 25 26 27 28 29 21 211 212 213 21 21 appreciation versus U.S. dollar Norwegian Krone Swedish Krona Japanese yen Euro Danish Krone Brazilian Real Mexican peso Swiss Franc Australian $ Canadian $ British pound NZ$ Singapore $ Korean Won % -25-2 -15-1 -5 Can the greenback repeat the feat in 215? To be sure, the divergence in monetary policy will continue, suggesting further upside for USD particularly against the euro and the yen. Higher yields, courtesy of the Fed, and solid growth prospects will be magnets for foreign flows into the U.S. in 215. The world s largest economy is indeed on a clear uptrend, buoyed by an invigorated private sector. The labour market has taken off and the resulting increased household income, coupled with cheap gasoline and re-leveraging, should boost consumption further. While exports could soften a bit due to the stronger dollar, that shouldn t prevent U.S. GDP growth from accelerating from an estimated 2.% in 21 to around 3% this year, the best performance in a decade. That s well above potential growth and close to the Fed s latest estimates. In addition to releasing new projections, the Fed decided in December to tweak its forward guidance by saying that it can be patient in beginning to normalize the stance of monetary policy. In the subsequent press conference, Fed Chair Janet Yellen defined patience as no change in rates at least for the next two meetings. That s quite a change from the previous forward guidance that rates would remain low for a considerable time. All told, rate hikes are coming, and markets are starting to adjust. U.S.: Fed rate hikes expected this year FOMC s own end-of-215 forecast for fed funds rate Number of FOMC participants 3 2 1..1.2.3..5.6.7.8.9 1. 1.1 1.2 1.3 1.5 1.7 1.8 1.9 2. Midpoint of target range or target level for fed funds rate at the end of 215 (%) NBF Economics and Strategy (data via Fed) While the outlook is promising for the U.S. dollar, the latter could nonetheless meet some resistance in 215. For instance, oil prices could stabilize somewhat, giving a breath of fresh air to commodity currencies. The Fed could also decide to be less aggressive than planned in raising interest rates despite solid GDP growth if the core PCE deflator remains soft, perhaps due to the persistence of low wage inflation or low imported prices (courtesy of the USD s appreciation in the last couple of years). U.S.: Inflation remains mild PCE deflator excluding food and energy y/y % chg. 2.1 2. 1.9 1.8 1.7 1.5 1.3 1.2 Jan 12 NBF Economics and Strategy (data via Datastream) QE in the Eurozone? Mar 12 May 12 Jul 12 Sep 12 Nov 12 Jan 13 Mar 13 May 13 Jul 13 Sep 13 Nov 13 Jan 1 Mar 1 May 1 Jul 1 Sep 1 Nov 1 One currency that s not expected to provide much resistance to the greenback s ascent is the euro. The common currency, which just had its worst year since 25, remains saddled with a stagnant economy and political uncertainty. The failure by the zone s members to implement growth-friendly reforms and policies should continue to cap employment and growth, thereby restraining wages and prices. 2

Markets seem to agree with that outlook based on inflation expectations which are now at record lows. Eurozone: Next stop, deflation? Inflation expectations measured by 5-yr inflation swaps 3. % 2.8 2.6 2. 2.2 2. 1.8 1.2 1..8.6 2 25 26 27 28 29 21 211 212 213 21 Once it gets its grip on the economy, deflation can show persistence and bring all sorts of problems. Besides the devastation it causes on consumption via deflationary expectations, deflation can worsen the already shaky government finances in the eurozone by raising the real value of debt, and restraining nominal GDP and hence tax revenues. Facing the threat of deflation amidst the ongoing deleveraging cycle, the European Central Bank has little choice other than follow its purchases of covered bond and asset-backed securities with outright quantitative easing. All told, we remain comfortable with our view that EURUSD will drop to 1.15 by the end of 215. Abenomics keeps pressure on yen Japan, another economy that will be battling deflation in 215, is also set for another difficult year despite loose monetary policy by its central bank. But after the December elections gave him a new majority government, Prime Minister Shinzo Abe may press ahead with necessary structural reforms. The cheap currency policy will continue as the BoJ ramps up the printing press, allowing the yen to depreciate against the USD to levels not seen since 22. The weaker yen will be welcome news for exporters and allow the current account balance, which has been sinking in recent years, to stabilize. We remain comfortable with our forecast for USDJPY to reach 128 by the end of 215. Japan: Cheap yen should help support external balance in 215 12-month cumulative Current account balance and Yen/US$ 28 2 2 16 12 8 Trillion yen Current account (L) Yen/US$ (R) - Difficult for loonie to resist USD surge Like other majors, the Canadian dollar struggled last year in the face of the USD surge, losing 9% against the greenback, its worst performance since the 29 recession. And that despite strengthening portfolio inflows and a Canadian economy growing an estimated 2.% in 21, the fastest pace in three years, and well above potential. Portfolio inflows supportive of loonie last year Monthly average net portfolio inflows by year C$ bn 1 9 8 7 6 5 3 2 1-1 -2-3 - 5 6 7 8 9 1 11 12 13 1 * Based on first ten months of 21 est.* NBF Economics and Strategy (data via Statistics Canada) So what exactly hurt the loonie in 21? Dovish talk by the Bank of Canada didn t help and was likely behind the observed drop in money market related inflows last year. Speculators also increased their net short positions on the Canadian dollar, adding pressure on the currency net shorts averaged almost 25, contracts last year, the largest on record. 15 1 13 12 11 1 9 8 7 TOTAL Bonds Equity Money market 3

Speculators shorting the loonie Non-commercial net long C$ positions, average by year contracts, 35, 3, 25, 2, 15, 1, 5, -5, -1, -15, -2, -25, 1996 1998 2 22 2 26 28 21 212 21 The oil price collapse also hammered the loonie later in the year, raising concerns about the 215 growth outlook for Canada. Oil price collapse hammered loonie in 21 Western Canada Select $/barrel 96 92 88 8 8 76 72 68 6 6 56 52 8 WCS in C$ WCS in US$ 36 13Q1 13Q2 13Q3 13Q 1Q1 1Q2 1Q3 1Q The magnitude and speed of the oil price slump took most analysts, including us, by surprise. That s because the collapse isn t commensurate with demand/supply fundamentals in the market. While there is admittedly some excess supply, speculative activity likely also played a role in the oil rout. If, as we expect, markets return to focusing on fundamentals, oil prices could pare back some of the recent losses, particularly if global demand continues to hold firm. That explains our forecast for WTI oil to stabilize and average $7 per barrel in 215. Still, this represents a roughly 25% drop from the 21 average, and therefore has negative implications for Canada. Canada. Government revenues will also be negatively impacted by the oil slide because nominal GDP growth will soften as a result. While the federal government will wait until after the elections to announce some bad news to the electorate, provinces may not be as patient. In Alberta, the projected revenue shortfall is likely to translate into spending cuts as the government attempts to control the budget deficit. That said, cheaper oil will also provide some benefits. Exporters will enjoy not only the accompanying cheaper Canadian dollar, but also the boost given by cheaper oil to our biggest trade partner. Increased investment outlays by non-energy firms may also offset part of the expected decline in the energy patch. Moreover, energy-intensive producers such as manufacturers, as well as consumers will benefit from cheaper fuel. On net, we estimate the unexpected 25% WTI oil price drop to chop roughly.3% from growth and we have accordingly lowered our 215 GDP growth forecast to just 2.2% (from our earlier estimate of 2.5%). Canada: Estimated impacts of oil price slump* on 215 growth Net exports/u.s. boost Net impact -.3% Government Investment Consumption -.8 -.6 -. -.2..2..6.8 * Assuming WTI oil averages US$7/barrel (25% lower than we had expected) and C$ averages 1.17 versus USD in 215 NBF Economics and Strategy (source NBF estimates) % of GDP The downgrade to both our inflation and growth forecasts explains why we now expect the Bank of Canada to delay interest rate hikes to 216. We have, accordingly, adjusted our targets, expecting the Canadian dollar (versus USD) to reach 1.2 by the end of 215. The energy sector, which accounts for about 1% of the economy, will take it on the chin. Nowhere will this be more apparent than in energy-related investment spending, the latter accounting for roughly a quarter of total non-residential investment in

Annex 1.7 Euro 1.1 Canadian dollar 1.5 1.5 1..95 1.3 1.2.9.85.8 1.1.75 1..7.9.65.8 Japanese yen 15 15 1 135 13 125 12 115 11 15 1 95 9 85 8 75 British pound 2.2 2.1 2. 1.9 1.8 1.7 1.5 1.3.6 Australian dollar 1.15 1.1 1.5 1..95.9.85.8.75.7.65.6.55.5.5 Chinese yuan 8.8 8.6 8. 8.2 8. 7.8 7.6 7. 7.2 7. 6.8 6.6 6. 6.2 6. 5.8 5.6 NBF Economics and Strategy (data via Datastream) 5

ECONOMICS AND STRATEGY GROUP 51-879-2529 Stéfane Marion Chief Economist & Strategist stefane.marion@bnc.ca Paul-André Pinsonnault Senior Fixed Income Economist paulandre.pinsonnault@bnc.ca Krishen Rangasamy Senior Economist krishen.rangasamy@bnc.ca Marc Pinsonneault Senior Economist marc.pinsonneault@bnc.ca Matthieu Arseneau Senior Economist matthieu.arseneau@bnc.ca 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. 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