Can the loonie make a comeback?

Can the loonie make a comeback? December 217 Even considering the low rate of U.S. inflation, monetary policy in the world s largest economy is arguably too loose. It s the first time since the 197 s that real interest rates are in negative territory despite a positive output gap. Some Fed members are now even expressing concerns about financial imbalances fearing a sharp reversal in asset prices according to the latest minutes. Recently approved tax cuts by Congress also warrant normalizing monetary policy. As such, we believe the Federal Reserve will raise interest rates more than what markets are currently expecting in 218. That translates to a comeback for the USD next year after a dreadful 217 for the currency. Boosted by a string of strong economic data in the eurozone, the euro had a good November even seeing its biggest jump in four months. While the European Central Bank s asset purchase program will come to an end and interest rates will eventually return to positive territory, a major tightening of monetary policy is unlikely anytime soon due to the persistence of low inflation. We do not see a lot of upside for EURUSD from current levels over the forecast horizon. The Bank of Canada just cannot ignore the strong labour market which created an average of 33K jobs/month in the last 12 months (including November s massive +8K print), the best performance in a decade. We continue to think the central bank will be forced by strong data to deliver more interest rate hikes than what markets are currently expecting for 218. As such, we would not be surprised to see USDCAD revisit 1.25 or even lower in early 218 before a relapse back towards 1.3 later in the year as oil prices stabilize and an improving U.S. economy prompts markets to price more Fed rate hikes. Stéfane Marion / Krishen Rangasamy 514-879-3781 514-879-31 NBF Currency Outlook* Current 1-Dec-17 217Q4 218Q1 218Q2 218 218Q4 USDCAD 1.27 1.25 1.24 1.27 1.28 1.32 US cents per CAD.79.8.81.79.78.76 EURUSD 1.19 1.2 1.18 1.17 1.14 1.12 USDJPY 112 115 114 112 11 18 AUDUSD.76.78.79.77.75.74 GBPUSD 1.35 1.34 1.32 1.27 1.23 1.2 USDCNY 6.62 6.6 6.58 6.57 6.56 6.55 USDMXN 18.67 18.6 18.5 18.8 19.2 19.7 * forecasts for end of period Source: NBF Economics and Strategy

Can the Fed surprise markets? After stabilizing somewhat in the prior two months, the trade-weighted U.S. dollar resumed its downward trend losing more than 1% in November. And that despite solid economic data which provided further evidence that U.S. GDP is set expand about 2.2% in 217, the fastest pace of growth in three years. Not only was growth revised up, but the fourth quarter also seems to have been good based on October data. Consumption remains strong based retail data which shows resilience in discretionary spending, while the real estate market continues to do well according to housing starts and home resales. The manufacturing sector is also on the rise due to exports but also because of business investment in machinery and equipment which is strengthening further based on shipments of non-defense capital goods excluding aircrafts. So what is holding back the USD? Markets just don t believe the Fed can significantly tighten monetary policy. While an interest rate hike later this month is now fully priced by markets, the latter are not expecting much of a follow-up over the next two years the fed funds rate is expected to be below 2% by the end of 22, in sharp contrast to the Fed s own view that rates will be closer to 3% by then. This market view has no doubt been shaped by years of disappointing readings on both wage growth and the overall inflation rate which have seemingly eroded trust in the Fed s ability to hit its 2% inflation target. negative territory despite a positive output gap according to the Congressional Budget Office economic slack has now been entirely absorbed. Chair Yellen and her designated successor Jerome Powell (who takes office in February 218) have both emphasized that the FOMC should continue the process of normalizing monetary policy. Some Fed members are now even expressing concerns about financial imbalances fearing a sharp reversal in asset prices according to the latest minutes. Recently approved tax cuts by Congress also warrant normalizing monetary policy. As such, we believe the FOMC will raise interest rates more than what markets are currently expecting. That translates to a comeback for the USD next year after a dreadful 217 for the currency. Strong euro complicates matters for ECB The euro had a good November, seeing its biggest jump in four months. The common currency was boosted by a string of strong economic data including real GDP growth which is on track to match that of the U.S. this year. The jobless rate at the end of was 8.9%, down a full percentage point from the same time last year and the lowest since early 29. The zone s economic revival coincides with the uptick in credit growth, highlighting the benefits of the European Central Bank s loose policies. But a reasonable argument could be made that, even considering the low rate of inflation, U.S. monetary policy is currently too loose. Indeed, it s the first time since the 197 s that real interest rates are in However, the annual core inflation rate (excluding energy, food, alcohol and tobacco) was less than 1% in November, pointing to the persistence of economic slack. The euro s appreciation is making things worse on that front. Recall that last September the ECB 2

lowered its inflation projections, blaming the euro s strength for disinflationary pressures. The central bank s forecast of 1.2% for the 218 inflation rate assumed EURUSD stabilizing at 1.18. So, if the euro appreciates further from here, another downward revision of the ECB s inflation forecasts may be necessary. Eurozone: Relapse of core inflation Consumer price index excluding energy, food, alcohol and tobacco 2.8 2.6 2.4 y/y % chg. Were it not for the central bank s verbal interventions, USDCAD would arguably be closer to 1.24, a level more consistent with current oil prices. Canada: Stable loonie in November despite soaring oil prices WTI oil price and USDCAD 64 1.12 US$/barrel Reverse axis 6 56 52 48 44 WTI oil price (L) 1.16 1.2 1.24 1.28 1.32 2.2 2. 1.8 1.6 1.4 1.2 1. 36 USDCAD (R) 32 28 24 215 216 217 NBF Economics and Strategy (data via Datastream) 1.36 1. 1.44 1.48 1.52.8.6.4 2 22 24 26 28 21 212 214 216 218 NBF Economics and Strategy (data via Datastream) Also of concern to the ECB are geopolitical uncertainties which could derail growth and make it even harder for the central bank to hit its inflation target. Anti-EU populists could gain power in Italy following the 218 elections by capitalizing on a soft economy and a youth unemployment rate of more than 35%. Brexit is another problem for the Eurozone considering the significant trade linkages with the UK. All told, while the ECB s asset purchase program will come to an end and interest rates will eventually return to positive territory, a major tightening of monetary policy is unlikely anytime soon. So, we do not see a lot of upside for EURUSD from current levels over the forecast horizon. Bank of Canada hammers C$ The Canadian dollar remained relatively stable in November despite surging oil prices during the month. Preventing the loonie from taking off was the Bank of Canada which spread its usual dovish messages to markets via speeches, including stated concerns about increased sensitivity of the economy to interest rate hikes, low inflation, labour market slack and downside risks presented by NAFTA negotiations. Even though timely data is not available to confirm, we suspect foreign portfolio inflows also continued to provide support to the loonie. Foreign demand for Canadian securities has indeed been strong in light of the country s AAA sovereign rating and solid economic performance. This year has been a banner year for foreign portfolio inflows with a record C$152 bn cumulative inflows into Canadian securities in the first nine months C$19 bn into bonds and C$52.3 bn into equities dwarfing divestment from money market instruments. Canada: Strong foreign demand for Canadian bonds 6 5 3 2 1-1 -2 Foreign purchases of Canadian bonds, by instrument C$ bn 6 C$ bn Corporates Federal 55 Provincial Municipal TOTAL BONDS 5 Solid foreign demand again for Canadian bonds in 215 216 217 NBF Economics and Strategy (data via Statistics Canada) Not surprisingly, those portfolio inflows were again the main source of financing for Canada s chronic current account deficit in the third quarter. While foreign inflows into Canada should be welcome with open arms, efforts should be made by policymakers to encourage longer-term investment such as FDI. 45 35 3 25 2 15 1 5-5 Foreign purchases of Canadian bonds, by currency Denominated in foreign currencies Denominated in Canadian dollar with particular interest in C$-denominated bonds 215 216 217 3

Continued dependence on short-term foreign capital makes the Canadian dollar more vulnerable because such flows have potential to quickly reverse. Canada: Continued dependence on short-term foreign capital Sources of financing for the current account deficit 6 5 3 2 1-1 -2-3 - -5-6 C$ bn Current account deficit FDI net outflows Stat. discrepancy Current account deficit entirely financed by short term foreign capital inflows for an eighth consecutive quarter FX reserves Portfolio/other net inflows 215q1 215q2 215q3 215q4 216q1 216q2 216q3 216q4 217q1 217q2 217q3 NBF Economics and Strategy (data via Statistics Canada) but don t rule out near-term rebound for loonie While the large current account deficit (3.6% of GDP in ) and the way it is being financed remain the loonie s Achilles heel, that s not to say the Canadian dollar only has downside. Interest rate spreads may improve in Canada s favour over the coming months if the Bank of Canada acknowledges the improving economy and raises its 218 Canadian GDP growth forecast in January s Monetary Policy Report. Recall that upcoming boosts from provincial governments ahead of elections in Quebec and Ontario (including the latter s minimum wage increase) are not fully accounted for in the BoC s estimate of 2.1% for next year s growth. So, don t rule out a forecast upgrade from the central bank (towards our own estimate of 2.5%) and hence another about-face on monetary policy in early 218. Also note that after Statistics Canada s recent upgrades to GDP data, there is no slack left in the economy according to the Bank of Canada s own integrated framework estimate of the output gap. The reduced slack explains why the annual core inflation rate has been creeping up in recent months. Sources of financing Financing needs Canada: Upward revisions allow output gap to shrink further 1,87, 1,86, 1,85, 1,8, 1,83, 1,82, 1,81, 1,8, 1,79, 1,78, 1,77, 1,76, 1,75, 1,7, 1,73, Real GDP Millions of chained 27 dollars Revised data Old data 213 214 215 216 217 NBF Economics and Strategy (data via Statistics Canada, Bank of Canada) Moreover, the central bank just cannot ignore the strong labour market which created an average of 33K jobs/month in the last 12 months (including November s massive +8K print), the best performance in a decade. Canada: Best labour market in a decade Employment creation according to Labour Force Survey, 12-month average 35 3 25 2 15 1 5-5 -1-15 -2-25 -3-35 m/m chg. thousands We still think the Bank of Canada will be forced by strong data to deliver more interest rate hikes than what markets are currently expecting for 218. As such, we would not be surprised to see USDCAD revisit 1.25 or even lower in early 218 before a relapse back towards 1.3 later in the year as oil prices stabilize and an improving U.S. economy prompts markets to price more Fed rate hikes. -.2 -.4 -.6 -.8-1. -1.2-1.4-1.6-1.8-2. -2.2-2.4-2.6-2.8-3. -3.2 % Output gap (integrated framework) Based on revised data Based on old data 213 214 215 216 217 27 28 29 21 211 212 213 214 215 216 217 NBF Economics and Strategy (data via Statistics Canada) Nov. 4

Annex 1.7 Euro 1.65 Canadian dollar 1.6 1.6 1.55 1.5 1.5 1.45 1.4 1. 1.3 1.35 1.3 1.2 1.25 1.2 1.1 1.15 1. 1.1 1.5.9 1..95.8.9 15 Japanese yen 1.15 Australian dollar 145 1.1 1 1.5 135 1. 13 125 12 115 11 15 1 95.95.9.85.8.75.7.65 9.6 85.55 8.5 75 British pound 2.2 2.1 2. 1.9 1.8 1.7 1.6 1.5 1.4 1.3 1.2 1.1.45 Chinese yuan 8.8 8.6 8.4 8.2 8. 7.8 7.6 7.4 7.2 7. 6.8 6.6 6.4 6.2 6. 5.8 5.6 NBF Economics and Strategy (data via Datastream) Canadian dollar* Current 1-Dec-17 217Q4 218Q1 218Q2 218 218Q4 USDCAD 1.27 1.25 1.24 1.27 1.28 1.32 EURCAD 1.51 1.5 1.47 1.48 1.46 1.47 CADJPY 88 92 92 88 86 82 AUDCAD.96.98.98.97.96.97 GBPCAD 1.71 1.68 1.64 1.61 1.58 1.58 CADCNY 5.23 5.28 5.3 5.19 5.12 4.98 CADMXN 14.75 14.88 14.89 14.85 14.98 14.97 * forecasts for end of period Source: NBF Economics and Strategy 5

Economics and Strategy Montreal Office Toronto Office 514-879-2529 416-869-8598 Stéfane Marion Marc Pinsonneault Kyle Dahms Warren Lovely Chief Economist and Strategist Senior Economist Economist MD, Public Sector Research and Strategy stefane.marion@nbc.ca marc.pinsonneault@nbc.ca kyle.dahms@nbc.ca warren.lovely@nbc.ca Paul-André Pinsonnault Matthieu Arseneau Jocelyn Paquet Senior Fixed Income Economist Senior Economist Economist paulandre.pinsonnault@nbc.ca matthieu.arseneau@nbc.ca jocelyn.paquet@nbc.ca Krishen Rangasamy Senior Economist krishen.rangasamy@nbc.ca Angelo Katsoras Geopolitical Analyst angelo.katsoras@nbc.ca General National Bank Financial (NBF) is an indirect wholly owned subsidiary of National Bank of Canada. 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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