Optimistic Fed supportive of USD

Optimistic Fed supportive of USD August 218 The U.S. dollar s near term prospects remain good amidst a hot economy that is prompting the Fed to tighten monetary policy. The return of risk aversion in the run up to mid-term U.S. elections could also prop up the world s reserve currency. But with the fed funds fast approaching the estimated neutral rate, the impact of rate differentials on the USD will fade and eventually reverse as other major central banks tighten policy. As such, we continue to expect the trade-weighted USD to weaken next year. The euro continues to struggle courtesy of a dovish European Central Bank. For now, speculators seem to be losing faith in the common currency based on their dwindling long positions. Comes a point, however, when investors will expect and hence price the end of Fed normalization, allowing yield differentials to push up EURUSD. The Chinese yuan has lost more than 8% against the USD since April, the worst four-month slump since 199 when the currency was devalued as part of broader reforms. Should the U.S. deliver on its threat to impose steeper tariffs on more imports from China, one can expect the yuan to sink further either via market forces or by currency management from Beijing. More generally, emerging market currency woes could persist amidst trade-related uncertainty, boosting the trade-weighted USD at least over the near term. Until the U.S.-Canada trade dispute is resolved, it s difficult for us to see the Canadian dollar flourish in a sustainable way. Our forecast for the loonie to appreciate after Q3 is based on a trade deal being reached by Washington and Ottawa, something that admittedly may not happen this year. For now, we are keeping unchanged our target range of 1.25-1.35 for USDCAD for the next 12 months. Stéfane Marion / Krishen Rangasamy 51-879-3781 51-879-31 Current 6-Aug-18 218Q3 218Q 219Q1 219Q2 219Q3 USDCAD 1.3 1.32 1.28 1.28 1.27 1.25 US cents per CAD.77.76.78.78.79.8 EURUSD 1.16 1.15 1.18 1.2 1.21 1.23 USDJPY 111 17 19 11 112 113 AUDUSD.7.73.76.77.78.8 GBPUSD 1.29 1.28 1.31 1.33 1.3 1.35 USDCNY 6.85 6.87 6.9 6.88 6.85 6.8 USDMXN 18.5 19. 18.7 18.6 18.2 17.9 *Forecasts for end of period NBF Economics and Strategy NBF Currency Outlook*

A more optimistic Fed After three consecutive monthly increases, the tradeweighted U.S. dollar took a breather in July, shedding more than 1%. The greenback declined against the euro, Canadian dollar, Australian dollar and Mexican peso, which altogether account for about half of the weight in the trade-weighted USD. The return of risk taking and strong performance of global stock markets the All- Country MSCI World index jumped more than 2% during July, helped by hopeful signs with regards to U.S.- European Union trade relations, seem to have boosted the above-mentioned currencies and hurt the tradeweighted greenback in the process. USD negatively correlated with stock market performance Trade-weighted USD versus MSCI All-Country index, 3-day moving correlation of daily changes.8.6 While it left the fed funds rate unchanged at 1.75-2.% in early August, the Fed signalled an imminent rate hike by expressing even more optimism about the economy. It now sees economic activity rising at a strong rate, saying that household spending (which accounts for 7% of the economy) has grown strongly. A September rate hike is now almost fully priced by markets, but the USD may yet get a boost next month should the Fed accompany the expected rate hike with bullish signals. And here we re thinking about the Summary of Economic Projections which could show an upgraded outlook. Those developments may be enough to encourage a majority of FOMC members to call for an additional hike in December (after the one in September), something that is not fully priced by markets. U.S.: Strong growth and mounting cost pressures. Real GDP and real final sales Employment cost index for the private sector.2. 6 q/q % chg. saar Real GDP Real final sales. 3.8 3.5 y/y % chg. Compensation now rising at the fastest pace since 28 -.2 -. 2 3.3 3. 2.8 Wages & salaries TOTAL COMPENSATION -.6-2 2.5 -.8-1. 1998 2 22 2 26 28 21 212 21 216 218 NBF Economics and Strategy (data via Datastream) - -6-8 Real final sales grew in 218Q2 at the fastest pace in 12 years 2.3 2. 1.8 1.5 1.3 Benefits But one month does not make a trend. With trade tensions running high and here we re thinking about U.S. relations with China and Canada the return of risk aversion and hence an immediate USD rebound cannot be ruled out over the near term. Moreover, the greenback could capitalize on more favourable interest rate spreads amidst tightening of U.S. monetary policy in response to an improving economy. Recall that real final sales in the U.S., i.e. GDP excluding inventories, grew a stunning 5.1% annualized during the second quarter, the best performance in 12 years. The only reason Q2 real GDP growth ended up at.1% (and not 5.1%) was the drag from inventories. The latter s drop, however, is good news for restocking activity and hence Q3 production. All in all, GDP growth this year (Q/Q) is on track to top 3%, the upper range of the Fed s forecasts. The labour market is also running hot as evidenced by the creation of 215K jobs/month on average in the first seven months of 218 (according to the establishment survey) and a jobless rate of just 3.9%. The tight labour market is creating cost pressures for firms the employment cost index for the private sector was up 2.9% year-on-year in Q2, the fastest pace in a decade and the Federal Reserve will do what it can to nip inflation in the bud. -1 26 28 21 212 21 216 218 NBF Economics and Strategy (data via Bureau of Economic Analysis, Bureau of Labor Statistics) But with the fed funds fast approaching the neutral rate, the impact of rate differentials on the USD will fade and eventually reverse as other major central banks tighten policy. Also keep in mind the bloating U.S. budget deficit and fading impact of fiscal stimulus on GDP growth. As such, we continue to expect the trade-weighted USD to weaken next year. ECB and BoJ keep money taps open Q2 For now, however, both the European Central Bank and Bank of Japan are in no rush to tighten policy. The ECB, which left monetary policy unchanged at its July meeting, said it expected interest rates to remain unchanged at least through the summer of 219. The ECB will continue to purchase assets at a pace of 3 bn/month until end-september after which the pace will drop to 15 bn/month until the end of the year when Quantitative Easing will end. The central bank will then reinvest principal payments from maturing securities for an extended period of time after the end of the net asset purchases. The ECB made clear that significant 1. Q2 28 21 212 21 216 218 2

monetary policy stimulus is still needed to support the further build-up of domestic price pressures and headline inflation developments over the medium term. As such looser monetary policy compared to the U.S. and the UK recall that the Bank of England raised interest rates to.75% in August will continue to weigh on the euro over the near term. For now speculators seem to be losing faith in the common currency based on their dwindling long positions. Comes a point, however, when investors will expect and hence price the end of Fed normalization, allowing yield differentials to push up EURUSD. Speculators losing faith in euro Non-commercial net long positions on the euro threatens to disrupt global trade flows and hence hurt growth prospects of emerging economies. Some emerging economies are better positioned than others to weather the current onslaught. Unlike Turkey and Argentina (whose currencies are among the worst performing this year), several major emerging economies including Brazil, India and China are in a much better economic situation than say 1997, when the Asian financial crisis started, thanks to sharp increases in foreign exchange reserves and manageable external deficits. But with foreign investors having a tendency of painting all emerging markets with the same brush, there s no guarantee even those economies with good fundamentals will remain unscathed. 16 12 Thousand contracts World: Can emerging economies weather the current onslaught? Current account balance versus FX reserves in 1997 and 218 8 3 China - -8-12 -16-2 -2 21 215 216 217 218 Like the euro, the yen is struggling with unfavourable yields against the U.S. The Bank of Japan, which was expected by markets to move towards normalization instead went for forward guidance, announcing its intention to maintain the current extremely low levels of short- and long-term interest rates for an extended period of time. The BoJ will continue with its asset purchase program with the amount outstanding of Japanese government bonds on its balance sheet increasing at an annual pace of 8 trillion. While the central bank says the economy is growing above its estimated potential, it bemoaned persistently weak inflation: due mainly to the experience of prolonged low growth and deflation firms' cautious wage- and price-setting stance as well as households' cautiousness toward price rises have not yet clearly changed. As such, the BoJ sees risks to prices as skewed to the downside. So, barring a sudden return of risk aversion, the yen is likely to remain under pressure over the forecast horizon. Emerging market currencies under pressure It s been a rough year so far for currencies of emerging economies. Investor sentiment has seemingly been impacted by mounting U.S. protectionism which Current account balance (% of GDP) 2 1-1 -2-3 - South Africa Mexico Brazil India Indonesia Turkey Argentina -5 Turkey Argentina -6 2 3 5 6 7 8 9 1 11 12 13 1 15 16 17 18 19 2 21 22 23 Foreign exchange reserves (% of GDP) NBF Economics and Strategy (data via IMF, Bloomberg) Indonesia South Africa Mexico India Brazil China The Chinese yuan for example has lost more than 8% against the USD since April. That s the worst four-month slump since 199 when the currency was devalued as part of broader reforms. Should the U.S. deliver on its threat to impose steeper tariffs on more imports from China, one can expect the yuan to sink further either via market forces or by currency management from Beijing. All told, emerging market currency woes could persist amidst trade-related uncertainties, boosting the trade-weighted USD at least over the near term. Yuan slump is worst since 199 Yuan per USD New U.S. Revaluation and Resumes reforms govt. with Devaluation as shift towards to increase protectionist 5.6-8 part of reforms managed float currency flexibility agenda % 5.8 - -month chg. (R) 6. 6.2 6. 6.6 6.8 7. 7.2 7. 7.6 7.8 8. 8.2 8. 8 12 16 2 2 28 32 36 8 Devaluation Tariffs 8.6 USDCNY(L) 52 2-year peg due to slowing imposed amidst global economy and by U.S. financial crisis 8.8 56 capital outflows 199 1996 1998 2 22 2 26 28 21 212 21 216 218 NBF Economics and Strategy (data via Datastream) 3

July surprise for loonie Better oil prices in 218 despite worst WCS-WTI spread in years Western Canada Select oil price versus Spread with WTI, annual averages The Canadian dollar shrugged off slumping oil prices and increased speculative short positions to gain 1% against the USD during July. And that despite largely unchanged interest rate spreads with the U.S. So, what exactly propelled the loonie last month? Capital inflows, which have been weak in the first half of the year, may have bounced back especially if investor sentiment about Canada s prospects improved. But because timely data is not available on capital flows, we ll have to wait a few months before confirming or rejecting that possibility. 9 8 7 6 5 3 2 1-1 -2 US$ WCS price/barrel WCS-WTI spread Speculative loonie shorts worst in a year Non-commercial net long positions on the Canadian dollar, monthly average -3 28 29 21 211 212 213 21 215 216 217 218* * Jan-Jul. average for 218 8 6 2 Thousand contracts So much so that the loonie s divergence with oil prices has worsened this year. As it turns out, the impact of unfavourable Canada-U.S. interest rate spreads has supplanted positives associated with higher oil prices. -2 - -6-8 -1 Jan 16 Apr 16 Jul 16 Oct 16 Jan 17 Apr 17 Jul 17 Oct 17 Jan 18 Apr 18 Jul 18 If capital flows were the reason for the C$ s surprise gains in July, then one can hardly be optimistic about the loonie s near term prospects given the increased likelihood of a reversal of those flows. As we ve seen in recent months, it only takes a wayward tweet to shift investor sentiment. And here we re thinking about the possibility of more heated rhetoric in the ongoing U.S.- Canada trade dispute. So, until the latter is resolved, it s difficult for us to see the Canadian dollar flourish in a sustainable way. Our forecast for the loonie to appreciate after Q3 is based on a trade deal being reached by Washington and Ottawa, something that admittedly may not happen this year. Could firmer oil prices save the loonie, even amidst persistent trade tensions? We re somewhat skeptical given the diverging trajectories of oil prices and the C$ this year. While WCS prices have risen this year the payoff could have been even better were it not for worsening spreads with WTI, the loonie has depreciated against the USD. Loonie should be stronger than current levels given current oil price WCS oil versus USDCAD, weekly data since May 28 USDCAD CNDOLL$ 1.8 1. 1. 1.36 1.32 1.28 1.2 1.2 1.16 1.12 1.8 1. 1..96.92 1 2 3 5 6 7 8 9 1 11 12 13 May/June/July WCS oil price (US$/barrel) SER1 So, should a trade deal materialize, the Canadian dollar s appreciation could be significant. The evaporation of trade-related uncertainties would brighten the economic outlook, increasing odds of policy tightening by the Bank of Canada and hence improve Canada-U.S. interest rate spreads. That would in turn allow the loonie to move closer to levels consistent with current oil prices. For now, we are keeping unchanged our target range of 1.25-1.35 for USDCAD for the next 12 months.

Annex Euro Canadian dollar 1.7 1.65 1.6 1.6 1.55 1.5 1.5 1.5 1. 1. 1.35 1.3 1.3 1.2 1.25 1.2 1.1 1.15 1.1 1. 1.5.9 1..95.8.9 Japanese yen Australian dollar 15 1.15 15 1.1 1 1.5 135 1. 13.95 125 12 115 11 15 1.9.85.8.75.7 95.65 9.6 85.55 8.5 75.5 British pound Chinese yuan 2.2 8.8 2.1 8.6 8. 2. 8.2 1.9 8. 7.8 1.8 7.6 1.7 7. 7.2 1.6 7. 1.5 6.8 1. 6.6 6. 1.3 6.2 1.2 6. 5.8 1.1 5.6 NBF Economics and Strategy (data via Datastream) Current 6-Aug-18 218Q3 218Q 219Q1 219Q2 219Q3 USDCAD 1.3 1.32 1.28 1.28 1.27 1.25 EURCAD 1.51 1.51 1.51 1.5 1.53 1.5 CADJPY 85 81 85 86 88 9 AUDCAD.96.96.97.99.99 1. GBPCAD 1.68 1.68 1.68 1.71 1.7 1.69 CADCNY 5.27 5.22 5.38 5.37 5.1 5. CADMXN 1.25 1. 1.59 1.51 1.38 1.32 *Forecasts for end of period NBF Economics and Strategy Canadian Dollar* 5

Economics and Strategy Montreal Office Toronto Office 51-879-2529 16-869-8598 Stéfane Marion Matthieu Arseneau Warren Lovely Chief Economist and Strategist Deputy Chief Economist MD & Head of Public Sector Strategy stefane.marion@nbc.ca matthieu.arseneau@nbc.ca warren.lovely@nbc.ca Krishen Rangasamy Paul-André Pinsonnault Marc Pinsonneault Senior Economist Senior Fixed Income Economist Senior Economist krishen.rangasamy@nbc.ca paulandre.pinsonnault@nbc.ca marc.pinsonneault@nbc.ca Kyle Dahms Jocelyn Paquet Angelo Katsoras Economist Economist Geopolitical Analyst kyle.dahms@nbc.ca jocelyn.paquet@nbc.ca angelo.katsoras@nbc.ca General This Report was prepared by National Bank Financial, Inc. (NBF), (a Canadian investment dealer, member of IIROC), an indirect wholly owned subsidiary of National Bank of Canada. National Bank of Canada is a public company listed on the Toronto Stock Exchange. 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