March 2016
The Revenant

With the global economy continuing to struggle, markets desperately need some good news. China, a
major source of bearish market sentiment in recent months, now has an opportunity to be a source of
hope for the world economy as it presents its five-year plan in March. One can only hope Beijing doesn’t
under-deliver. Else, risk aversion could move up a gear and rekindle flight towards USD.

The greenback’s woes in February was partly due to soft US economic data which had investors pare
expectations about the Fed this year. While the trade-weighted USD should give back some of the
outsized gains registered in the last two years, it could nonetheless find bouts of strength if the
European Central Bank and the Bank of Japan decide to provide more stimulus.

Mauled by bears and left for dead just a few weeks ago, the Canadian dollar is now back with a
vengeance. The loonie’s Revenant-like performance was helped by a softening greenback, but
markets also started to question whether or not the Bank of Canada really needs to cut interest rates
considering that upcoming fiscal stimulus will provide a boost to the economy. The earlier oil price
collapse suggests there is more upside than downside for the commodity, and as such we remain
comfortable with our view that WTI will hit $40/barrel by year-end. While the loonie has room to
appreciate, don’t expect a linear movement towards our newly adjusted USDCAD end-of-year target
of 1.32. Currency volatility is the name of the game, more so with Canada’s dependence on short term
foreign inflows and much uncertainty with regards to commodity prices and Fed policy.
Stéfane Marion/Krishen Rangasamy
NBF Currency Outlook*
Current
2016Q1
2016Q2
2016Q3
2016Q4
2017Q1
29-Feb-16
USDCAD
US cents per CAD
1.35
0.74
1.35
0.74
1.34
0.75
1.33
0.75
1.32
0.76
1.30
0.77
EURUSD
1.09
1.07
1.08
1.09
1.10
1.11
USDJPY
113
115
118
122
125
125
AUDUSD
0.71
0.73
0.74
0.74
0.75
0.75
GBPUSD
1.39
1.36
1.41
1.43
1.45
1.46
USDCNY
6.55
6.54
6.52
6.51
6.50
6.50
AUDCAD
0.96
0.99
0.99
0.98
0.99
0.98
* forecasts for end of period
Source: NBF Economics and Strategy
FOREX
Will negative USD sentiment last?
The trade-weighted US dollar fell in February for the
first time in four months. Soft economic data had
investors pare expectations about the Fed this year.
Speculators also reduced their bets on the greenback,
although they still hold sizable net long positions.
Still plenty of long positions on US dollar
evidenced by manufacturing and services purchasing
managers indices which were both the weakest in a
year in February. ECB President Draghi already made
clear that staff estimates of inflation will again be
revised down. The annual inflation rate turned
negative in February, moving further away from the
ECB’s 2% target. But what the central bank will be
most concerned about is long term inflation
expectations which have sunk to all-time lows.
Non-commercial net long positions on USD
90,000
Eurozone: Long term inflation expectations are dropping fast
contracts
Inflation expectations in 5 years for the next five years
80,000
2.9 %
70,000
2.8
60,000
2.7
50,000
2.6
40,000
2.5
2.4
30,000
2.3
20,000
2.2
10,000
2.1
1.9
-10,000
1.8
-20,000
1.7
-30,000
ECB inflation target
2.0
0
1.6
2000
2002
2004
2006
2008
2010
2012
2014
2016
NBF Economics and Strategy (data via Bloomberg)
1.5
1.4
1.3
2004
While the FOMC is still on track to raise interest rates
this year because of the tight labour market and uptick
in the inflation rate, it may want to wait for global
market jitters to subside and for domestic data to
improve before hiking again. Recall that US GDP
growth moderated to 1% in the final quarter of 2015,
and considering the inventory buildup odds are that
growth won’t be spectacular in Q1 either. Also note
that the ISM manufacturing index has now been in
contraction territory (i.e. under 50) for four months in a
row, something that hasn’t been seen since the Great
recession of 2008/09. With enhanced uncertainties
about 2016 prospects, the Fed will act with utmost
caution.
We expect the Fed to deliver at most two of the four
hikes it says it expects this year. We continue to see
the trade-weighted USD giving back some of the
outsized gains registered in the last two years, helped
in part by a further drop in the still-sizable net long
speculative positions. But the decline won’t be linear.
The world’s reserve currency could find bouts of
strength if the Bank of Japan or European Central
Bank decide to provide more stimulus.
ECB should do more in March
To be sure, the ECB is poised to loosen monetary
policy further at its March meeting. After growing last
year at the fastest pace in four years, the Eurozone
economy now seems to be struggling a bit as
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015 2016
NBF Economics and Strategy (data via Bloomberg)
In addition to pushing interest rates further into
negative territory, the central bank may increase the
size of its QE program to give itself a better chance of
defeating deflation. That will put pressure on the euro
to depreciate towards 1.07 against the USD before the
end of Q1. Longer-term, however, the common
currency has room to make a comeback as increases
in government expenditures to address the migrant
crisis, e.g. on housing and social services, provide a
lift to growth and allow the ECB to take a breather.
And if, as we expect, the USD loses steam later this
year, EURUSD could again head up past 1.10.
Yen and Sterling diverge
Helping push the trade-weighted USD down is the
Japanese yen which is likely benefiting from unwinding
of carry trades due to risk aversion. USDJPY has
appreciated over the last three months at the fastest
pace since 2008. So, the Bank of Japan’s surprise
move to take interest rates into negative territory did
not have the intended effects. Perhaps the central
bank will have to instead consider increasing the size
of its QE program to have a chance of fighting off
deflation and bring the yen back to more competitive
levels. The trade-weighted USD’s dive in February
could have been much more brutal were it not for the
British Pound’s slump. Latest polls suggest Britons are
equally divided about “Brexit” i.e. the prospect of the
2
FOREX
UK leaving the European Union. The related
uncertainties have taken cable down more than 5%
this year to hit its lowest level since 2009. Our forecast
for GBPUSD to bounce back above 1.40 by mid-year
assumes the June 23rd referendum keeps the UK in
the EU.
all developing economies. So, China’s public sector
has plenty of room to borrow and invest.
China: Plenty of room for government to borrow and invest
External debt stock
36
% of Gross National Income
32
28
Yen surges on risk aversion, GBP plunges on Brexit fears
Japanese yen versus British Pound
260
Developing Total
24
GBPJPY
20
250
240
16
230
12
220
210
China Total
8
200
4
190
180
0
170
160
China public sector
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
NBF Economics and Strategy (data via World Bank)
150
140
130
120
110
Feb.
2016
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
NBF Economics and Strategy (data via Bloomberg)
Yuan policy remains unclear
Another wildcard that could lift the trade-weighted
USD is yuan weakness. The persistence of capital
outflows has put China’s currency under pressure but
the government is doing what it can to support the
currency by selling reserves. Last year Beijing ran
down its foreign currency reserves by about half a
trillion dollars to maintain the peg with the USD. But
that’s clearly not sustainable.
The government needs to stem those outflows by
bringing back confidence in China’s economy and its
currency. That is why the five-year plan to be
presented in March is so crucial. One can only hope
Beijing doesn’t under-deliver. Else, risk aversion could
move up a gear and rekindle flight towards USD.
The government has been doing the groundwork to
give the five-year plan the best chance of success. It
granted foreign access to the majority of its onshore
bond market: the third largest in the world at $7.5
trillion USD. Why is that important? The central
government’s pledge to enhance the generosity of
social programs in order to unleash consumer
spending (and reduce household savings rate of
around 30%) can only be accomplished by leveraging
the central government with the help of foreign money.
And China’s public sector has plenty of room to
borrow. Note that Chinese debt held by foreigners is
only 10% of GNI currently (with public sector debt a
puny 1.5%). That compares to an average of 24% for
The move to open up its bond markets is expected to
encourage portfolio repositioning among global
investors and help create two-way flows on the yuan.
If that works as intended, the currency could break out
of its current downtrend.
Loonie makes comeback
Even Leo DiCaprio should be impressed. Mauled by
bears and left for dead just a few weeks ago, the
Canadian dollar is now back with a vengeance. After
plunging as low as 1.46 early in the year, USDCAD is
now testing 1.35. And that, even with commodity prices
remaining depressed. The loonie’s Revenant-like
performance was helped by a softening greenback, but
markets are also looking at yields and starting to
question whether or not the Bank of Canada really
needs to cut interest rates considering that upcoming
fiscal stimulus will provide a boost to the economy.
Canada: The Revenant Loonie
Bank of Canada commodity index and
Canadian dollar
520
Probability of Bank of Canada lowering
overnight rate in 2016
1.16
Loonie has made a
comeback despite
relatively stagnant
commodities ...
500
480
460
1.18
1.20
1.22
440
1.24
420
1.26
400
1.28
380
360
340
1.30
BoC
commodity
price index (L)
1.32
1.34
320
1.36
300
1.38
280
1.40
260
220
2015q1
1.42
USDCAD (R)
240
2015q1
2015q2
2015q3
2015q4
1.44
2016q1
1.46
70
%
... in part due to
markets lowering
expectations about
BoC rate cuts
60
50
40
30
20
10
0
End-January
End-February
NBF Economics and Strategy (data via Bloomberg)
3
FOREX
True, the latest fiscal update made clear public finances
are deeper in the red than first thought, but the
government pledged again to increase fiscal stimulus to
boost an otherwise stagnant Canadian economy. If, as
we expect, the Liberal government delivers on its
election promises, the budget deficit could top C$25
billion over each of the next two fiscal years.
Budget deficits of $34 bn over next two years … before stimulus
Projections for Canadian budget balance
2016-2017
0
2017-2018
negative last year, i.e. net direct investment by
foreigners were more than offset by massive outflows
by Canadian corporations whose direct investment
abroad hit C$104 bn, the highest ever. Instead, the
external deficit last year was financed entirely by short
term flows such as portfolio flows and “other” flows
such as loans, currency and deposits. Those relatively
unstable flows ― because they can quickly reverse ―
have potential to cause gyrations in the loonie’s value.
Canada: External deficit financed entirely by short-term flows last year
Financing the current account deficit
-5
FDI
-15.5
-18.4
-10
150
-15
Other
Portfolio
Current account deficit
C$ bn
100
-20
50
-25
0
-30
C$ bn
Feb2016 update with Liberal platform stimulus
Feb2016 update without stimulus
-50
NBF Economics and Strategy (data via Department of Finance)
-100
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Ottawa seems to have convinced markets. Investors
have lowered their expectations of a BoC rate cut this
year with the probability of a rate cut falling from nearly
70% to roughly 40% at the end of February. The
Canadian dollar’s comeback isn’t over in our view. The
earlier oil price collapse suggests there is more upside
than downside for the commodity. If, as we expect,
WTI hits $40/barrel this year, USDCAD could be in the
low 1.30’s by year-end.
But don’t rule out volatility. Canada’s massive current
account deficit leaves the loonie vulnerable. Note that
Canada’s external balance last year was C$65.7 bn, the
worst ever.
Goods Services Investment income Other TOTAL
80
60
40
C$ bn
C$ bn
50
Inflows
0
Large external
deficit leaves
CAD vulnerable
1.5
1.0
-10
0.5
NET
-20
0.0
-0.5
0
60
10
2.0
20
Portfolio flows
20
% of GDP
2.5
Deterioration of
current account last
year largely due to
goods trade
Canada: Net portfolio outflows in Q4 last year
30
Current account balance
3.0
As we’ve seen in recent months, portfolio flows can
have a sizable impact on the currency. While investors
continued to buy Canadian securities in Q4 last year
that was more than offset by Canadians putting a record
amount of capital to work outside the country. On net,
the portfolio outflows in Q4 were the worst since 2007.
Little wonder that the Canadian dollar came under such
intense pressure during that period.
40
Canada: Current account deteriorated sharply last year
Current account balance by component
NBF Economics and Strategy (data via Statistics Canada)
-30
Outflows
-1.0
-20
-40
-1.5
-2.0
-40
Q4
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
NBF Economics and Strategy (data via Statistics Canada)
-2.5
-3.0
-60
-3.5
-80
-4.0
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
-4.5
1985
1990
1995
2000
2005
2010
2015
NBF Economics and Strategy (data via Statistics Canada)
But the really bad news was the way the external
deficit was financed. The preferred source of
financing, FDI because it is stable and long term, was
So, while the loonie has room to appreciate with
improving oil prices, don’t expect a linear movement
towards our newly adjusted USDCAD end-of-year
target of 1.32. Currency volatility is the name of the
game, more so with Canada’s dependence on short
term foreign inflows and much uncertainty with regards
to commodity prices and Fed policy.
4
FOREX
Annex
Euro
Canadian dollar
1.7
1.65
1.60
1.6
1.55
1.50
1.5
1.45
1.40
1.4
1.35
1.3
1.30
1.25
1.2
1.20
1.1
1.15
1.10
1.0
1.05
1.00
0.9
0.8
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
0.95
0.90
1994
1996
1998
Japanese yen
1.15
140
1.05
135
1.00
130
2004
2006
2008
2010
2012
2014
0.95
2010
2012
2014
2010
2012
2014
1.10
125
0.90
120
0.85
115
110
0.80
0.75
105
0.70
100
95
0.65
90
0.60
85
0.55
80
0.50
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
0.45
1994
1996
1998
2000
British pound
2.1
2.0
1.9
1.8
1.7
1.6
1.5
1.4
1994
1996
1998
2000
2002
2004
2006
2008
2002
2004
2006
2008
Chinese yuan
2.2
1.3
2002
Australian dollar
150
145
75
2000
2010
NBF Economics and Strategy (data via Datastream)
2012
2014
8.8
8.6
8.4
8.2
8.0
7.8
7.6
7.4
7.2
7.0
6.8
6.6
6.4
6.2
6.0
5.8
5.6
1994
1996
1998
2000
2002
2004
2006
2008
5
FOREX
ECONOMICS AND STRATEGY Montreal Office
Toronto Office 514‐879‐2529 416‐869‐8598
Stéfane Marion Marc Pinsonneault Warren Lovely Chief Economist & Strategist Senior Economist MD, Public Sector Research and Strategy
stefane.marion@nbc.ca marc.pinsonneault@nbc.ca warren.lovely@nbc.ca Paul‐André Pinsonnault Matthieu Arseneau Senior Fixed Income Economist Senior Economist Krishen Rangasamy Angelo Katsoras Senior Economist Geopolitical Associate Analyst krishen.rangasamy@nbc.ca matthieu.arseneau@nbc.ca paulandre.pinsonnault@nbc.ca angelo.katsoras@nbc.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.
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.  Canadian Residents: In respect of the distribution of this report in Canada, NBF accepts responsibility for its contents. To make
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