Matthew Strauss George Davis CMT Global FX Strategy

Senior Currency Strategist Chief Technical Analyst

RBC Dominion Securities Inc. RBC Dominion Securities Inc. 4 November 2010
+1 416 842 6631 +1 416 842 6633

CAD Pulse: BoC vs Fed – A 2002/03 Policy Rerun?

Market Summary z FX Bottom-line: Heading into 2011, USD/CAD is facing a divergence in US-
Currencies Level 1 wk chg Canadian policy rates reminiscent of the 2002/03 period. Although USD/CAD
USD/CAD 1.0026 -0.0185 declined by 15% during that period, we do not envision a similar demise in
EUR/CAD 1.4247 0.0022
GBP/CAD 1.6312 0.0028 USD/CAD but diverging policy stances will keep USD/CAD under downward
CAD/JPY 80.45 1.1100 pressure throughout 2011.
USD/CAD RBC F Forwards z The Fed continues to pursue easier monetary policy while the BoC may have simply
1M 1.0200 1.0033 postponed its tightening/normalization campaign as a precautionary move.
3M 1.0400 1.0048
6M 1.0100 1.0072 z However, should the growth decoupling between the global and the US recoveries
CAD cash rates Level 1 wk chg (bp)
continue at the same pace as seen during the last 12 months, the 2002/03 scenario
BOC target 1.00 0 could well repeat itself in the currency market, leaving the trend in CAD against
1m 1.19 0 USD looking increasingly similar to the most recent rally in AUD/USD.
3m 1.29 0
6m 1.38 1 RBC’s Canadian Dollar Valuations
12m 1.67 0
Fundamentals Comment Impact on USD/CAD
Govt bonds Yield 1 wk chg (bp) Quarterly fair value USD/CAD is fairly valued §¨
2yr 1.41 -2
5yr 1.97 -6 Weekly fair value USD/CAD is fairly valued §¨
10yr 2.82 -6 Canadian Economic Surprise Index +33 and is bearish USD/CAD ª
30yr 3.48 0
Canadian Data Risk Barometer Neutral USD/CAD §¨
CA-US spread (bp) Level 1 wk chg Market Positions and M&A Activity
2yr 109 2 1-month, 25-delta risk reversals Neutral USD/CAD §¨
5yr 1 13 Trend M&A inflows into Canada Net outflow of US$0.7bn and is bullish USD/CAD
10yr 35 13 ©
30yr -55 1 1. Official policy stance expected to diverge even further
Equity markets Level 1 wk chg 13.0 Offical rates - Fed funds, Canadian ov ernight (bank rate -25bp prior to 1993)
Canada TSX comp. 12,879 315
US S&P500 1,214 30 USA
Source: Bloomberg 11.0
Canada

USD/CAD Options 9.0 RBC Outlook

USD/CAD volatility
(%, annualised)
Historical Implied 7.0
1w 3.25 11.39
1m 10.42 11.31
3m 10.84 11.61 5.0
6m 12.85 12.19
12m 11.94 12.74
1m R.R 0.3c 3.0
Source: Bloomberg

1.0

USD/CAD Technicals -1.0

1.0350 Congestive resistance level
1.0121 Short-term resistance trendline 91 96 01 06 11
1.0026 Spot
0.9977 Triple bottom
0.9820 Descending channel base Source: RBC Capital Markets, Bloomberg

Source: Bloomberg

For Required Conflicts Disclosures, please see page 5.

4 November 2010
BoC and FOMC – A 2002/03 Policy Rerun?
Matthew Strauss
FX Bottom-line: Heading into 2011, USD/CAD is facing a
divergence in US-Canadian policy rates reminiscent of the
2002/03 period. Although USD/CAD declined by 15%
during that period, we do not envision a similar demise in
USD/CAD but diverging policy stances will keep USD/CAD
under downward pressure throughout 2011. However,
should the growth decoupling between the global and the
US recoveries continue at the same pace as seen during
the last 12 months, the 2002/03 scenario could well repeat
itself in the currency market, leaving the trend in CAD
against USD looking increasingly similar to the most
recent rally in AUD/USD.
During the last 19 years (and since the Bank of Canada adopted
inflation targeting in 1991), the period between 2002 and 2003
stands out as the only meaningful divergence in monetary policy
approaches between Canada and the US. The BoC hiked rates
5 times between April 02 and April 03, from 2.00% to 3.25%,
while Greenspan took US rates down from 1.75% to 1.00% in
June 2003. USD/CAD fell 15% over the same 15-month period
as these divergences promised a cyclical decoupling between
these two economies, backed by expectations of sub-par US
growth, strong global growth and higher commodity prices (crude
oil prices almost doubled between Dec 2002 and March 2003).
However, the divergence was interrupted by SARS*, BSE and
the dampening effect of a stronger currency on the local
economy. The BoC was forced to give back the hikes during the
subsequent twelve months. USD/CAD, however, hardly
recovered any of its prior losses, but found a new base around
1.30 / 1.40 after trading as high as 1.60 in 2002.
Fast forward to November 2010 – the Fed continues to pursue
easier monetary policy while the BoC may have simply
postponed its tightening/normalization campaign as a
precautionary move against a possible further growth slowdown
in the US. The FOMC announced another round of quantitative
easing yesterday – to the tune of US$600bn, expected to unfold
through mid-2011. In contrast, the BoC noted at the last meeting
on October 19th that “any further reduction in monetary policy
stimulus would need to be carefully considered”. Thus, while
FOMC members are prepared to deliver more stimulus if
economic data deteriorate further; the BoC, at present, merely
seems prepared to hold off on further hikes well into 2011 should
data disappoint.
Our own expectations are that Q3 probably represented the
slowest quarterly growth increase of the current recoveries in
both the US and Canada. Heading into 2011 we expect both
recoveries to regain traction, although renewed momentum will
fall well short compared to previous recoveries. The timing of
additional policy action by both the Fed and the BoC will of
course depend on the strength of these expected recoveries.
Exact timing aside, it is easy to see the Canadian economy
regaining momentum faster and stronger than the US given the
absence of a housing slump in Canada, decent Canadian job
2
Global FX Strategy: CAD Pulse: BoC vs Fed – A 2002/03 Policy Rerun?
creation (which should be confirmed by Oct employment data
released on Friday), relatively strong balance sheets compared
to the US, a healthy banking sector, the lesser degree of fiscal
tightening needed in Ottawa and Canada’s vast commodity
base. Thus, while the Fed will probably wait until at least a
number of months after the final QE2 purchases in 2011 to start
talking about exit strategies (with the first interest rate hike even
further down the line), the BoC seems prepared to pull the
trigger much sooner. The next BoC hike could well occur 6 to 12
months before the first change in the Fed funds rate and might
even start before the Fed has completely taken QE off the table.
Once the BoC re-engages the normalization campaign, we
expect a steady 25bp increase per meeting during the initial
phase, but as noted in the CAD Pulse on September 30, cyclical
divergences between Canada and the US have limits and we do
not expect the BoC to open the official rate gap much beyond
200bp (gap currently just below 100bp). At present, the market is
hardly pricing in any further policy divergence.
2. US and Canadian rate expectations not too different
YEN Ex pectations of rate increases
0
ex pected until:
USD 16 34
AUD 31 29 Nov '11
CAD 26 35 Nov '12
CHF 23 42 Cumulativ e increase in basis points
EUR 43 37
GBP 24 60
SEK 49 36
NZD 97 58
0 50 100 150 200
Source: RBC Capital Markets, Bloomberg
However, unlike 2002/03 we do not see USD/CAD plummeting
but rather grinding lower given that our base case scenario also
includes a broad-based USD recovery as US economic growth
slowly regains traction with limited upside surprises in economic
activity in the rest of the globe and therefore limited commodity
price appreciation. These assumptions also highlight an
important risk to our medium-term USD/CAD outlook. Should the
growth decoupling between the global recovery and the US
continue at the same pace as seen during the last 12 months,
i.e. above-trend growth in emerging markets, increasing
commodity prices and sluggish US growth, the pace of decline in
USD/CAD could well mirror 2002/03 although the BoC, unlike
the RBA, will likely be less enthusiastic to raise rates in an
environment characterized by aggressive USD/CAD declines.
But then again, if the decline is largely driven by a strong
improvement in Canada’s terms of trade, as in Australia, CAD
strength might be more readily accepted by the BoC.
* SARS – Severe Acute Respiratory Syndrome
** BSE – Bovine Spongiform Encephalopathy
Global FX Strategy: CAD Pulse: BoC vs Fed – A 2002/03 Policy Rerun? 4 November 2010

Full-time jobs still below pre-crisis levels 3. Quality, not only quantity, is needed
The strong recovery in Canadian jobs during 2010 (up 328K 3700
14000
year-to-date), together with the gains in H2 2009 (95K), more
than offset the 417K jobs lost during the recession. However, 13500 3500
the quality of new jobs created has deteriorated. Part-time jobs 3300
13000
have increased by 200K during the last 11 months, pushing total
part-time jobs passed the pre-crisis peak. Full-time jobs, on the 12500 3100
other hand, are still 157K short of the 2008 peak despite having 2900
12000
added 333K since the depth of the crisis. Expectations are for a Full-Time Employ ment, LHS
30K increase in full-time jobs in October, continuing the path of 11500 2700
Part-Time Employ ment, RHS
both a quantitative and qualitative recovery. Also, private sector 11000 2500
jobs have not yet fully recovered from the recession lows and
00 02 04 06 08 10
need to add another 162K to surpass the previous peak.
Source: RBC Capital Markets, Haver Analytics

Trade balance – another negative month coming up 4. Trade - staying in the red
Canada’s August trade deficit improved to C$1.3bn from 10 C$bn
C$2.70bn in July, a stronger improvement than the C$2.25bn 8
deficit expected. In Aug, exports caught the market off side, with 6
a stellar 3.1% (C$1.0bn) increase. Such an increase is unlikely 4
to be repeated in September according to our economists who 2
believe the number overstated the underlying concerns facing 0
Canadian exporters, both from a currency perspective and given -2
the slow growth in the US in Q3. Exports are expected to Trade ex Energy Balance C$bn
-4 Total Trade Balance
decline by 0.8%, with a small decline in imports marginally -6 Energy Trade Balance
offsetting the impact on the trade balance, leaving the trade -8
deficit slightly worse off than in August and pushing the 2010
00 01 02 03 04 05 06 07 08 09 10
deficit even further into the red.
Source: RBC Capital Markets, Bloomberg
USD/CAD testing bottom end of technical range 5. Close below 0.9977 would expose 0.9820 next
Bearish sentiment has prevailed in USD/CAD after the recent
price correction failed to surmount the congestive resistance
level at 1.0350. We note that the subsequent move lower has
formed a descending channel pattern that has pushed prices
toward parity – and just shy of a key triple bottom at 0.9977.
This is the next key downside level to watch now, with a daily
close below 0.9977 adding to bearish price momentum. This
outcome would then expose secondary support against the
channel base at 0.9820, followed by a long-term level at 0.9713.
With the daily studies at neutral valuation levels, retracements
to resistance at 1.0121 and 1.0350 are expected to attract
selling interest in USD/CAD.
Source: RBC Capital Markets, Tradermade

Data Risk Neutral USD/CAD

Nov Data/Event RBC Mkt Pre Risk *
8 Oct Housing Starts 184.0K 186.4K
9 Sep Housing Price Index 0.1%
10 Sep International Merchandise Trade -1.5bn -1.3bn
Source: RBC Capital Markets, Bloomberg

3
4 November 2010 Global FX Strategy: CAD Pulse: BoC vs Fed – A 2002/03 Policy Rerun?

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4
Global FX Strategy: CAD Pulse: BoC vs Fed – A 2002/03 Policy Rerun? 4 November 2010

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