David Watt George Davis CMT Global FX Strategy

Senior Currency Strategist Chief Technical Analyst

RBC Dominion Securities Inc. RBC Dominion Securities Inc. 16 December 2010
+1 416 842 4328 +1 416 842 6633

CAD Pulse: The Grinch That Could Steal CAD Bulls’ Bliss

Market Summary CAD Pulse returns on January 13, 2011. We at RBC wish all a happy and safe holidays.
Currencies Level 1 wk chg FX Bottom-line: The confidence intervals around our FX forecasts remain significant and
z
USD/CAD 1.0071 -0.0035
EUR/CAD 1.3280 -0.0100 we have identified four key risks to our 2011 bullish CAD outlook: 1) spreading European
GBP/CAD 1.5675 -0.0263 sovereign issues; 2) a faltering US recovery; 3) a sharp downward correction in
CAD/JPY 83.77 0.9000
commodity prices and; 4) stumbling Canadian consumers.
USD/CAD RBC F Forwards z For 2011, we see USD/CAD declining toward 0.97 during the first nine months of the year
1M 1.0200 1.0077
3M 1.0100 1.0090 before retesting parity into year-end (spot at time of forecast: 1.01; Q3 11 Bloomberg
6M 0.9800 1.0114 consensus forecast: 1.01).
CAD cash rates Level 1 wk chg (bp) z We expect CAD to be one of the best performing G10 currencies during the first nine
BOC target 1.00 0 months of 2011.
1m 1.20 0
3m 1.30 0 RBC’s Canadian Dollar Valuations
6m 1.45 1
12m 1.77 3 Fundamentals Comment Impact on USD/CAD
Quarterly fair value USD/CAD is fairly valued §¨
Govt bonds Yield 1 wk chg (bp)
2yr 1.73 6
Weekly fair value USD/CAD is fairly valued §¨
5yr 2.56 7 Canadian Economic Surprise Index -33 and is bullish USD/CAD ©
10yr 3.32 7 Canadian Data Risk Barometer Neutral USD/CAD §¨
30yr 3.72 4
Market Positions and M&A Activity
CA-US spread (bp) Level 1 wk chg 1-month, 25-delta risk reversals Neutral USD/CAD §¨
2yr 105 0 Trend M&A inflows into Canada Net outflow of US$0.2bn and is bullish USD/CAD
5yr 60 27 §¨
10yr -24 -28
30yr -88 -17
1. RBC more bearish than market, but numerous upside risks as 2011 approaches
Equity markets Level 1 wk chg
Canada TSX comp. 13,161 -6
1.30 Most bullish/bearish v iew submitted to Bloomberg
US S&P500 1,235 2
Source: Bloomberg USD/CAD actual Upside risks to RBC's bearish
USD/CAD call:
RBC forecast
USD/CAD Options Faltering US recov ery
1.20
USD/CAD volatility Bloomberg consensus Increased sov ereign debt concerns
(%, annualised) Sharp commodity price correction
Historical Implied
Canadian consumers retrenching
1w 2.53 8.29
1m 10.23 8.73
3m 9.92 10.17 1.10
6m 10.93 11.05
12m 11.68 11.72
1m R.R 0.8c
Source: Bloomberg

1.00
USD/CAD Technicals
1.0350 Congestive resistance level
1.0140 Descending channel top
1.0071 Spot
0.9977 Key quintuple bottom 0.90
1.0350 Congestive resistance level
Jan-07 Jan-08 Jan-09 Jan-10 Jan-11
Source: Bloomberg

Source: RBC Capital Markets, Bloomberg

For Required Conflicts Disclosures, please see page 5.

16 December 2010 Global FX Strategy: CAD Pulse: The Grinch That Could Steal CAD Bulls’ Bliss

Developments That Could Upset The CAD Bullish Applecart

x
FX Bottom-line: Our USD/CAD call for 2011, with a cyclical
bottom around 0.97, is on the lower side of consensus.
Last week we laid out the rationale for our continued CAD
optimism¹. However, the confidence intervals around our
forecast remain significant and we have identified four key
risks to our medium-term bullish CAD outlook: 1)
spreading European sovereign issues; 2) a faltering US
recovery; 3) a sharp downward correction in commodity
prices; and 4) stumbling Canadian consumers.
For 2011, we see USD/CAD declining toward 0.97 during the
first nine months of the year before retesting parity into year-
end (spot at time of forecast: 1.01; Q3 11 Bloomberg
consensus forecast: 1.01). But, as emphasized by central
bankers around the globe, uncertainty around forecasts remain
historically elevated and no forecast (bullish or bearish) would
be complete without discussing the risks around the forecast.
Although obvious upside and downside risks flank our
USD/CAD forecast, we consider upside risks as more
significant with the potential magnitude impact on USD/CAD
clearly overshadowing the potential shock of downside risks.
We have identified four key risks to our medium-term bullish
CAD outlook: 1) spreading European sovereign issues, 2) a
faltering US recovery, 3) a sharp downward correction in
commodity prices and 4) stumbling Canadian consumers.
have downgraded the risk of a sluggish recovery in H1 2011
from critical to low and for H2 from critical to moderate.
However, with economic growth expectations increasingly
driving markets, doubts about the ability of the private sector to
eventually take over the growth baton could easily turn into
outright pessimism, similar to Q3 2010. An unemployment rate
hugging 10% rather than the expected gradual improvement, a
continuation of low consumer confidence and another wave of
housing weakness driven by shadow inventory, foreclosures
and distressed sales could fuel this pessimism. These
developments will affect global sentiment and the timing of the
expected normalization campaign by the BoC, possibly
resulting in a repeat of the perverse USD-economic data
relationship when disappointing US data resulted in a renewed
flight to safe haven assets, boasting UST’s, USD and JPY.
CAD will be particularly vulnerable against the crosses if this
risk materialises.
2. US-Can spreads expected to narrow further
1.30 1.3
0.8
1.20
0.3
1.10 -0.2

Risk 1) Spreading European sovereign issues: This week’s -0.7

European Council meeting is unlikely to end with a definite and 1.00
USD/CAD, LHS
detailed agreement amongst EU nations regarding the -1.2
expansion of the European Financial Stability Facility (EFSF), US-Can 2y r sw ap spread, RHS
0.90 -1.7
E-bonds or a long-term solution to the current
Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10
sovereign/banking problems faced by many Eurozone
members. The lack of clear direction could render the fiscally Source: RBC Capital Markets, Bloomberg
challenged EZ-members particularly vulnerable in early 2011
Risk 3) Commodity price correction: The V-shaped recovery
as a heavy European government bonds issuance season
in emerging markets has pushed commodity prices close to or
unfolds – for a detailed discussion see last week’s European
past their 2008 highs, with most commodity prices currently
Directions². Our European strategists see Portugal succumbing
trading at historically elevated but not necessarily unjustifiable
to the same fate as Ireland and Greece. Spain, on the other
levels – as long as emerging market growth continues. Our EM
hand, might be able to avoid a formal bailout, albeit barely. If
team sees overall EM growth moderating from 6.7% in 2010 to a
our Spanish call is wrong and Spanish spreads continue to
more sustainable 5.8% in 2011, enough to keep commodity
widen to the point where PM Zapatero’s hand is forced and he
prices around current levels, but insufficient to generate further
requests financial assistance, a new wave of European
upward momentum. However, an under-appreciation of the
sovereign concerns will likely emerge, weighing not only on
adverse impact on EM growth from slowing cross-border trade
peripheral Europe but also on core Europe as the fourth largest
and tighter monetary policy by EM central banks could lead to a
EZ member turns from contributor to the EFSF to the probably
sharp sell-off in commodity prices if reality starts undershooting
the biggest recipient. Global risk sentiment and
EM growth expectations. We consider this a moderate risk, but if
commodity/cyclical currencies, including CAD, will likely
this risk plays out, the impact on USD/CAD could be severe with
become collateral damage and safe havens USD and JPY the
a rally back to 1.10 quite conceivable.
beneficiaries. We consider this a critical risk to our USD/CAD
call. Risk 4) Stumbling Canadian consumers: Unlike US
households post the 2008 credit fallout, Canadian households
Risk 2) Faltering US recovery: The double-barrelled
continue to augment their purchases through borrowing. Since
approach by US authorities - QEII and an extension/expansion
the credit crisis, Canadian household debt has increased by 18%
of fiscal measures - has greatly reduced the probability of a
sluggish economic recovery during the early part of 2011. We … continued on next page …

2
Global FX Strategy: CAD Pulse: The Grinch That Could Steal CAD Bulls’ Bliss 16 December 2010

while US household credit declined by 2% over the same period. 4. Close tie between commodity prices and CAD
In Q3 2010 household debt in Canada, as a percentage of
0.60
personal disposable income, surpassed the US ratio and almost BoC Commodity Price Index , LHS
150% the BoC and Canadian government are justified in 800
0.80
sounding the warning bells. As noted in the latest (Dec) USD/CAD, inv erted, RHS
Financial System Review, developments “since the June FSR 600 1.00
suggest that the vulnerability of the Canadian household sector
has increased … Without a significant change in behaviour, the 1.20
proportion of households that would be susceptible to serious 400
1.40
financial stress from an adverse shock will continue to grow.
The probability of an adverse labour market shock materializing
200 1.60
is judged to have edged higher in recent months …” Also see
97 98 99 00 01 02 03 04 05 06 07 08 09 10
Global Directions³ for a more in depth discussion of Canadian
household debt issues. Thus, while it is unlikely that the
Source: RBC Capital Markets, Bloomberg
Canadian recovery will stall amid strong EM growth and a
decent recovery in the US, a growth slowdown in EM Asia (via 5. Sharp divergence between US and Canadian debt trends
commodities) or a faltering US economy could accentuate the 175 Household debt as % of
vulnerability of Canadian household balance sheets, potentially
personable disposable
necessitating a painful deleveraging at a time when the
150 income
Canadian recovery is not yet fully entrenched. Although non-
negligible, this risk is viewed as the least likely of the four risks
to come to fruition, but could exacerbate the adverse impact on 125
CAD as other risk scenarios unfolds.
USA
¹ CAD Pulse, 9 December, “US Stimulus a Balm to CAD Strength’s Sting, and 100
Global Directions, 9 December, “2011 Outlook.” As well, the Currency Report Canada
Card, 15 December, “2011 Outlook.”
² European Directions 8 December, “Supply Outlook Q1 2011.”
³ Also see the Canadian section of Global Directions, 16 December. 75
Mar-90 Mar-94 Mar-98 Mar-02 Mar-06 Mar-10

Source: RBC Capital Markets, Haver Analytics

Quintuple bottom at 0.9977 remains untested 6. USD/CAD: Trading range persists

Bearish price action has remained prevalent in USD/CAD as
prices remain mired near the bottom of the 0.9977-1.0679
trading range that has been in place since June. Our core
technical view is that bearish sentiment will persist as long as
prices remain below the key congestive resistance area at
1.0350 on a daily closing basis. The 200-day moving average at
1.0273 has also aided in limiting the upside since September.
We continue to stress that the key quintuple bottom at 0.9977
must give way in order to produce a new bearish phase for
USD/CAD and expose the 2010 low at 0.9931, followed by a
long-term support level at 0.9713 thereafter. Topside resistance
at 1.0140 and 1.0215 is expected to attract selling interest.
Source: RBC Capital Markets, Tradermade

Data Risk: Neutral USD/CAD

Dec Data/Event RBC Mkt Pre Risk *
20 Oct Wholesale Sales m/m 0.4%
21 Nov Consumer Price Index 2.4% (0.4%)
21 Nov Core CPI 1.8% (0.4%)
21 Oct Retail Sales (less auto) 0.6% (0.4%)
Source: RBC Capital Markets, Bloomberg

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16 December 2010 Global FX Strategy: CAD Pulse: The Grinch That Could Steal CAD Bulls’ Bliss

RBC Capital Markets Fixed Income & Currency Strategy

RBC Capital Markets, LLC:
Stevyn Schutzman Global Head of FIC Strategy & (212) 618-2553 stevyn.schutzman@rbccm.com
Research and Chief Macro Strategist

Europe
Royal Bank of Canada Europe Limited:
James Ashley Senior European Economist +44-20-7029-0133 james.ashley@rbccm.com
Norbert Aul European Rates Strategist +44-20-7029-0122 norbert.aul@rbccm.com
Gustavo Bagattini European Economist +44-20-7029 0147 gustavo.bagattini@rbccm.com
Adam Cole Global Head of FX Strategy +44-20-7029-7078 adam.cole@rbccm.com
Sam Hill UK Fixed Income Strategist +44-20-7029-0092 sam.hill@rbccm.com
Jens Larsen Chief European Economist +44-20-7029-0112 jens.larsen@rbccm.com
Christian Lawrence Fixed Income Strategist +44-20-7029-7085 christian.lawrence@rbccm.com
Elsa Lignos G10 Currency Strategist +44-20-7029-7077 elsa.lignos@rbccm.com
Peter Schaffrik Head of European Rates Strategy +44-20-7029-7076 peter.schaffrik@rbccm.com

Asia-Pacific
Royal Bank of Canada – Sydney Branch:
Su-Lin Ong Head of Australian and
New Zealand FIC Strategy +612-9033-3088 su-lin.ong@rbccm.com
Michael Turner Fixed Income & Currency Strategist +612-9033-3088 michael.turner@rbccm.com

Royal Bank of Canada – Hong Kong Branch:

Sue Trinh Senior Currency Strategist +852-2848-5135 sue.trinh@rbccm.com

North America
RBC Dominion Securities Inc.:
Mark Chandler Head of Canadian FIC Strategy (416) 842-6388 mark.chandler@rbccm.com
David Watt Senior Currency Strategist (416) 842-4328 david.watt@rbccm.com
Kam Bath Fixed Income Strategist (416) 842-6362 kam.bath@rbccm.com
George Davis Chief Technical Analyst (416) 842-6633 george.davis@rbccm.com
Paul Borean Associate (416) 842-2809 paul.borean@rbccm.com

RBC Capital Markets, LLC:

Michael Cloherty Head of US Rates Strategy (212) 437-2480 michael.cloherty@rbccm.com
Tom Porcelli Chief US Economist (212) 618-7788 tom.porcelli @rbccm.com
Jacob Oubina Senior US Economist (212) 618-7795 jacob.oubina@rbccm.com
Keith Blackwell Associate Rates Strategist (212) 858-6077 keith.blackwell@rbccm.com
Chris Mauro Head of US Municipals Strategy (212) 618-7729 chris.mauro@rbccm.com
Dan Grubert Associate (212) 618-7764 dan.grubert@rbccm.com

4
Global FX Strategy: CAD Pulse: The Grinch That Could Steal CAD Bulls’ Bliss 16 December 2010

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