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

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For Required Conflicts Disclosures, please see page 5.

David WattSenior Currency StrategistRBC Dominion Securities Inc.

+1 416 842 4328

George Davis CMTChief Technical AnalystRBC Dominion Securities Inc.

+1 416 842 6633

Global FX Strategy

16 December 2010

CAD Pulse: The Grinch That Could Steal CAD Bulls Bl iss

Market Summary

Currencies Level 1 wk chg

USD/CAD 1.0071 -0.0035EUR/CAD 1.3280 -0.0100GBP/CAD 1.5675 -0.0263CAD/JPY 83.77 0.9000

USD/CAD RBC F Forwards

1M 1.0200 1.00773M 1.0100 1.00906M 0.9800 1.0114

CAD cash rates Level 1 wk chg (bp)BOC target 1.00 01m 1.20 03m 1.30 06m 1.45 112m 1.77 3

Govt bonds Yield 1 wk chg (bp)2yr 1.73 65yr 2.56 710yr 3.32 730yr 3.72 4

CA-US spread (bp) Level 1 wk chg2yr 105 05yr 60 2710yr -24 -2830yr -88 -17

Equity markets Level 1 wk chgCanada TSX comp. 13,161 -6US S&P500 1,235 2

Source: Bloomberg

USD/CAD Options

USD/CAD volatility

(%, annualised)Historical Implied

1w 2.53 8.291m 10.23 8.733m 9.92 10.176m 10.93 11.0512m 11.68 11.721m R.R 0.8c

Source: Bloomberg

USD/CAD Technicals

1.0350 Congestive resistance level

1.0140 Descending channel top1.0071 Spot

0.9977 Key quintuple bottom1.0350 Congestive resistance level

Source: Bloomberg

CAD Pulse returns on January 13, 2011. We at RBC wish all a happy and safe holidays.

FX Bottom-line: The confidence intervals around our FX forecasts remain significant and

we have identified four key risks to our 2011 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).

We expect CAD to be one of the best performing G10 currencies during the first nine

months of 2011.

RBCs Canadian Dollar Valuations

Fundamentals Comment Impact on USD/CAD

Quarterly fair value USD/CAD is fairly valued

Weekly fair value USD/CAD is fairly valued

Canadian Economic Surprise Index -33 and is bullish USD/CAD

Canadian Data Risk Barometer Neutral USD/CAD

Market Positions and M&A Activ ity1-month, 25-delta risk reversals Neutral USD/CAD Trend M&A inflows into Canada Net outflow of US$0.2bn and is bullish USD/CAD

1. RBC more bearish than market, but numerous upside risks as 2011 approaches

0.90

1.00

1.10

1.20

1.30

Jan-07 Jan-08 Jan-09 Jan-10 Jan-11

Most bullish/bearish v iew submitted to Bloomberg

USD/CAD actual

RBC forecast

Bloomberg consensus

Upside risks to RBC's bearish

USD/CAD call:

Faltering US recovery

Increased sovereign debt concerns

Sharp commodity price correctionCanadian consumers retrenching

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

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Developments That Could Upset The CAD Bullish Applecartx

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

optimism. However, the confidence intervals around our

forecast remain significant and we have identified four keyrisks 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.

Risk 1) Spreading European sovereign issues:This weeks

European Council meeting is unlikely to end with a definite and

detailed agreement amongst EU nations regarding theexpansion of the European Financial Stability Facility (EFSF),

E-bonds or a long-term solution to the current

sovereign/banking problems faced by many Eurozone

members. The lack of clear direction could render the fiscally

challenged EZ-members particularly vulnerable in early 2011

as a heavy European government bonds issuance season

unfolds for a detailed discussion see last weeks European

Directions. Our European strategists see Portugal succumbing

to the same fate as Ireland and Greece. Spain, on the other

hand, might be able to avoid a formal bailout, albeit barely. If

our Spanish call is wrong and Spanish spreads continue towiden to the point where PM Zapateros hand is forced and he

requests financial assistance, a new wave of European

sovereign concerns will likely emerge, weighing not only on

peripheral Europe but also on core Europe as the fourth largest

EZ member turns from contributor to the EFSF to the probably

the biggest recipient. Global risk sentiment and

commodity/cyclical currencies, including CAD, will likely

become collateral damage and safe havens USD and JPY the

beneficiaries. We consider this a critical risk to our USD/CAD

call.

Risk 2) Faltering US recovery: The double-barrelledapproach by US authorities - QEII and an extension/expansion

of fiscal measures - has greatly reduced the probability of a

sluggish economic recovery during the early part of 2011. We

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 intooutright 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 USTs, USD and JPY.

CAD will be particularly vulnerable against the crosses if this

risk materialises.

2. US-Can spreads expected to narrow further

0.90

1.00

1.10

1.20

1.30

Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10

-1.7

-1.2

-0.7

-0.2

0.3

0.8

1.3

USD/CAD, LHS

US-Can 2yr swap spread, RHS


Risk 3) Commodity price correction:The V-shaped recovery

in emerging markets has pushed commodity prices close to or

past their 2008 highs, with most commodity prices currently

trading at historically elevated but not necessarily unjustifiable

levels as long as emerging market growth continues. Our EM

team sees overall EM growth moderating from 6.7% in 2010 to a

more sustainable 5.8% in 2011, enough to keep commodity

prices around current levels, but insufficient to generate further

upward momentum. However, an under-appreciation of the

adverse impact on EM growth from slowing cross-border trade

and tighter monetary policy by EM central banks could lead to a

sharp sell-off in commodity prices if reality starts undershooting

EM growth expectations. We consider this a moderate risk, but if

this risk plays out, the impact on USD/CAD could be severe with

a rally back to 1.10 quite conceivable.

Risk 4) Stumbling Canadian consumers: Unlike US

households post the 2008 credit fallout, Canadian households

continue to augment their purchases through borrowing. Since

the credit crisis, Canadian household debt has increased by 18%

continued on next page


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

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4. Close tie between commodity prices and CAD

200

400

600

800

97 98 99 00 01 02 03 04 05 06 07 08 09 10

0.60

0.80

1.00

1.20

1.40

1.60

BoC Commodity Price Index, LHS

USD/CAD, inverted, RHS


5. Sharp divergence between US and Canadian debt trends

while US household credit declined by 2% over the same period.

In Q3 2010 household debt in Canada, as a percentage of

personal disposable income, surpassed the US ratio and almost

150% the BoC and Canadian government are justified in

sounding the warning bells. As noted in the latest (Dec)

Financial System Review, developments since the June FSR

suggest that the vulnerability of the Canadian household sector

has increased Without a significant change in behaviour, the

proportion of households that would be susceptible to serious

financial stress from an adverse shock will continue to grow.

The probability of an adverse labour market shock materializing

is judged to have edged higher in recent months Also see

Global Directions for a more in depth discussion of Canadian

household debt issues. Thus, while it is unlikely that the

Canadian recovery will stall amid strong EM growth and a

decent recovery in the US, a growth slowdown in EM Asia (via

commodities) or a faltering US economy could accentuate the

vulnerability of Canadian household balance sheets, potentially

necessitating a painful deleveraging at a time when the

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

CAD as other risk scenarios unfolds.

CAD Pulse, 9 December, US Stimulus a Balm to CAD Strengths Sting, anGlobal Directions, 9 December, 2011 Outlook. As well, the Currency ReportCard, 15 December, 2011 Outlook. European Directions 8 December, Supply Outlook Q1 2011. Also see the Canadian section of Global Directions, 16 December. 75

100

125

150

175

Mar-90 Mar-94 Mar-98 Mar-02 Mar-06 Mar-10

USA

Canada

Household debt as % of

personable disposable

income

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 along-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

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RBC Capital Markets Fixed Income & Currency Strategy

RBC Capital Markets, LLC:

Stevyn Schutzman Global Head of FIC Strategy &

Research and Chief Macro Strategist

(212) 618-2553 [email protected]

Europe

Royal Bank of Canada Europe Limited:

James Ashley Senior European Economist +44-20-7029-0133 [email protected]

Norbert Aul European RatesStrategist +44-20-7029-0122 [email protected]

Gustavo Bagattini European Economist +44-20-7029 0147 [email protected]

Adam Cole Global Head of FX Strategy +44-20-7029-7078 [email protected]

Sam Hill UK Fixed Income Strategist +44-20-7029-0092 [email protected]

Jens Larsen Chief European Economist +44-20-7029-0112 [email protected]

Christian Lawrence Fixed Income Strategist +44-20-7029-7085 [email protected]

Elsa Lignos G10 Currency Strategist +44-20-7029-7077 [email protected]

Peter Schaffrik Head of European Rates Strategy +44-20-7029-7076 [email protected]

Asia-Pacific

Royal Bank of Canada Sydney Branch:

Su-Lin Ong Head of Australian andNew Zealand FIC Strategy +612-9033-3088 [email protected]

Michael Turner Fixed Income & Currency Strategist +612-9033-3088 [email protected]

Royal Bank of Canada Hong Kong Branch:

Sue Trinh Senior Currency Strategist +852-2848-5135 [email protected]

North America

RBC Dominion Securities Inc.:

Mark Chandler Head of Canadian FIC Strategy (416) 842-6388 [email protected]

David Watt Senior Currency Strategist (416) 842-4328 [email protected]

Kam Bath Fixed Income Strategist (416) 842-6362 [email protected]

George Davis Chief Technical Analyst (416) 842-6633 [email protected]

Paul Borean Associate (416) 842-2809 [email protected]

RBC Capital Markets, LLC:

Michael Cloherty Head of US Rates Strategy (212) 437-2480 [email protected]

Tom Porcelli Chief US Economist (212) 618-7788 tom.porcelli @rbccm.com

Jacob Oubina Senior US Economist (212) 618-7795 [email protected]

Keith Blackwell Associate Rates Strategist (212) 858-6077 [email protected]

Chris Mauro Head of US Municipals Strategy (212) 618-7729 [email protected]

Dan Grubert Associate (212) 618-7764 [email protected]


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

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