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For Required Conflicts Disclosures, please see page 5.

Matthew StraussSenior Currency StrategistRBC Dominion Securities Inc.

+1 416 842 6631

George Davis CMTChief Technical AnalystRBC Dominion Securities Inc.

+1 416 842 6633

Global FX Strategy

4 November 2010

CAD Pulse: BoC vs Fed A 2002/03 Polic y Rerun ?

Market Summary

Currencies Level 1 wk chg

USD/CAD 1.0026 -0.0185EUR/CAD 1.4247 0.0022GBP/CAD 1.6312 0.0028CAD/JPY 80.45 1.1100

USD/CAD RBC F Forwards

1M 1.0200 1.00333M 1.0400 1.00486M 1.0100 1.0072

CAD cash rates Level 1 wk chg (bp)BOC target 1.00 01m 1.19 03m 1.29 06m 1.38 112m 1.67 0

Govt bonds Yield 1 wk chg (bp)2yr 1.41 -25yr 1.97 -610yr 2.82 -630yr 3.48 0

CA-US spread (bp) Level 1 wk chg2yr 109 25yr 1 1310yr 35 1330yr -55 1

Equity markets Level 1 wk chgCanada TSX comp. 12,879 315US S&P500 1,214 30

Source: Bloomberg

USD/CAD Options

USD/CAD volatility

(%, annualised)Historical Implied

1w 3.25 11.391m 10.42 11.313m 10.84 11.616m 12.85 12.1912m 11.94 12.741m R.R 0.3c

Source: Bloomberg

USD/CAD Technicals

1.0350 Congestive resistance level

1.0121 Short-term resistance trendline1.0026 Spot0.9977 Triple bottom0.9820 Descending channel base

Source: Bloomberg

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.

The Fed continues to pursue easier monetary policy while the BoC may have simply

postponed its tightening/normalization campaign as a precautionary move.

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.

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 bearish USD/CAD

Canadian Data Risk Barometer Neutral USD/CAD

Market Positions and M&A Activ ity

1-month, 25-delta risk reversals Neutral USD/CAD Trend M&A inflows into Canada Net outflow of US$0.7bn and is bullish USD/CAD

1. Official policy stance expected to diverge even further

-1.0

1.0

3.0

5.0

7.0

9.0

11.0

13.0

91 96 01 06 11

USA

Canada

RBC Outlook

Offical rates - Fed funds, Canadian overnight (bank rate -25bp prior to 1993)

Source: RBC Capital Markets, Bloomberg

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

2

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/CADunder 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 rates5 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 economyregaining momentum faster and stronger than the US given the

absence of a housing slump in Canada, decent Canadian job

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 Canadas vast commodity

base. Thus, while the Fed will probably wait until at least anumber 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

97

49

24

43

23

26

31

16

58

36

60

37

35

29

34

0

42

0 50 100 150 200

NZD

SEK

GBP

EUR

CHF

CAD

AUD

USD

YEN

Cumulative increase in basis points

Nov '11

Nov '12

Expectations of rate increases

expected until:


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 animportant 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 Canadas 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

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

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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

year-to-date), together with the gains in H2 2009 (95K), more

than offset the 417K jobs lost during the recession. However,

the quality of new jobs created has deteriorated. Part-time jobs

have increased by 200K during the last 11 months, pushing total

part-time jobs passed the pre-crisis peak. Full-time jobs, on theother hand, are still 157K short of the 2008 peak despite having

added 333K since the depth of the crisis. Expectations are for a

30K increase in full-time jobs in October, continuing the path of

both a quantitative and qualitative recovery. Also, private sector

jobs have not yet fully recovered from the recession lows and

need to add another 162K to surpass the previous peak.

11000

11500

12000

12500

13000

13500

14000

00 02 04 06 08 10

2500

2700

2900

3100

3300

3500

3700

Full-Time Employment, LHS

Part-Time Employment, RHS

Source: RBC Capital Markets, Haver Analytics

Trade balance another negative month coming up 4. Trade - staying in the red

Canadas August trade deficit improved to C$1.3bn from

C$2.70bn in July, a stronger improvement than the C$2.25bndeficit expected. In Aug, exports caught the market off side, with

a stellar 3.1% (C$1.0bn) increase. Such an increase is unlikely

to be repeated in September according to our economists who

believe the number overstated the underlying concerns facing

Canadian exporters, both from a currency perspective and given

the slow growth in the US in Q3. Exports are expected to

decline by 0.8%, with a small decline in imports marginally

offsetting the impact on the trade balance, leaving the trade

deficit slightly worse off than in August and pushing the 2010

deficit even further into the red.

-8

-6

-4

-2

0

2

4

6

8

10

00 01 02 03 04 05 06 07 08 09 10

Trade ex Energy Balance C$bn

Total Trade Balance

Energy Trade Balance

C$bn


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, retracementsto 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 -1.3bnSource: RBC Capital Markets, Bloomberg

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

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RBC Capital Markets Fixed Income & Currency Strategy

Europe

Royal Bank of Canada Europe Limited:

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

Norbert Aul European Rate Strategist +44 207-029-0122 [email protected] Beauchamp X-Market Strategist +44-20-7653-4865 [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]

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Asia-PacificRoyal Bank of Canada Sydney Branch:

Su-Lin Ong Head of Australian and

New 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]

Matthew Strauss Senior Currency Strategist (416) 842-6631 [email protected]

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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] Porcelli Head of US Market Economics (212) 618-7788 tom.porcelli @rbccm.com

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

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

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

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