MORE UPSIDE FOR THE AUSTRALIAN DOLLAR

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1 Dec. 23 Jan. 2 ECONOMY AND STRATEGY Clément Gignac Strategist and Chief Economist Stéfane Marion Assistant Chief Economist Paul-André Pinsonnault Senior Fixed Income Economist Marc Pinsonneault Senior Economist Pierre Lapointe Assistant Market Strategist Yanick Desnoyers Senior Economist Éric Dubé Economist MORE UPSIDE FOR THE AUSTRALIAN DOLLAR After breaking 77 cents US in early December, the loonie has retreated on expectations of Bank of Canada rate cuts. Portfolio rebalancing is likely to put downward pressure on the U.S. dollar. Demand for commodities, driven by global economic acceleration, will push the Australian dollar to higher ground in 2. Stéfane Marion Eric Dubé Copyright, National Bank Financial, 23

2 Dec. 23 Jan. 2 NBF Currency Outlook Exchange rate Current 1-month 2-month -month December 23 CAD/USD USD/EUR JPY/USD USD/GBP USD/AUD CAD/AUD (1) Performance of the Canadian dollar in 23 Change in value against selected currencies to December Australian dollar N.Z. dollar Euro Yen Pound U.S. dollar Review of the Month NBF Long-Term Currency Outlook* Exchange rate Current 2Q1 2Q2 2Q3 2Q 25Q1 December 23 CAD/USD USD/EUR JPY/USD USD/AUD On December 2 nd the Canadian dollar closed above 77 cents US for the first time since November 8, It has since lost 2 against the USD and.5 against the euro. The U.S. dollar remains under pressure. The euro continues to rise, breaking US$1.2 in December. The yen has fallen below 17 to the USD for the first time in years. The Australian dollar remains on a very sharp uptrend driven by commodity prices. USD/GBP * forecasts for end of quarter Forecasts This month we revise our -month forecast for the euro up significantly, from US$1.25 to US$1.35 In keeping with our recent upgrading of global economic growth in 2 and our expectation of a further increase in commodity prices, we are raising our -month target for the Australian dollar from 75 cents US to 85 cents US. For the Canadian dollar we maintain our -month target of 1.25 CAD/USD. The ascent of the loonie is being temporarily braked by expectations of monetary easing in Canada early in 2. 2

3 Dec. 23 Jan. 2 The Bank of Canada talks down the dollar After closing December 2 nd at a decade high of 77 cents US, the Canadian dollar came under pressure in recent weeks (chart 2). It has lost 2 against the greenback and more than against the euro. One probable factor, besides a seasonal pattern (the CAD has lost ground in eight of the last 1 Decembers) (chart 3), is a sudden change of tone at the Bank of Canada. (2) The volatile CAD USD/CAD and 3-day change day change (left) Oversold - 21M1 21M7 22M1 22M7 23M1 23M7 2M1 USD/CAD (right) (3) December is rarely the loonie s month Seasonal pattern of the Canadian dollar since Monthly change.78 USD/CAD Overbought Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec The loonie has lost ground in 8 of the last 1 Decembers Through most of 23 the Bank downplayed the impact of the record appreciation of the loonie, arguing that acceleration of the U.S. economy would more than offset it. Yet despite the strongest U.S. upturn in a decade, the Canadian economy continues to surprise on the downside because of weakness in exports. In response to the evidence, the Bank of Canada changed its rhetoric in early December. Governor David Dodge now hints at the possibility of a rate cut, saying in a recent speech: However and let me stress this the effect of the recent sharp appreciation of the Canadian dollar is a major uncertainty at this time. It is not clear to what extent the increase in foreign demand I have just mentioned will be offset by the effects of a stronger currency. Nor can we be sure that there is enough monetary stimulus in the economy to support the increases in household spending and business investment that would be required to return the economy to full capacity by early 25. () The loonie appreciation in historical perspective -month change in USD/CAD y/y These comments stopped the Canadian dollar in its tracks. But in all likelihood, expectations of rate cuts will not keep a lid on further appreciation beyond early 2. Easing, if it comes, will probably be very modest not enough, in our view, to offset the lift to the currency from commodity prices, driven up by global economic acceleration, and from further depreciation of the greenback. Our -month forecast for the loonie remains 1.25 CAD/USD. Foreigners awash in U.S. dollars Though U.S. economic news continues to surprise on the upside, the dollar has not rallied. What s the story? As Fed chairman Alan Greenspan noted in November: The foreign accumulation of U.S. assets would likely slow if dollar assets, irrespective of their competitive return, came to occupy too large a share of the world s portfolio of store-of-value assets. In these circum- 3

4 Dec. 23 Jan. 2 stances, investors would seek greater diversification in non-dollar assets. Mr. Greenspan may have a point. At the end of 22, about half of private cross-border holdings and.5 of central-bank foreign-exchange reserves were denominated in U.S. dollars (chart ) (The euro was second in reserve holdings, at 18.7.) The USD share of reserves is no doubt much higher now after a record accumulation of U.S. assets by foreign central banks in 23. We expect portfolio rebalancing to keep the greenback under pressure over the coming year. The aussie and the loonie Commodity currencies those strongly influenced by resource prices touched a cyclical bottom in January 22 and have been rising strongly since then. The leader is the Australian dollar, up more than. The loonie meanwhile has risen 23 (chart 7). (7) A widening gap Appreciation of the loonie and the aussie since January Index January 22 = 1 Aussie (5) Massive accumulation by foreign central banks U.S. government securities held at the Fed for foreign central banks $ billion 5 Loonie M 22M7 22M1 23M1 23M 23M7 23M M7 21M1 21M7 22M1 22M7 23M1 23M7 Sources: NBF Economic Research, Federal Reserve () leaves them awash in U.S. dollars USD share of total official holdings of foreign exchange (end of year) Sources: NBF Economic Research, IMF * NBF estimate for 23 However, it is only against the aussie that the loonie is strongly lagging. Year to date it has risen against all other currencies (except aussie and Kiwi). Though both are considered commodity currencies, the aussie tracks commodity prices much more closely than the loonie and is much more volatile (chart 8). (8) Strong correlation Change in value of the aussie vs. change in CRB Raw Materials index (y/y) Aussie CRB Raw Materials

5 Dec. 23 Jan. 2 This is largely because of the differing export structures of the two countries. Commodities account for 5.2 of Australian exports and only 39.2 of Canadian exports (chart 9). (9) The difference in export structures Export mix, Canada and Australia of total exports Manufactured goods* Canada * Finished goods only Commodities Services Other of total exports Australia Commodities Services Manufactured goods* The difference in export structures also makes Australia much less vulnerable than Canada to appreciation of the currency. Only 19 of Australia s exports are manufactured goods compared to 5 of Canada s. Partly for this reason, the Australian economy has held up well this year despite the meteoric rise of its currency. and it s not over What s ahead for the aussie? In our view, practically all the conditions, cyclical and structural, are in place for a further sharp rise. Among these conditions is Australia s mix of trading partners. As chart 1 shows, about 35 of Australia s Others (1) Booming Asia wants what Australia offers Australian trade by region Asia ex Japan* Japan European Union North America Other regions * ASEAN countries, China and India exports go to Asia excluding Japan, by far its largest market. With the world s economies accelerating in sync and global demand rising strongly, Asia ex Japan is booming. Its GDP expanded.5 in 23 and is likely to repeat this performance in 2. The region has become the hub of global manufacturing and now accounts for the lion s share of world demand for commodities. Australia is particularly well-positioned to benefit. China in particular has emerged as a hungry market: its share of Australian exports has risen from to 8 in less than 1 years and is climbing steadily. China s industrialization boosts the aussie China s industrialization is transforming the global economy. It is now the world s largest producer of steel. Its yawning appetite for coking coal imports is expected to reach 5 million tonnes in 2, up from 3 million tonnes in 23 and 1 million tonnes in 22. Australia is extremely well-placed to ride this demand. It is the world s biggest exporter of this commodity (the country s largest trade) and accounts for 28 of total world exports of coal products (chart 11). 5

6 Dec. 23 Jan. 2 (11) Australia: Major player in the coal trade Country and region shares of world coal product exports , trillion of BTU Australia Asia & Oceania ex Australia North America Eastern Europe Africa South America Western Europe Conclusion The loonie, after closing at a decade high of 77 cents on December 2, has retreated on expectations of modest Bank of Canada easing. In our view this setback is temporary. Further depreciation of the U.S. dollar and a strong global economic rebound in 2 will continue to favour commodity currencies. We are maintaining our -month target of 1.25 CAD/USD or 8 cents US. Though the Australian dollar has risen since January 22, we see further upside. Surging demand from Asia combined with attractive short-term interest rate spreads between Australia and other industrial countries will continue to provide lift in 2. We now see the aussie at 85 cents US by the end of 2.

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