For more on our current view and outlook,

consult The Global Investment Outlook.

DECEMBER 2018 GLOBAL PERSPECTIVE FOR INVESTORS

Priced as of November 30

Dagmara Global Currency Outlook

Fijalkowski, MBA, CFA
Head, Global Fixed Income Too much love for the dollar
& Currencies
RBC Global Asset
Management The U.S. dollar’s upswing is well into its seventh year, a length of
time that is far from exceptional for a long-term rally in the greenback
Daniel Mitchell, CFA but which is starting to look mature based on the experience of past
Portfolio manager, Global cycles (Exhibit 1). Still, our working thesis for several quarters has
Fixed Income & Currencies
RBC Global Asset been that the U.S. dollar is peaking more gradually than was the case
Management
in the mid-1980s and early 2000s because the currency is far less
overvalued than it was in either of the previous periods (Exhibit 2). We
are, therefore, witnessing and likely will continue to witness a choppy
period during which the greenback remains mildly overvalued for a
We look for a moderation in U.S.- longer time.
dollar strength given fading fiscal The distinction between the quick turning points of the past and the current
stimulus, less aggressive tightening protracted cycle top is an important one for two reasons.
by the U.S. Federal Reserve (Fed)
and stretched positioning in the First, this thinking led us to resist calls to sell the dollar at the end of 2017 amid
§§
U.S. dollar. However, we note that popular concern over U.S. fiscal and trade deficits. Staying bullish on the dollar at
the greenback hasn’t reached the time was the right course of action as the greenback has since outperformed
extreme levels of overvaluation almost all G10 and emerging-market currencies.
in the current cycle and we Second, the distinction now suggests that investor enthusiasm for the greenback
§§
suspect the dollar can remain due to U.S. economic strength may not continue. We think the next ‘chop’ in the
mildly expensive for longer than
it has during prior cycle peaks.
Our forecasts envision relatively
modest fluctuations as the dollar Exhibit 1. Trade-weighted USD index
navigates through an extended
topping process. Against this 145
8 yrs 6 yrs 10 yrs 7 yrs 9 yrs 7 yrs
backdrop, we think emerging- 135 -26% +67% -47% +43% -40% +42%
market currencies can outperform, 125
particularly given political
115
instability in Europe and Brexit
105
uncertainty that could weigh on
95
the euro and the pound. We expect
further weakness in the Canadian 85
dollar amid the recent drop in oil 75
prices, competitiveness challenges 65
and a slowing economy. 1971 1975 1979 1983 1987 1991 1995 1999 2003 2007 2011 2015
U.S. Trade-weighted dollar

Source: Federal Reserve, Bloomberg, RBC GAM

 Global Currency Outlook – December 2018

choppy topping process will likely involve a weaker U.S.

dollar in the first half of next year. Exhibit 2: USD purchasing-power-parity valuation

Our view that the U.S. dollar will reverse course is not simply
140
an inclination to go against the grain. Rather, it’s an effort to 130
keep an even keel in an environment where sentiment swings 120
wildly between dollar-optimism and dollar-pessimism. As a 110
result, we are keeping our forecasts for most G10 currencies 100

relatively close to current levels. For instance, a small 90

appreciation in the euro toward our 12-month forecast of 1.17 80

70
implies a 0 percent return after accounting for lower interest
60
rates in the Eurozone. 73 76 79 82 85 88 91 94 97 00 03 06 09 12 15 18
USTW$: 92.03 [Nov 30, 2018] PPP: 82.50 [Dec-18]
2 standard deviations: [67.47, 97.52]
There are three reasons for our shorter-term concern over the
U.S. dollar: Source: RBC GAM

1. Relative economic trends

Currency movements can be thought of as a by-product of
global capital flows and of differing levels of confidence
Exhibit 3: Citibank data-change indexes
that investors have in chasing returns across regions. This
is evident in Exhibit 3, as the dollar’s performance has lined 20 400

Relative data change (U.S. vs. G10)

up closely with the extent to which the U.S. economy has 15 300
6-month change in DXY index

outgrown others. A good deal of the U.S.-dollar weakness in 10

200

2017 was driven by more attractive growth and investment 100

5
opportunities abroad. This year we’ve seen the reverse – the 0
0
greenback’s 9 percent rally since January reflects an economy -100
that is expanding faster than most others. However, much -5
-200
of this economic strength is thanks to tax cuts that have -10 -300
temporarily fuelled business and personal spending – a fiscal -15 -400
impulse that is set to decelerate in 2019. Also worrying is the 2010 2011 2012 2014 2015 2016 2017 2019
6m change in USD vs G10 US vs G10 Data Momentum (3-month lead)
impact of tighter U.S. financial conditions driven by higher
bond yields and wider credit spreads. Together, these will Source: Citibank, RBC GAM
restrain business and consumer optimism and remove some
of the economic tailwind that the U.S. economy has been
enjoying (Exhibit 4).
Exhibit 4: Financial conditions versus Purchasing
2. Interest-rate convergence
Managers Index
Our more conservative estimate of economic activity in the 97 65

U.S. is linked to our expectation that the U.S. Federal Reserve 98 60

U.S Financial conditions (inverted)

(Fed) will be forced to temper interest-rate hikes next year. 99 55

We foresee two rate hikes in 2019, a much reduced pace
Manufacturing PMI

100 50
compared to the one-per-quarter clip so far in 2018. Since
101 45
much of the past decade’s dollar strength has stemmed from Tighter
conditions
America’s relatively higher interest rates, it’s fair to assume 102 Lower PMI 40

that a more dovish Fed will have an impact on currency 103 35

markets. And let’s not forget that the rate divergence could 104 30
1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018
be further dented by policy decisions abroad. For now, little
GS US Financial Conditions Index ISM Manufacturing PMI SA
attention has been paid to the most important of these other
Source: Goldman Sachs, Bloomberg, RBC GAM

2 |
 Global Currency Outlook – December 2018

central banks: the European Central Bank (ECB) has all-but-

promised an interest-rate hike for September 2019. To us, Exhibit 5: European wage indicators
investors’ lack of attention is notable because the ECB’s 4.0
mandate is to focus on inflation only, and wage pressures 3.5

have been building in the Eurozone (Exhibit 5). As markets 3.0

% change (YoY)
begin to take the likelihood of ECB rate hikes into account, the 2.5

dollar may lose some of its sheen. 2.0

1.5
3. Positioning in the foreign-exchange market 1.0

With an impressive run of U.S.-dollar strength this year, 0.5

it’s natural that trend-following investors are bullish on the 0.0

2004 2005 2007 2009 2011 2013 2015 2017
dollar. The extreme optimism, however, creates concern that ECB, negotiated wages Eurostat, LCI
Eurostat, Nat. Avg. wages (nom) OECD, wage rate
the greenback’s prospects may not be so promising. As of Comp per employee Comp per hour worked

November 27, leveraged investors own US$28 billion of U.S. Source: Macrobond, Eurostat, OECD, RBC GAM
dollar futures, and while foreign-exchange futures account
for only a fraction of the US$5 trillion-per-day market, they
do offer a useful indicator of how the much larger over-the-
counter forward market is positioned. Exhibit 6 illustrates that
Exhibit 6: USD positioning
current levels of bullishness are rarely followed by
further strength, as there are fewer marginal buyers to keep
20% -150%
the music playing.
Subsequent 6m return (USD

1y change in net USD positions

15% -100%

(% open interest, inverted)

These three elements – growth trends, interest-rate 10%
-50%
convergence and U.S.-dollar positioning – support our 5%
0%
outlook for a choppy topping in the U.S. dollar. We expect 0%
the choppy range to continue until such time as longer-term 50%
-5%
forces indicate a downtrend. This shorter-term caution on Too
-10% 100%
bullish
the greenback is an acknowledgement that a repeat of recent
-15% 150%
gains is increasingly unlikely over the next few months and 2009 2011 2013 2015 2018
that the balance of risks portends a weaker start for the Subsequent 6m USD return (LHS) 1y change in net USD positions (RHS)

greenback in the new year.

Source: Bloomberg, CFTC, RBC GAM

If we are right – particularly about a slower pace of Fed rate

hikes – there will be implications for currency markets as the
U.S. dollar loses strength. In our estimation, emerging-market
currencies are likely to outperform developed-market ones for
several reasons. For a start, the major currencies are burdened
by specific problems: concerns about the Italian budget and
banking sector are weighing on the euro; weaker crude prices
are a headwind for the Canadian dollar; and Brexit creates
major uncertainty around the outlook for the pound. Within
the G10, the yen is the only currency that we favour as it
generally strengthens the most when U.S. yields are falling.
It is also among the most undervalued, and benefits from a
healthy current-account surplus.
It is far easier for us to find value among emerging-market
currencies at this stage. In reaction to external funding
concerns in Argentina and Turkey over the summer, many
other emerging-market currencies were dragged down by
association. These were, in many cases, currencies in which
investors cut positions with little regard for better fiscal and
economic situations. Local-currency-denominated assets
now offer better valuations and are poised to strengthen if
the Fed softens its stance. They now also offer higher yields
since many emerging-market central banks raised interest-rate
buffers as a tool to deter currency speculation. Finally, concern
about currency outflows from China may be overblown now
that authorities have imposed controls on capital flight, and
the risk of a hard landing in China is reduced by the suite of
fiscal and monetary tools at the disposal of policymakers
(Exhibit 7).

| 3
 Global Currency Outlook – December 2018

Exhibit 8 puts in context the spot performance of emerging-

market and developed-market currency baskets since Exhibit 7: China has lots of easing options
President Trump took office. Both groups of currencies rose
and fell against the U.S.-dollar in tandem until mid-2018, •• Infrastructure investment •• Measured CNY depreciation
when market jitters arising in Argentina and Turkey caused
•• Easing of property measures
some fairly significant emerging-market underperformance. •• Fiscal spending
(selectively)
Only a fraction of the declines have been reversed, suggesting
•• Liquidity provision •• Cut benchmark rates
a further closing of the gap still lies ahead. Perhaps the
more interesting insight from this chart, though, is that on a •• Encourage total social
financing
total-return basis, emerging-market currencies have provided
Source: Standard chartered
enough extra yield to compensate for exchange-rate declines.
An environment in which exchange rates and yield both
contribute to currency returns is one that we expect might get
Exhibit 8: Developed-market versus emerging-market
investors to re-engage with emerging-market currencies. currency returns

A focus on Canada 115

Canada’s status as an export-driven, commodity-oriented 110

economy makes its assets and currency proxies for risk

105
sentiment. It’s only natural, then, that the currency would
weaken in recent months amid stock-market declines and 100

weakening oil prices. What might surprise is the fact that it

95
isn’t weaker still. Equities in both Canada and the U.S. are
down about 8 percent since the end of summer, high-yield 90
Jan-17 Apr-17 Jul-17 Oct-17 Jan-18 Apr-18 Jul-18 Oct-18
bond spreads have widened and emerging-market assets G10 average spot EM Average* spot EM Average TR
have been thumped. Yet the Canadian dollar has remained
within its 2018 range. Why is this the case? We think the Note: *Average of KRW, CNY, INR, BRL, CLP, MXN, TRY, ZAR, RUB.
Source: Blomberg, RBC GAM
loonie has been supported by the Bank of Canada’s (BOC)
more hawkish stance. Interest rates have, in fact, been a much
more important driver for the Canadian dollar than for other
G10 currencies this year (Exhibit 9).
Exhibit 9: Interest-rate correlation to G10 currencies
Underpinning the central bank’s optimistic outlook is the ever- 1.0
present expectation that both exports and investment will
0.8
contribute more meaningfully to economic activity at a time
when consumers are slowing purchases due to higher interest 0.6
rates. We note that with Canada’s lower-grade oil trading
Correlation

below US$20 a barrel, exports and capital expenditures will 0.4

certainly not be thriving in the western provinces. So, it is now 0.2

up to central and eastern Canada to lead the economy, and
the case for that outcome is faltering. The recently announced 0.0

plan to close GM’s auto plant in Ontario is not encouraging.

-0.2
Nor is the fact that Canada continues to spend much less than CAD AUD NZD SEK CHF NOK GBP JPY EUR

the U.S. as a share of GDP on boosting its production capacity

Note: Daily correlation between (XXX/USD) & XX-US 2Y swap spread, past
(Exhibit 10). 18 mos. Source: Bloomberg, RBC GAM

4 |
 Global Currency Outlook – December 2018

On the other hand, the completion of the US-Mexico-Canada
trade agreement removes an important obstacle to business
spending. The recent announcement of a new natural-gas
plant to be built in Kitimat, northern British Columbia, is
another positive, albeit the timing of the investment is
uncertain.
There are also signs that the federal government is finally
taking Canada’s weakening competitiveness seriously, with
a recent budget that gives businesses greater incentive to
invest. Such policies, however, take a long time to affect
the economy’s overall growth potential – there is no silver
bullet that can reverse a decade of steadily declining
competitiveness. Research published by the BOC cites
competitive pressures as primarily responsible for Canada
having lost a 6-percentage-point share of U.S. non-energy
imports since 2002.1 Data from the OECD (Exhibit 11)
suggests research and development spending lags other
countries, which perhaps sheds light on why patents
generated in Canada have not risen (Exhibit 12).
Despite hawkish talk from key BOC policymakers, staff
research notes at the central bank reveal that there is much
more debate about the outlook. One paper explains that the
interest-rate-sensitive parts of the economy are affected
1
Brouillette,,D’Souza, Gagnon & Godbout (2018). What Is Restraining Non-
Energy Export Growth? (Note # 25). Bank of Canada Staff Analytical Note

Exhibit 10: Business investment in machinery, equipment Exhibit 11: 10-year annualized growth rate in business
and intellectual property R&D spending
12 10%
8%
11
6%
10 4%
% of GDP

2%
9
0%

8 -2%
-4%
7 -6%
-8%
6
-10%
S .Korea

Switzerland

Mexico
Turkey
Germany

Italy
Netherlands
Norway
Denmark
China
Austria

Poland

Israel

Greece

France
Singapore
Romania
Australia

S. Africa
Sweden
Canada
Finland
New Zealand

Ireland
Spain

Chile
Argentina
Russia
Belgium
Hungary

Portugal

U.S.
Taiwan

Czech Rep.

Japan

Iceland
U.K.
5
1982 1986 1990 1994 1998 2002 2006 2010 2014 2018
Canada United States

Source: Macrobond, StatsCan, BEA, RBC GAM Source: OECD, RBC GAM

Exhibit 12: Patent applications Exhibit 13: Mortgage interest costs

3,500 10

3,000 8
6
2,500
Per million people

% change (YoY)

4
2,000 2

1,500 0
-2
1,000
-4
500 -6

0 -8
1980 1984 1989 1993 1998 2002 2007 2011 2016
-10
CA US CHN GER JAP MEX 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

Source: Macrobond, World International Patent Organization, RBC GAM Source: Macrobond, StatsCan, RBC GAM

| 5
 Global Currency Outlook – December 2018

by rate hikes four to six quarters after they take place.2 So

the impact of the latest round of hikes is only now due to Exhibit 14: Investment bank forecasts for USD-CAD
become evident in the economic data. We do not expect a 1.40
recession, but are hardly surprised to see credit growth soften Current
1.35
and housing starts slow at a time when interest costs on
1.30
mortgages have risen sharply (Exhibit 13). All this to say that
there are good reasons why the central bank’s hawkishness

USD-CAD
1.25

could suddenly dissipate – and with it the main factor that 1.20
has been supporting the Canadian dollar. Given the loonie’s 1.15
Median

current sensitivity to interest rates, removing even a single

1.10
BOC hike from market expectations vis-à-vis the Fed would
1.05
cause the currency to weaken by about 3 percent, according to Q1 19 Q2 19 Q3 19 Q4 19 2020 2021 2022 2023
our models. This possibility is not currently embedded in the
forecasts of major investment banks (Exhibit 14), including Source: Bloomberg, RBC GAM
most of Canada’s big banks, who expect the U.S. dollar to
weaken to levels below C$1.30 per U.S. dollar. With our own
12-month forecast of C$1.35, we stand comfortably apart from
the consensus.

2
Chernis & Luu (2018). Disaggregating Household Sensitivity to Monetary
Policy by Expenditure Category. (Note # 32). Bank of Canada Staff Analytical
Note

6 |
 Global Currency Outlook – December 2018

For more on our current view and outlook, please consult the full version of The Global Investment Outlook posted on our
website at http://www.rbcgam.com/investment-insights/investment-outlook/index.html

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Any investment and economic outlook information contained in this report has been compiled by RBC GAM from various sources. Information
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All opinions and estimates contained in this report constitute RBC GAM’s judgment as of December 15, 2018, are subject to change without notice
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Return estimates are for illustrative purposes only and are not a prediction of returns. Actual returns may be higher or lower than those shown and
may vary substantially over shorter time periods. It is not possible to invest directly in an unmanaged index.

A note on forward-looking statements

This report may contain forward-looking statements about future performance, strategies or prospects, and possible future action. The words
“may,” “could,” “should,” “would,” “suspect,” “outlook,” “believe,” “plan,” “anticipate,” “estimate,” “expect,” “intend,” “forecast,”
“objective” and similar expressions are intended to identify forward-looking statements. Forward-looking statements are not guarantees of
future performance. Forward-looking statements involve inherent risks and uncertainties about general economic factors, so it is possible that
predictions, forecasts, projections and other forward-looking statements will not be achieved. We caution you not to place undue reliance on
these statements as a number of important factors could cause actual events or results to differ materially from those expressed or implied in any
forward-looking statement made. These factors include, but are not limited to, general economic, political and market factors in Canada, the United
States and internationally, interest and foreign exchange rates, global equity and capital markets, business competition, technological changes,
changes in laws and regulations, judicial or regulatory judgments, legal proceedings and catastrophic events. The above list of important factors
that may affect future results is not exhaustive. Before making any investment decisions, we encourage you to consider these and other factors
carefully. All opinions contained in forward-looking statements are subject to change without notice and are provided in good faith but without
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