GLOBAL FX STRATEGY CURRENCY STRATEGISTS

Daily Foreign Exchange Update Camilla Sutton, CFA, CMT

(416) 866-5470
Sacha Tihanyi
(416) 862-3154
Camilla_Sutton@scotiacapital.com Sacha_Tihanyi@scotiacapital.com
Friday, July 23, 2010

STRESS TEST IS THE KEY MACRO EVENT FOR FX TODAY

CANADIAN CORE INFLATION STICKS NEAR BOC PROJECTIONS
• Massive upside surprise to UK GDP sends GBP soaring.
• German IFO hits three year high, helping EUR ahead of stress tests.
• Core Canadian inflation remains close to BoC view, neutral impact for CAD today.
• Stress tests to be released at 12:00 EST.

FX Market Update - Economic data has been particularly supportive for European
currencies today, with the German IFO hitting its highest level in three years, while the
UK’s second quarter GDP mightily outperformed expectations by growing
at its fastest pace in four years. This has left GBP as the best performing currency
today by far, while EUR and NZD are also doing well. The USD is generally weaker
against most majors, followed by CHF and JPY. European equities could be doing bet-
ter perhaps, however the looming release of the stress tests seem to be keeping some
uncertainty in the market. Nevertheless, US equity futures are sitting in positive territory
while commodities remain supported. The yields on US Treasuries are also ticking
higher, helped by the after effects of yesterday’s large equity gains. S.T.

Stressful Tests - The release of the European stress tests (at 12:00pm EST) is the
most important macro event today, as all have been eagerly (and some not so eagerly) UK GDP HITS FASTEST Q/Q GROWTH SINCE 2006
anticipating what these results will have to say about the state of European banks,
particularly those with strong directional views on EUR. Expectations are set that
the stress tests will show a number of failures with a focus of interest on the
state of banks in Spain, France and Germany, though the smaller European countries
will certainly be watched as well. There is a fine line to be walked by the results; not
enough “fails” and critics will say that the tests were not stringent enough, stimulating
a sense mistrust and opacity. Should too many banks fail, the market will worry about
recapitalization and whether Europe has the financial resources to cover all needs and
still provide a buffer for sovereigns. Both of these scenarios would not be positive for
EURUSD as it dredges up memories of only months ago when the yields on many Euro-
zone sovereign bonds looked to be on a one-way ticket to the moon. The best case
scenario would be for stress tests that appear stringent enough to identify a number of
weak banks (but not too many), allowing for a modest capital boosting exercise. Dis-
appointment with the results may rapidly lead to the market reversing its
position on EUR’s questionable short term rebound. S.T.

Americas
USDCAD (1.0406) • CAD is underperforming today, down 0.2% against the USD as
weakness in oil heading into the North American day has hurt the loonie. Canada’s GERMANY IS SAVING EUROPE AS IFO SURGES
June CPI came in at 1% y/y on the headline and 1.7% y/y on the core measure against
1% and 1.9% expected respectively. Thus Q2 core inflation averaged 1.8% y/y in the
second quarter of 2010, compared with the Q2 base case projection of 1.9% from the
Bank of Canada, as stated in yesterday’s MPR. This difference is negligible and
shouldn’t have any kind of implication for policy. Nevertheless, the miss on the
1.9% expected (total CPI) led CAD to weaken after the data was released. The BoC has
marked down its headline inflation estimates over the coming quarters by a reasonable
amount, however projections for core inflation (their measure of the underlying trend)
has not changed much and is basically showing a flat profile with convergence to the
Bank’s 2% target by Q4 of next year. • The stress tests will be important for CAD to-
day. Should the market and EUR react negatively to the news, we will likely see the
USD broadly strengthen, which could have positive implications for relative
CAD outperformance (rock solid banking system, attractive sovereign posi-
tion). The deciding factor is how commodity markets take any negative (or positive)
news as crude oil’s reaction to any sharp directional risk move will drive CAD, despite
the correlation between CAD and oil weakening recently to 0.65 on a rolling 1-month
basis. We expect today’s USDCAD range to hold between 1.0333 and 1.0491. S.T.
GLOBAL FX STRATEGY Friday, July 23, 2010

Europe
EURUSD (1.2913) • EURUSD is up 0.2% to leave EUR outperforming today as the currency has been bolstered GBPUSD (1.5431) • GBP is leading the majors,
by better economic data over the past two sessions. Support in EURUSD is now seen at 1.2750 as we have up 1% against the USD as the UK’s ad-
had that level generally hold over the past two sessions upon pushes lower in the pair, while 1.30 is still the vanced Q2 GDP number shocked mar-
key upside level given EURUSD has failed to close above that point on multiple attempts within the past 1.5 kets by coming in at 1.1% q/q against
weeks. The stress tests will be the most important event for EUR today. Key for confidence in the expectations of a 0.6% q/q gain. This sent
currency will be transparency and a sense of thorough rigorous tests. Should the market fail to receive a cable back through 1.54 and towards last
sense that this was achieved through the stress testing procedure, then confidence in EUR will week’s highs. This has ensured that the six
be undermined and the downside risks we believe are inherent in EUR will be realized. To sum it week uptrend in the pair remains in place to-
up; an ugly but believable result will end up being much more beneficial for EUR in the medium term than a day as support had been tested over the past
positive but highly opaque result. • While yesterday it was the manufacturing and service sector PMIs which two sessions (support now holds at 1.5175
were positive, today’s German IFO for the month of July jumped to 106.2 (highest since July 2007) against an today). Particularly encouraging in the growth
expected 101.5. This is certainly good news for the Eurozone “core” and provides hope that German momen- data is that manufacturing output increased by
tum will help ensure that general European growth traction is not faltering. • ECB President Trichet has 1.6% in the quarter, the most since 1999
written an opinion piece in today’s FT (see suggested readings), calling for industrialized (services increased by 0.9%). Combined with
economies to end fiscal stimulus and restore fiscal sustainability. Mr. Trichet raises a good point the upside surprises to inflation and a dissent
about the non-linearities in the economic impact of fiscal restraint on economic growth. Essentially what Mr. on the Bank of England’s policy committee,
Trichet has said is that while fiscal stimulus may have an estimable positive impact on growth at lower levels this data may well help push additional
of debt, or a negative one if it is fiscal restraint we are speaking of, at higher levels of debt the effect is no GBP strength on more hawkish BoE ex-
longer as clear cut or predictable. Debt burdens that reach worrying levels hurt prospects for future growth as pectations. S.T.
confidence wanes and the expectation for higher taxes hinders consumption. We have only to look at the
Eurozone periphery for an example of what happens to borrowing costs when the market says enough with Asia / Oceania
debt levels. Interestingly, this puts Mr. Trichet in opposition to what seems to be the tact in the US right now. USDJPY (87.19) • USDJPY is trading towards
It would be a strange switch of positions to see the Eurozone as the paragon of fiscal probity but that is ex- the middle of its weekly range as JPY is the
actly what will happen if the US does not address its fiscal outlook over the next 6 to 8 months. Should the US worst performing major today, down 0.3%
not come to a positive fiscal resolution, then we would be much more in favour of EURUSD trading in line against the USD. Rate spreads still hold the
with current levels over that time period. S.T. most sway over USDJPY from a 1-month rolling
Key Pricing & Levels correlation basis. Though having declined over
the month of July, we still see a rather strong
30 Day 1 Day 1 Week 100 Day 200 Day Pivot 1st Pivot 1st
Spot 0.62 correlation between USDJPY and 2-year
Hist Vol Change Change MA MA Support Resistance
rate spreads between US and Japanese gov-
USDCAD 12.7 1.0406 0.0035 -0.0176 1.0301 1.0416 1.0333 1.0491 ernment bonds. There is virtually nil correla-
EURUSD 11.8 1.2913 0.0021 -0.0017 1.2880 1.3634 1.2778 1.3007 tion between USDJPY and global equities,
GBPUSD 10.7 1.5431 0.0172 0.0129 1.4997 1.5565 1.5237 1.5537 however this is not to say that the yen, despite
USDCHF 10.0 1.0452 0.0023 -0.0058 1.0912 1.0638 1.0393 1.0514 its propensity to strengthen regardless of all
USDJPY 8.1 87.19 0.24 0.62 91.15 90.67 86.61 87.51 other factors, is not still tied to the risk trade.
AUDUSD 16.2 0.8941 0.0008 0.0252 0.8868 0.8966 0.8796 0.9029 The rolling 1-month correlation between
USDMXN 11.0 12.73 - 0.04 - 0.20 12.61 12.77 12.68 12.84 global equities and AUDJPY remains
DXY (USD index) 8.1 82.37 - 0.26 - 0.11 83.58 80.49 81.94 83.08 extremely (and consistently) elevated at
CRB Commodity 266.86 5.33 2.65 265.57 270.63 N/A N/A the current 0.89, proof that the risk
Gold 1,197.50 2.55 4.50 1,181.46 1,146.97 1,185.21 1,205.88 trade is still in vogue. S.T.
WT Crude (Nymex) 78.85 -0.45 2.82 78.42 77.66 76.81 80.25
Nat Gas (Nymex) 4.62 -0.02 0.10 4.36 4.74 4.52 4.73
BoC Noon Rate 1.0376 CAD (close from Bloomberg not BoC): 1.0371 Commodities
Pricing Source: Bloomberg 7/23/2010 Oil ($78.80) • Crude oil is trading lower today,
but surged through topside resistance at its
Today's Releases & Speakers Period Cons Last Significance 100-day moving average yesterday, a very
10:00 AM MX Trade Balance JUN P 100.0M 178.9M Medium bullish signal for oil. It also pushed to its high-
10:00 AM MX Unemployment Rate JUN 5.1% 5.1% Medium est level since early May, and will now target
12:00 PM EC European Banking Supervisors Release Stress-Test Results High the 80 level much more firmly. S.T.

Suggested Reading
Stimulate no more – it is now time for all to tighten, Jean-Claude Trichet, FT (July 22, 2010)
Hungary PM rejects new IMF deal and austerity, Chris Bryant, FT (July 22, 2010)
Smaller Banks See Loan-Book Rebound, Marshall Eckblad, WSJ (July 23, 2010)
Bank stress test success hinges on data, not failure count, BB (July 23, 2010)

2
GLOBAL FX STRATEGY Friday, July 23, 2010

Our July Monthly FX Strategy Call is now available, please dial in at your convenience.

Dial: 416-695-5800
Passcode: 77386016#

This month's 20-minute call is hosted by Sacha Tihanyi and discusses:

1) Economic and FX forecast update - less tightening for the Fed and BoC
2) USD decline - factors driving the downturn

The presentation can be found at:

http://www.scotiafx.com/conference/index.htm

Conference call commands

Press 1 – Skip backward 5 seconds
Press 3 – Skip forward 5
Press 4 – Skip backward 5 minutes
Press 6 – Skip forward 5 minutes
Press 5 – Pause the playback

If you have any questions, please contact:

Camilla Sutton at (416)866-5470, camilla_sutton@scotiacapital.com or
Sacha Tihanyi at (416)862-3154, sacha_tihanyi@scotiacapital.com

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