The Cyprus precedent

---

April 2013

The Cyprus precedent 

The deal concocted by the troika is bad for Cyprus, and the impacts won’t be isolated to just that small country of the periphery. By reaching into their constituents’ bank accounts European policymakers have extended their streak of awful policies, magnifying the potential for future bank runs elsewhere in the periphery. As if the eurozone really needed those additional headwinds. We’re now well on our way to hit our end-of-Q2 target of 1.23 for EURUSD.



The US dollar has room for further gains if market jitters make an unwelcome return. As Cyprus and Italy have shown, the worst may not be behind us with regards to the European economic and political situation. Moreover, a sequester-related moderation in US economic activity in Q2 may add to the riskoff mood and prompt flows towards the US dollar. In light of the Bank of Japan’s massive stimulus, we’ve raised our end-of-year USDJPY targets to 100 for 2013 and 110 for 2014.



The Canadian economy accelerated to around 2% in Q1 in synch with the US rebound, something that may cause markets to adjust rate expectations marginally upwards and provide a lift to loonie. Capital inflows should also be positive for the Canadian dollar as foreigners seek refuge in AAA-rated securities, more so now that the Cyprus precedent has put into question the safety of even bank accounts in the eurozone. That said, those friendly forces could be dwarfed by the return of risk aversion and a softening of commodity prices in Q2. So, while we acknowledge the upside potential for the loonie, we’re leaving our USDCAD mid-year target unchanged for now at 1.04.

NBF Currency Outlook* Current

2013Q2

2013Q3

2013Q4

2014Q1

2014Q2

2012

2013

2014

04-Apr-13

USDCAD US cents per CAD

1.01 0.99

1.04 0.96

1.05 0.95

1.04 0.96

1.03 0.97

1.02 0.98

0.99 1.01

1.04 0.96

0.99 1.01

EURUSD

1.29

1.23

1.24

1.25

1.26

1.27

1.32

1.25

1.29

USDJPY

96

94

98

100

102

104

87

100

110

AUDUSD

1.04

1.01

1.02

1.03

1.04

1.05

1.04

1.03

1.08

GBPUSD

1.52

1.46

1.48

1.51

1.53

1.55

1.63

1.51

1.57

USDCNY

6.21

6.22

6.21

6.20

6.19

6.18

6.23

6.20

6.15

AUDCAD

1.05

1.05

1.07

1.07

1.07

1.07

1.03

1.07

1.07

* forecasts for end of period Source: NBF Economic Research

ECONOMIC AND STRATEGY GROUP – 514.879.2529 Stéfane Marion, Chief Economist and Strategist General: National Bank Financial Markets is a business undertaken by National Bank Financial Inc. (“NBF”), an indirect wholly owned subsidiary of National Bank of Canada, and a division of National Bank of Canada.  This research has been produced by NBF. National Bank of Canada is a public company listed on Canadian stock exchanges  The particulars contained herein were obtained from sources which we believe to be reliable but are not guaranteed by us and may be incomplete. The opinions expressed are based upon our analysis and interpretation of these particulars and are not to be construed as a solicitation or offer to buy or sell the securities mentioned herein. Canadian Residents: In respect of the distribution of this report in Canada, NBF accepts responsibility for its contents. To make further inquiry related to this report or effect any transaction, Canadian residents should contact their NBF Investment advisor.  U.S. Residents: NBF Securities (USA) Corp., an affiliate of NBF, accepts responsibility for the contents of this report, subject to any terms set out above. Any U.S. person wishing to effect transactions in any security discussed herein should do so only through NBF Securities (USA) Corp.  UK Residents – In respect of the distribution of this report to UK residents, NBF Securities UK has approved the contents (including, where necessary, for the purposes of Section 21(1) of the Financial Services and Markets Act 2000). NBF Securities UK and/or its parent and/or any companies within or affiliates of the National Bank of Canada group and/or any of their directors, officers and employees may have or may have had interests or long or short positions in, and may at any time make purchases and/or sales as principal or agent, or may act or may have acted as market maker in the relevant securities or related financial instruments discussed in this report, or may act or have acted as investment and/or commercial banker with respect thereto. The value of investments can go down as well as up. Past performance will not necessarily be repeated in the future. The investments contained in this report are not available to retail customers. This report does not constitute or form part of any offer for sale or subscription of or solicitation of any offer to buy or subscribe for the securities described herein nor shall it or any part of it form the basis of or be relied on in connection with any contract or commitment whatsoever. This information is only for distribution to Eligible Counterparties and Professional Clients in the United Kingdom within the meaning of the rules of the Financial Services Authority. NBF Securities UK is authorized and regulated by the Financial Services Authority in the United Kingdom and has its registered office at 71 Fenchurch Street, London, EC3M 4HD.  Copyright: This report may not be reproduced in whole or in part, or further distributed or published or referred to in any manner whatsoever, nor may the information, opinions or conclusions contained in it be referred to without in each case the prior express written consent of National Bank Financial.

FOREX European realities coming to light Unemployment rates in double digits, dysfunctional governance, unstable governments, sovereign defaults, capital controls, and confiscation of bank deposits all seem like traits belonging to a handful of third world economies. But those are also Europe’s new realities, with which markets are slowly coming to terms. The euro which recently sank below 1.28 (versus USD) is now well on its way towards our 1.23 end-of-Q2 target. The euro’s slump was precipitated largely by Cyprus whose potential exit from the zone put markets on edge. The ECB had threatened to cut its lifeline to Cyprus if it didn’t adopt an EU/IMF program to ensure the solvency of its banks and the sustainability of its public finances. In exchange for a €10 bn lifeline from the troika (i.e. IMF/EU/ECB), the Cypriot government accepted the troika’s harsh conditions in the form of a levy on bank deposits €100,000 and above, and the downsizing of the banking sector. And to stem the anticipated capital flight associated with such drastic measures, controls were put in place by the Cypriot government.

Even more dangerous is the fact that the Cyprus deal signals to depositors in other countries of the periphery that their cash may not be safe in bank vaults. That could magnify future bank runs. If, for example, depositors feel that their banks are in the process of taking more write-downs on bad loans (and hence raises the odds of troika intervention), the Cyprus precedent may entice larger and more frequent bank withdrawals than what would normally be the case. As if the eurozone really needed those additional headwinds. The recession shows no signs of ending with another GDP contraction slated for Q1 if the sub50 purchasing managers indices are any guide. And with credit continuing to contract for both consumers and businesses alike, the growth outlook for subsequent quarters isn’t bullish. So, eurozone output which at the end of last year was 3% below the pre-recession peak, has room to fall further. Eurozone: Credit still contracting Loans by Monetary and Financial Institutions 16

y/y % chg.

14

Non-financial corporations

12

The deal isn’t just bad for Cyprus in that it ensures years of pain ahead, but it also sets a dangerous precedent. If the troika can force Cyprus to shrink its banking sector towards the EU average by 2018, what’s to say that it won’t ask Malta, Ireland or Luxembourg, all of which have even larger bank assets, to do the same. Such a demand could be catastrophic for those economies. Indeed, given the importance of the financial sector to those economies, its shrinkage will likely translate into massive layoffs and a GDP slump, as will be the case for Cyprus over the years ahead. Eurozone: Financial sector too big to fail in some countries Eurozone exposure to financial sector Financial sector’s share of employment (%)

12

Luxembourg

11

Bank assets as a multiple of GDP

Luxembourg

33.3

Ireland Malta

10

Cyprus

9

France Netherlands

8

Portugal Spain

7

Finland

6

Cyprus

5 4 3 2 1

Austria

Ireland

Malta Belgium Netherlands Portugal EUROZONE 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25

Financial sector’s share of the economy (%)

Belgium Germany Italy

10 8 6 4 Households 2 (ex-mortgages)

0 -2 -4

98 99 00 01 02 03 04 05 NBF Economy & Strategy (data via ECB)

Feb

06

07

08

09

10

11

12

13

The outlook is further darkened by the refusal of European policymakers to reverse course on the disastrous austerity drive that have made the recession worse and, ironically, made it harder for governments to achieve budget targets. But there is a glimmer of hope, not from current policymakers, but rather from a suffering populace that now seems to have had enough and demanding a change in direction. Italy’s election results, with strong showings from anti-austerity politicians, may be a signpost of things to come elsewhere in the periphery. That said, with elections only years away in some of those affected nations, change will be painfully slow.

Canada Slovenia Estonia US Slovakia

0

2

4

6

NBF Economy & Strategy (data via Eurostat, European Banking Federation)

8

10

12

So bad is the outlook for the eurozone that developing nations are reducing their exposure to the common currency, instead flocking towards other majors including the US dollar. Last year was the first time since 2007 that the value of allocated euroApril 2013

2

FOREX denominated foreign exchange reserves of developing nations was below that of advanced nations. Euro holdings by advanced nations were, of course, artificially supported last year by the likes of the Swiss National Bank which needed to defend its peg to the common currency. But overall, the euro doesn’t seem to inspire confidence. Developing economies reducing exposure to euro Total value of euro holdings by advanced and developing nations in IMF’s COFER 800 US$ bn

Advanced

700 600 500 400 300

Developing

200 100 0

99

00

01

02

03

04

05

06

07

08

09

10

11

12

NBF Economy & Strategy (data via IMF)

And that despite the relatively tighter monetary policy by the ECB. Note that the Fed’s balance sheet continues to grow thanks to the quantitative easing program stateside while the ECB’s is shrinking. If as we expect the ECB is forced by a persistently weak economy to loosen monetary policy further, the euro should get even closer to our mid-year target of 1.23.

Bank of Japan walks the talk Japan is now out of recession thanks to upward revisions to Q4 data and the surge in output in Q1 this year. But that’s not deterring the Bank of Japan from pushing more liquidity towards achieving its 2% inflation target within two years. In his first meeting Governor Haruhiko Kuroda took the deflation bull by the horns by presenting the most aggressive monetary easing in the country’s history. The BoJ abandoned the interest rate as a target and will instead target the monetary base which is now slated to rise to 200 trillion yen at the end of this year, and to 270 trillion (more than 50% of GDP) by end-2014, the latter being almost double the end-2012 levels. To achieve that objective, the BoJ plans to buy about 7 trillion yen of long-term government bonds per month. The maturity restrictions have been scrapped, meaning that the BoJ will now include 40-year bonds on its shopping list. The Bank will also expand its purchase of exchange traded funds by 1 trillion yen per year and real estate trust funds by 30 billion yen per year. All told, the BoJ’s program is a lot more aggressive than even the Fed’s QE program. Bank of Japan more aggressive than even the Fed Japanese monetary base Trillion yen 280

Asset purchases as % of GDP %

16

260 240 220

end-2013 target (42% of GDP)

180 140

14 12

200 160

Euro has done poorly despite relatively tighter ECB policies

end-2014 target (56% of GDP)

10 Current (28% of GDP)

6

100

Ratio

80

1.40 1.38 1.36 1.34 1.32 1.30 1.28 1.26 1.24 1.22 1.20

EURUSD (R)

1,250 1,200 1,150 1,100

40 0 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14

12Q1

12Q2

12Q3

12Q4

0

BoJ (US$ 70 bn/month)

Fed (US$ 85 bn/month)

NBF Economy & Strategy (data via Bank of Japan)

Fed balance sheet divided by ECB balance sheet (L)

11Q4

2

20

950 900

4

60

1,050 1,000

8

120

13Q1

NBF Economy & Strategy (data via Bloomberg)

So while the euro may get temporary boosts as investors grasp at straws, e.g. get excited by irrelevant data like say Germany’s ZEW or IFO indices, the path of least resistance for the common currency remains downwards.

While the BoJ’s expanded stimulus should have minimal impacts on already low interest rates, it will likely be beneficial via other channels. One such channel is the stock market, where the Nikkei may add to its 21% rally so far this year, and generate positive wealth effects for investors. Another is the weakening of the yen which should help prop up a struggling export sector. While the BoJ’s policies should eventually take USDJPY into triple digit territory — we’re accordingly raising our end-of-year targets to 100 for 2013 and 110 for 2014 — note that the yen’s decline may not be linear. Those who had forgotten about the yen’s haven-like properties got a reminder as the Japanese currency appreciated 2% in the last half of March as Cyprus rocked markets.

April 2013

3

FOREX Canadian dollar has potential, but… After a difficult start to the year, the Canadian dollar rebounded somewhat in March, albeit not making up all of the lost ground — USDCAD indeed remains roughly 2% weaker than its end-of-2012 level. The lack of investor enthusiasm for the loonie extended to speculators who switched from CAD longs at the start of the year to net short positions, adding further pressure on the currency. So much so that the Canadian dollar has diverged from commodity prices, the latter being on a clear uptrend in synch with the apparent Q1 global economic rebound. Canadian dollar hasn’t kept up with commodities …

So what exactly has been keeping the loonie under wraps? The weak economy is the obvious suspect. The string of weak economic data, including those confirming sub-1% GDP growth in the second half of 2012, now have markets pricing in some probability of rate cuts after they were expecting rate hikes earlier this year. Pared down rate expectations restrain loonie Market expectations about BoC overnight rate at the end of 2013

1.25

%

1.00

0.75

index 680

0.970

670 660

0.50

0.975

BoC commodity price index (L)

0.980

650

0.985

640

0.990

630

0.995

620

1.000

610

1.005

600

0.25

0.00 Expectations start of 2013

Expectations on April 1st

NBF Economy & Strategy (data via NBF calculations)

1.010

USDCAD (R)

590

1.015

580

1.020

570

1.025

560

1.030 12Q2

12Q3

12Q4

13Q1

NBF Economy & Strategy (data via Bank of Canada)

While in the past the relatively large discrepancy between the loonie and commodity prices could have been explained by the price differential between WTI oil and the price received by our oil exporters, this time round the argument is less compelling given that the spread has been narrowing since the start of the year. …despite shrinking spread Western Canada Select crude oil differential -4

US$/barrel

-8 -12 -16 -20 -24 -28 -32

In our view, expectations of rate cuts are as unwarranted as those of hikes. The Bank of Canada, still obsessed with household debt accumulation, is unlikely to add fuel to the problem. If the economy accelerates briefly to around 2% in Q1 in synch with the US rebound, the related uptick in market rate expectations could help prop up the loonie. Capital inflows should also help support the Canadian currency as foreigners seek refuge in AAA-rated securities, more so now that the Cyprus precedent has put into question the safety of even bank accounts in the eurozone. But those friendly forces for the loonie could be dwarfed by the impact of a strengthening US dollar and softening commodity prices if market jitters make an unwelcome return. As Cyprus and Italy have shown, the worst may not be behind us with regards to the European economic and political situation. Moreover, a sequester-related moderation in US economic activity in Q2 may add to the risk-off mood and prompt flows towards the US dollar. So, while we acknowledge the upside potential for the loonie, we’re leaving our USDCAD mid-year target unchanged for now at 1.04.

-36 -40 -44 Jul 12

Stéfane Marion/Krishen Rangasamy Aug 12

Sep 12

Oct 12

Nov 12

Dec 12

Jan 13

Feb 13

Mar 13

NBF Economy & Strategy (data via Bank of Canada)

April 2013

4

FOREX Annex EURO

CANADIANDOLLAR

1.64

1.12

1.60

1.08

1.56 1.04

1.52 1.48

1.00

1.44

0.96

1.40 0.92

1.36 1.32

0.88

1.28

0.84

1.24 0.80

1.20 1.16

0.76 2007

2008

2009

2010

2011

2012

2013

2007

2008

J APANESEYEN

2009

2010

2011

2012

2013

2011

2012

2013

2011

2012

2013

AUSTRALIANDOLLAR

125

1.12 1.08

120

1.04 115

1.00

110

0.96

105

0.92 0.88

100

0.84

95

0.80

90

0.76 0.72

85

0.68 80

0.64

75

0.60 2007

2008

2009

2010

2011

2012

2013

2007

2008

2009

BRITISHPOUND

2010 CHINESEYUAN

2.2

8.0

2.1

7.8 7.6

2.0

7.4

1.9

7.2 1.8 7.0 1.7 6.8 1.6

6.6

1.5

6.4

1.4

6.2

1.3

6.0 2007

2008

2009

2010

2011

2012

2013

2007

April 2013

2008

2009

2010

5