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					Global Economic Research                                                           September 10, 2010




                                                  Capital Points
Derek Holt (416) 863-7707
derek_holt@scotiacapital.com

Gorica Djeric (416) 862-3080
gorica_djeric@scotiacapital.com                    — A weekly look ahead at Canadian and U.S. financial markets


Why Raising Taxes on the ‘Rich’ Will Impair US Growth                                         Index
In the debate over extending the Bush tax cuts that expire at the end of this year, it       1-2   Commentary
is important to acknowledge the role played by various income cohorts in driving               3   Canadian Preview
the US economy over recent years.
                                                                                             3-4   U.S. Preview
Currently, the Obama administration is proposing to extend the tax cuts                        4   International Preview
introduced through the Economic Growth and Tax Relief Reconciliation Act of
2001 and the Jobs and Growth Tax Relief Reconciliation Act of 2003 (the “Bush                5-6   Canadian Macro Comment
cuts”) beyond their scheduled expiration at the end of this year and permanently             7-8   Canadian Monetary Policy Comment
so, but only for families making less than $250,000 per year and individuals
                                                                                            9-10   Emerging Markets
earning under $200,000. Families and individuals over these income limits will
see the tax cuts expire, and substantially higher tax burdens in the new year.                10   International Markets

                                                                                              11   Fiscal Policy
That means that evaluating the microeconomic roles of income cohorts is
important to determining the economic impact of such tax changes. Using figures               12   Fixed Income Markets
from the Bureau of Labor Statistics (go here: http://www.bls.gov/cex/                      13-14   Foreign Exchange Markets
csxstnd.htm#2007, table T2301) we can evaluate the amounts earned and spent by
various income cohorts and, more importantly, their growth rates over time.                15-16   Indicator Preview Tables


The available data only breaks down the income cohorts to the upper limit of $150k+, and so it isn’t perfect in
mapping onto the cut -off point at which tax hikes are either extended or expire. The method used in the BLS data
relies on the ‘consumer unit’ which can be either an individual or all members of a household. Thus, here too the
data isn’t perfect, but we can nonetheless draw some useful inferences from the data. These are only partial
concerns, however, since a family comprised of, say, two earners making an average of $125k each would fall
within the categories for which data is available, and would be out of luck in hoping for tax cut extensions.

The accompanying chart depicts the results. Those earning over $150k accounted for about one-third of the growth
in nominal consumer spending over the five-year boom period of 2003-08, over 40% of income growth during this
same period, and paid over 60% of total tax revenues collected by all governments in 2008. If we broaden this to
include anyone earning $120k+ by combining the two upper categories, then almost half of all growth in total
consumer spending over the same period, over half of income growth, and 75% of taxes paid to all levels of
government came from upper-income earners. Clearly growth has come very disproportionately from the 7% of
consumer units earning over $150k and the 12% earning over $120k.

But tax cuts targeted                               Upper Earners Do the Heavy Spending
toward lower-income            45
                                     % share of grow th in income
individuals can entail         40
higher multiplier effects            and consumption, 2003-08
since they have a higher       35
marginal propensity to         30                                                 Total income
consume out of income          25                                                 Total spending
(i.e., they save less out of   20
each incremental dollar’s
worth of income). Indeed,      15
those earning under $70k       10
in aggregate spend more         5
than their incomes and          0
fund this through debt (or
used to…). Such                        <$70k        $70-80k        $80-100k      $100-120k $120-150k                  $150k+
multiplier effects rely upon   Source: Bureau of Labor Statistics, Scotia Capital Economics

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Global Economic Research                                                                                September 10, 2010

                                                                                                               Capital Points
hotly contested assumptions such as how the cuts are financed and hence whether the effects are taken back through
spending cuts and cuts to income transfers, and whether or not the cuts are believed to be truly permanent. Getting into the
debate over fiscal multiplier effects isn’t our immediate focus versus the simpler point we’re trying to make. Further,
whether or not tax cut extensions are even noticed versus simply being an extension of what lower-income households have
become accustomed to since the tax cuts were introduced in 2001 and 2003 also matters in terms of incorporating the role of
adaptive expectations and any potential shock effect.

Our simpler point is that raising taxes on upper-income earners defies the fact that they have generated a heavily
disproportionate amount of growth in total consumer spending over time, and a hike would stand the greater likelihood of
being interpreted as a modest shock to their finances since — like lower- to middle-income earners — upper-income earners
have likely adapted to the earlier cuts that are about to expire.

So if tax cuts to lower- and middle-income earners are extended, don’t look for a rise in their consumer spending stemming
from proposed policy changes, but at least it shouldn’t be negatively impacted as it would be should the cuts expire. On the
other hand, look for a contraction in spending by upper-income earners in response to what can add up to very material tax
increases when all sources of change are included. Weight the spending implications for the upper-income individuals
much more heavily given their role in driving consumption growth. On net, given the massive role played by upper-income
earners in driving spending growth, we think the proposed tax changes still leave intact expectations for a potential
retrenchment in total consumer spending in 2011 barring a much more convincing recovery in job and income growth, or a
stronger positive wealth effect through higher house prices that we doubt will happen for years yet, or wealth gains through
stronger financial markets.

We even doubt that the proposed extension of tax cuts for lower- and middle-income earners will arrive in time to avoid
negative consequences stemming from the uncertainty regarding future tax burdens, given current political gridlock,
uncertainty over how the divide between Republicans and Democrats in the House after the mid-terms will affect the
feasibility of legislative changes, and the speed with which they would have to act when a new Congress sits.

Our aim in writing this is not to encroach upon the issue of tax fairness which we’ll leave to politics and normative
judgments, especially for a country that frankly faces among the lowest personal tax burdens anywhere despite having
among the greatest fiscal imbalances in the world. Our aim is to instead point out the potential macroeconomic
consequences of uneven changes to tax policy in 2011 that we think will have the net effect of impeding growth.

There is likely no way around this challenge. The estimated extra $1 trillion or more that it would cost the US government
over the next decade to extend the cuts for the ‘rich’ would be a difficult price tag for bond markets to swallow unless offset
by other measures that themselves would leave net stimulus flat. Extending tax cuts for relatively wealthier individuals on a
more affordable temporary basis would also not work, since a well telegraphed temporary tax cut extension would likely be
saved in anticipation of higher future taxes. There are many other considerations we haven’t broached either, such as
whether cutting taxes for some and not for others will encourage income splitting and avoidance measures.

So what’s our bottom line? Most economists would probably agree that if one had to make an expensive choice over who
should get tax cuts and who shouldn’t in providing stimulus to the economy relative to what would otherwise happen, then
err on the side of those who spend more of their incomes contingent upon what assumptions one subscribes to as noted
above. But under the circumstances, do so with tempered expectations over whether or not such stimulus will flow through
overall economic growth in light of the vastly different roles played by the various income cohorts in driving growth in total
consumption over time.




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Global Economic Research                                                                                              September 10, 2010

                                                                                                                              Capital Points
Next Week’s Key Market Risks
The key release schedule for next week can be found on pages 15-16. The Basel Committee on Banking Supervision
meets on Sunday at the Bank for International Settlements headquarters in Basel, Switzerland, where banking regulators will final-
ize new rules on financial regulation. Of the four central bank meetings next week (Chile, New Zealand, Switzerland and Tur-
key), the spotlight is likely to be on the Reserve Bank of New Zealand. The country’s policymakers are expected to keep their
overnight rate unchanged for the first time since June, as they monitor the economy in the aftermath of the 7.1-magnitude earth-
quake, which severely damaged the country’s second-largest city of Christchurch on September 4. On the macro front, the focus of
the Canadian docket will be July manufacturing sales. It will be considerably busier in the United States, where we get August
updates on major drivers of the economy, including retail sales, industrial production and prices. Following tonight’s monthly data
dump from China — consisting of August retail sales, industrial production, capital investment and prices — next week’s line-up
will be much lighter, comprising only August bank loans and foreign direct investment. Elsewhere, we will get pan-European
second quarter employment numbers, July industrial production, trade balance and construction output as well as U.K. July updates
on house prices and the ILO unemployment rate, the August release of retail sales, CPI and jobless claims.

CANADA
In terms of leading indicators of manufacturing activity, there is not    6              Canadian Manufacturing Sales vs. Exports
much to go by in Canada other than key export data, as Purchasing         4
                                                                               m/m % change, 3-mma
Managers’ Indices (PMIs) are not reliable. As such, based on ex-
                                                                          2
ports, we think that manufacturing sales are likely to have con-
tracted a modest 0.3% m/m in July. While the nominal prices will be       0
pushed up by higher commodity prices, real values will be lowered        -2
by softer export volumes, a reasonably strong base effect and the lag    -4                Exports
effect of a stronger Canadian dollar. Export losses were widespread      -6                                Manufacturing Shipments
across all export sectors with the exception of industrial goods &
                                                                         -8
materials, which account for roughly 15% of overall manufacturing
shipments. Machinery and equipment, other consumer goods and            -10
forestry products led nominal export declines. Tail risks to this fore-     00    01      02    03     04     05     06     07 08           09    10
                                                                        Source: Statistics Canada, Scotia Capital Economics
cast are considerable as exports do not capture domestic manufactur-
ing sales and not all exports come from current production. Note that
the manufacturing sales report will also provide more insight on the inventory restocking cycle and pipeline orders.

The Bank of Canada Governor Carney will give a lecture on “The Economic Consequences of Financial Reform” at the
Bundesbank in Berlin, Germany on Tuesday at 10:45amET. A brief Q&A will follow. Bank of Canada Deputy Governor Lane
will speak to the St. John’s Board of Trade at 11:45amET on Wednesday.

The Bank of Canada will sell two-year notes at noon on Monday.

UNITED STATES
Next week brings an update on industrial production, both in terms of August official numbers and the September regional re-
ports from the New York and Philadelphia Feds. We expect headline industrial production to have posted growth of 0.4% m/m, a
pick-up over July’s 0.2% gain. The ongoing unseasonably warm weather is likely to cause a large gain in utilities production for
the fourth straight month. While payrolls show that manufacturing employment contracted by 27,000 in August, a first since De-
cember, average weekly and overtime hours continue to gradually edge higher — which may signal production gains — and the
latest ISM production index pointed to a pick-up in the pace of
production (to 59.9 from 57.0), as did three of the five regional       U.S. Retail Sales* vs. Personal Consumption Expenditure (PCE)
surveys (Chicago, Dallas, Empire).                                8.0
                                                                       y/y % change, 3-mma
                                                                          6.0
American shoppers remain cautious— a sentiment reinforced by
                                                                          4.0
lacklustre job growth since May and slowly recovering household
income and balance sheets, — while idle liquidity is providing            2.0
only some offset. In July, the first month of the third quarter, the      0.0
details were worse than the headlines. Only autos and gas prices
                                                                         -2.0    Retail Sales (LHS)                        Real PCE (RHS)
lifted sales. Stripping out these components unmasked declines in
most other categories. More importantly, momentum in inflation-          -4.0
adjusted sales is turning sour. We estimate that retail sales posted            * Input for real GDP (ex. MVP, building materials and gasoline)
                                                                         -6.0
modest growth of 0.2% m/m in August, on gains in core compo-                 96        98        00       02         04       06           08          10
nents, partly offset by lower gasoline prices and weaker motor            Source: B.E.A., Census Bureau, Scotia Capital Economics




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Global Economic Research                                                                                   September 10, 2010

                                                                                                                  Capital Points
vehicle sales. Leading indicators and private surveys give mixed guidance for next week’s release of the August Advance Retail Sales
report. On the fundamental front, private-sector employment gains continued to lack enthusiasm in August. Consumer confidence
surveys were soft. Prices at the pump fell, down 2.3% m/m. Car and light truck purchases softened to an annual rate of 11.2 million
units in August, down from 11.5 million in July, but in line with the year-to-date average. Lower retail volumes accounted for last
month’s moderation, reversing the improvement in July. That said, private retail sales surveys (ICSC Chain-Store Sales index, John-
son Redbook index, MasterCard Advisors’ SpendingPulse, ShopperTrak) were mixed, in part supported by back-to-school spending.

Headline consumer and producer prices are expected to reg-                                  U.S. Core CPI vs. PPI
                                                                   0.5                                                                 0.4
ister modest headline gains — of 0.2% m/m each — in August,               m/m % change, 3-mma
despite softer commodity prices. Core prices are also likely to    0.4
                                                                                                                                       0.3
post advances, although more modest than at the headline level. 0.3
While deflation is hardly evident as the core CPI basket has
                                                                                                                                       0.2
been posting widespread gains, core prices remain depressed by 0.2
historical standards. Uncertainty over employment prospects,       0.1                                                                 0.1
weak income growth and ongoing deleveraging mean that
household budgets are constrained, limiting pass-through effects 0.0
                                                                                                                                       0.0
of higher producer prices into the CPI basket. If forced to spend -0.1             Core Producer Price            Core Consumer
more on core staples like food and energy, households will sub- -0.2                   Index (LHS)               Price Index (RHS)     -0.1
stitute away from discretionary items just as they did in 2008.        05         06          07         08         09          10
Going forward, we are of the opinion that very low y/y readings Source: B.L.S., Scotia Capital Economics
on the headline CPI will occur over the latter stages of this year
and into the next before a low base effect leads to a modest upward bias later in 2011.

New York state primaries — for Democrats and Republicans — are set to begin on Tuesday of next week. The 2010 elections
will take place on November 2, 2010. These include elections for Senate, House of Representatives as well as state and local seats.

Atlanta Fed President Lockhart will moderate, on Monday at 12:30pmET, the Q&A portion of the World Affairs Council of
Atlanta session with Sir Nigel Sheinwald, British Ambassador to the United State. Fed Governor Tarullo will deliver a speech on
the shadow banking system at 11:30amET at the Brookings Institution in Northwest, Washington DC. The Chicago Fed will hold
a hearing on the Home Mortgage Disclosure Act. Time and details have yet to be announced.

According to the Tentative Outright Treasury Operation Schedule Table, the Fed will complete more purchases of Treasury
notes, using the principal payments from agency debt and agency MBS. The purchase of notes is lined up for noon on Wednesday.

INTERNATIONAL
Of the four central bank meetings — in Chile, New Zealand, Switzerland and Turkey — policymakers in Chile are the only ones
expected to alter the overnight rates, up by 50bps to 2.5%. The Reserve Bank of New Zealand (RBNZ) is likely to garner the
most attention, as the consensus increasingly shifted from hiking further to a hold, until all the respondents changed camps by mid-
day Friday. The RBNZ embarked on the tightening cycle in June, raising rates twice after more than a year on the sidelines. How-
ever, the central bank might keep its key lending rate unchanged next Thursday, as a 7.1-magnitude earthquake devastated the
country’s second-largest city of Christchurch on September 4. Christchurch accounts for roughly 12% of the country’s overall
population and of its economy. According to the preliminary estimates, the cost of restructuring could be as high as NZ$2 billion,
comparable to about 1% of the country’s economy.

Rough trading seas are likely to persist as investors face a week of heavy data flows amid rising concerns over the global economic
outlook. Following tonight’s regular monthly data dump, China will release two more August reports, one on new loans and the other
on foreign direct investment. Most recent data suggest that the economy remained on the expansionary path, but is gradually shifting
into lower gear. After two weeks of back-to-back fundamental releases, it will be an exceptionally light week in Japan, with only Au-
gust condominium sales scheduled for Tuesday. Also out of Asia, we get August unemployment rate from South Korea, second-
quarter dwelling starts from Australia as well as August housing prices and July retail sales from New Zealand. A number of key
fundamental releases will be published in the euro-zone region. At the pan-European level, the region’s statistical agencies will circu-
late second quarter employment numbers, July industrial production, trade balance and construction output as well as September‘s
ZEW sentiment survey. Germany will update its producer prices with August data. Italy will distribute July reports on current ac-
count and industrial activity. And, Spain will release data on July house transactions and second-quarter house prices. Last but not
least, it will be a busy week in the United Kingdom, with July updates on house prices and the ILO unemployment rate as well as
August release of retail sales, CPI and jobless claims. Private surveys indicate that retail sales increased in August, supported by back-
to-school shopping. Despite uncertainty over the impact of austerity measures and the outlook for the labour market, consumer senti-
ment is showing signs of improvement in the U.K., increasing for the first time in six months in August.


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Global Economic Research                                                                                   September 10, 2010

                                                                                                                 Capital Points

                                                                           Gorica Djeric (416) 862-3080         Derek Holt (416) 863-7707
Canadian Macro Comment                                                   gorica_djeric@scotiacapital.com      derek_holt@scotiacapital.com

Canada’s Mythical Job Reports

Canada’s reported gain of 35,800 jobs in August was as mythical an occurrence as the reported drop of 9,300 jobs the month be-
fore. At the heart of the matter is that Statistics Canada is having record-breaking problems in controlling for abnormal seasonal
variations in education sector jobs.

Statistics Canada has our sympathies
with respect to dealing with the very
recent changes to the contracts affect-
ing workers in the education sector
including, but not limited to, teachers.
A shift to temporary contracts that
have risen as a share of the education
sector's employment, and a shift in the
nature of the contracts across various
school boards in the country that zero
the contracts at the end of the school
year and renew them in August/
September, have combined to lead to
problems in applying long-run sea-
sonal adjustment factors to the data
ever since 2007. In recent years, those
contract changes make it such that
when education sector workers are
asked whether or not they are em-
ployed during July, they technically respond by saying no. But in responding to the next month’s survey, they then record them-
selves as working. This year's distortions marked by steep declines in education sector employment in July followed by large re-
ported hiring the next month are the most pronounced by far and the problem is getting worse over time as this year’s distortions
are off the charts (see accompanying chart). Clearly a break in series has occurred since 2007 that analysts and markets should be
controlling for, if not StatsCan by altering its seasonal factors post-2007 in what would be a desirable special research note. To
this point, StatsCan noted in their accompanying commentary to the Labour Force Survey that it applies seasonal adjustment fac-
tors defined over a 7-year period, and that there has been no consistent pattern in the direction or magnitude of these changes over
the seven years. True enough, but there is definitely a break that the accompanying chart clearly flags over the past four years
during which contracts have changed, and we cannot think of a reason why that would be expected to go away in future years.
Controlling for this is difficult, but markets and analysts should at least be aware of the heavy distortions when reacting to the job
headlines at this time of year.

Just as markets didn't question the bearish headline in the July jobs report that was fed by a mythical decline in education sector
jobs accompanied by nary a cry of protest from well-organized labour, markets at least initially reacted to the August report by
doing little to question the headline jobs gain that was equally fictitious and (not surprisingly) accompanied by a lack of cheer
among teachers with respect to a seemingly unprecedented hiring bonanza. CAD and the short-end of the curve have been fully
off base in their reactions to the past two jobs reports, only to get surprised by a very different reading of this and other domestic
data by the BoC in the lead up to this past week's 25bps rate hike.




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Global Economic Research                                                                                   September 10, 2010

                                                                                                                Capital Points

                                                                           Gorica Djeric (416) 862-3080        Derek Holt (416) 863-7707
Canadian Macro Comment                                                   gorica_djeric@scotiacapital.com     derek_holt@scotiacapital.com

Canadian Housing Affordability Is Worse Than In The Early 1990s

Properly measured housing affordability is at among its worst points ever in the Canadian economy. Our opinion on this matter is
rooted in using actual information on mortgage payments sourced from hard data, versus marketing surveys that are designed to
address the issue under particular assumptions for someone just entering the market. As a share of after-tax disposable income,
Canadians are spending more than ever on mortgage interest and mortgage principal payments. That makes abundantly more
sense to us in the context of record-high house prices.

The accompanying chart is mostly a replay of the chart                    Housing Affordability Is Worse Than the Early 1990s
                                                              25
that we ran in last week’s Capital Points article titled            Mortgage interest
“Canada’s Record-High Household Debt Service Bur-                   payments + mortgage
                                                              20                                           Total
den” but this version excludes interest paid on non-                principal payments
mortgage debt in order to focus exclusively upon housing
                                                              15
costs. Therefore, we’re adding mortgage interest paid
and mortgage principal paid and dividing by after-tax
personal disposable income. The same caveats to this          10                                                        Principal
data that were noted in our prior article still apply, and
they bias our figures to be on the low side of reality by       5
only capturing mortgage principal payments going to                                             Interest
banks since data for other lenders isn’t available. Further, 0
we haven’t even begun to add other home ownership                 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10
costs like property taxes, insurance, and utilities—each of Source: Bank of Canada, Statistics Canada, Scotia Capital Economics
which is harder to line up through hard data with the
same group of individuals who are making mortgage payments. The payment ratio may have come off in recent years simply by
coinciding with the arrival of longer amortization mortgages that have borrowers lowering their payments and extending their
debts further out in life. That option was not available prior to 2007 since the standard 25-year conventional mortgage defined all
prior lending cycles.

Our preferred affordability measures nonetheless remain metrics that we presented in “Did Canadians Learn Much From The
Global Crisis?” (September 1st 2010). They compare various measures of home prices over time by adjusting for inflation, or by
expressing them relative to incomes, and they are all at record-high levels (i.e., poor affordability). By contrast, looking simply at
the carrying cost of an asset like housing relative to income offers a potentially fatally flawed gauge of an asset’s fair value. By
that standard, low interest rates on margin debt would make the carrying costs of equities look affordable even if they too were
over-valued and even if principal was gradually paid back out of future years’ income.




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Global Economic Research                                                                                  September 10, 2010

                                                                                                               Capital Points

                                                                          Gorica Djeric (416) 862-3080        Derek Holt (416) 863-7707
Canadian Monetary Policy Comment                                        gorica_djeric@scotiacapital.com     derek_holt@scotiacapital.com

The Bank of Canada Cast Doubt On the Pause Argument

The Bank of Canada hiked to 1.0% in a short and sweet statement on September 8th, and did so with a bias that we interpret to
lend little to the pause view over the duration of 2010. A comparison of changes to the September statement with the wording of
the July statement follows on the next page. Yes, the closing sentence is ever-so-slightly more cautious in nature compared to the
last statement, and the BoC now expects the Canadian recovery to be “slightly” softer than projected in July. But we attach more
weight to the fact that the BoC has said that nothing has changed in its inflation outlook, and that the BoC is still flagging upbeat
expectations for strengths in the domestic economy supported by “exceptionally stimulative” financial conditions we think are
owing in part to lower government bond yields, still very low short rates, commodity prices that generally lie beyond many project
break evens, and a small depreciation in CAD compared to earlier this summer. Thus, we read the balance of the statement’s
wording to indicate that the BoC may well not be done for this year in contrast to the Scotia Economics/FX house view that it will
pause at each of the next two meetings. That looks less likely, barring a much more serious deterioration in global fundamentals
and market flows, so the BoC may get to an end point around 1.75-2% sooner than forecast alongside our view that the Fed is on
hold until at least 2011Q4.

Our additional thoughts on the statement follow:

   By essentially looking through many points of recent softness, the BoC is so far signaling that it is leaning heavily toward
     giving the benefit of the doubt in favour of its longer-run themes as opposed to being blown off course for 2011 expectations
     by near-term data. A much sharper deterioration in global growth prospects with more sustained signals in that direction
     would be required to significantly move the Bank off this line of reasoning in support of the pause view.

   The BoC looked through the last inflation print by bluntly noting that “Inflation in Canada has been broadly in line with the
     Bank’s expectations and its dynamics are essentially unchanged.” As we’ve argued, the BoC had no reason to be fundamen-
     tally blown off its inflation outlook by the last inflation report. The non-seasonally adjusted m/m dip was countered by a
     small 0.1% m/m seasonally adjusted gain in core CPI so the markets misread it but, more importantly, the BoC’s argument
     regarding the near-term downward indirect influence of refunded tax credits on core CPI stemming from the July 1st move
     toward a harmonized sales tax in Ontario and BC remains intact before those effects shake off and inflation tracks back up to
     the BoC’s 2% target by next summer.

   The BoC also looked through the latest GDP print that came in softer than it (and most analysts) had expected by noting that
     the domestic economy remains solid and in line with its views to date. That acknowledges that an import leakage effect dis-
     torted headline GDP, and actually reflected domestic strengths via imported capital equipment. As a confidence booster, the
     BoC is sticking to its guns in terms of forecast strengths in the domestic economy, flagging “solid” expectations for consump-
     tion growth and its “business investment to rise strongly” viewpoint.

   There was no reference to household debt risks in this statement in contrast to worries expressed by Governor Carney in past
     speeches and BoC reports. But the indirect reference may well lie in how the BoC translates strong credit channels as being
     supportive of “solid” expectations for consumption growth.

   Of note is that the BoC still says that financial conditions in Canada “have tightened modestly but remain exceptionally stimu-
     lative.” To this effect, the BoC specifically referenced the sharp declines in government bond yields.

   On global growth risks, the BoC acknowledged emerging market strengths but that recent US indicators suggest a more muted
     recovery “in the near-term.” That says that the BoC is not prepared to toss out its views on longer-run US growth and the
     sustainability of the recovery as opposed to simply acknowledging weak near-term growth.

   Look for small downward revisions to US and Canadian GDP growth in the October MPR compared to the July MPR which
     had itself downwardly revised the BoC’s expectations compared to the April forecasts. The BoC noted that “The Bank now
     expects the economic recovery in Canada to be slightly more gradual than it had projected in its July MPR, largely reflecting a
     weaker profile for U.S. activity.”




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Global Economic Research                                                                                            September 10, 2010

                                                                                                                            Capital Points

                                                                                 Gorica Djeric (416) 862-3080             Derek Holt (416) 863-7707
Canadian Monetary Policy Comment (continued)                                   gorica_djeric@scotiacapital.com          derek_holt@scotiacapital.com



               Release Date: September 8, 2010                                                  Release Date: July 20, 2010
The Bank of Canada today announced that it is raising its target for the     The Bank of Canada today announced that it is raising its target for the
overnight rate by one-quarter of one percentage point to 1 per cent.         overnight rate by one-quarter of one percentage point to 3/4 per cent.
The Bank Rate is correspondingly 1 1/4 per cent and the deposit rate         The Bank Rate is correspondingly 1 per cent and the deposit rate is
is 3/4 per cent.                                                             1/2 per cent.

The global economic recovery is proceeding but remains uneven,               The global economic recovery is proceeding but is not yet self-
balancing strong activity in emerging market economies with                  sustaining. Greater emphasis on balance sheet repair by households,
weak growth in some advanced economies. In the United States,                banks, and governments in a number of advanced economies is
the recovery in private demand is being held back by high                    expected to temper the pace of global growth relative to the Bank's
unemployment and recent indicators suggest a more muted                      outlook in its April Monetary Policy Report (MPR). While the policy
recovery in the near term.                                                   response to the European sovereign debt crisis has reduced the risk of
                                                                             an adverse outcome and increased the prospect of sustainable long
Economic activity in Canada was slightly softer in the second                term growth, it is expected to slow the global recovery over the
quarter than the Bank had expected, although consumption and                 projection horizon. In the United States, private demand is picking
investment have evolved largely as anticipated. Going forward,               up but remains uneven.
consumption growth is expected to remain solid and business
investment to rise strongly. Both are being supported by                     Economic activity in Canada is unfolding largely as expected, led by
accommodative credit conditions, which have eased in recent                  government and consumer spending. Housing activity is declining
weeks mainly owing to sharp declines in global bond yields.                  markedly from high levels, consistent with the Bank's view that policy
                                                                             stimulus resulted in household expenditures being brought forward
The Bank now expects the economic recovery in Canada to be slightly          into late 2009 and early 2010. While employment growth has resumed,
more gradual than it had projected in its July Monetary Policy Report        business investment appears to be held back by global
(MPR), largely reflecting a weaker profile for U.S. activity. Inflation in   uncertainties and has yet to recover from its sharp contraction during
Canada has been broadly in line with the Bank's expectations and its         the recession.
dynamics are essentially unchanged.
                                                                             The Bank expects the economic recovery in Canada to be more
Against this backdrop, the Bank decided to increase its target for the       gradual than it had projected in its April MPR, with growth of 3.5 per
overnight rate to 1 per cent. As a result of monetary policy                 cent in 2010, 2.9 per cent in 2011, and 2.2 per cent in 2012. This
measures taken since April, financial conditions in Canada have              revision reflects a slightly weaker profile for global economic growth
tightened modestly but remain exceptionally stimulative. This is             and more modest consumption growth in Canada. The Bank
consistent with achieving the 2 per cent inflation target in an              anticipates that business investment and net exports will make a
environment of significant excess supply in Canada.                          relatively larger contribution to growth.

Any further reduction in monetary policy stimulus would need to              Inflation in Canada has been broadly in line with the Bank's April
be carefully considered in light of the unusual uncertainty                  projection. While the Bank now expects the economy to return to full
surrounding the outlook.                                                     capacity at the end of 2011, two quarters later than had been
                                                                             anticipated in April, the underlying dynamics for inflation are little
                                                                             changed. Both total CPI and core inflation are expected to remain near
                                                                             2 per cent throughout the projection period. The Bank will look through
                                                                             the transitory effects on inflation of changes to provincial indirect
                                                                             taxes.

                                                                             Reflecting all of these factors, the Bank has decided to raise the target
                                                                             for the overnight rate to 3/4 per cent. This decision leaves
                                                                             considerable monetary stimulus in place, consistent with achieving the
                                                                             2 per cent inflation target in light of the significant excess supply in
                                                                             Canada, the strength of domestic spending, and the uneven global
                                                                             recovery.

                                                                             Given the considerable uncertainty surrounding the outlook, any
                                                                             further reduction of monetary stimulus would have to be weighed
                                                                             carefully against domestic and global economic developments.




                                                                                                                                                      8
Global Economic Research                                                                                                                                September 10, 2010

                                                                                                                                                                   Capital Points

                                                                                                                                                                 Joe Kogan (212) 225-6541
Emerging Markets                                                                                                                                              joe_kogan@scotiacapital.com

Peru: Assessing The Risk From The Left

The odds of a radical left presidency have fallen considerably since the last presidential elections. No one we spoke to in Lima
last month thinks Humala can win in 2011 and few think he can make it to the second round. We explain the reasons why.
(This article is an abridged version of the full report published on September 8, 2010)


Almost five years ago, Ollanta Humala surprised observers by emerging from last place and winning the first round of the 2006
Presidential elections with 31% of the vote. Humala’s strong showing in the first quarter of that year was enough to frighten
markets. In the six weeks prior to the first round, sovereign CDS doubled, increasing from a low of 113bp to a high of 250bp. It also
underperformed Brazil by 100bp. The currency reacted as well, depreciating by 3% while Brazil’s currency remained unchanged.
Humala ultimately lost to Alan Garcia by a vote of 47% to 53% in the second round. Nevertheless, memories of this episode raise
concerns among some foreign investors going forwards, especially since the market prices almost no election risk.

Investors should probably take only limited comfort from         Figure 1 - Humala’s surprising rise in 2006
Humala’s poor showing in recent polls. He currently ranks
                                                                 40
fourth, with only 12% of the total vote, according to Ipsos
Apoyo’s mid-August survey. In August of 2005, Humala             35
had only about 7% of the vote, yet managed to improve
significantly by the end of the year (Figure 1). Thus, we        30
cannot rely exclusively on early polls. Still, there are three   25
reasons to think that Humala will perform worse in this
election than in the prior one. These concern changes in the     20
country, changes in the candidates, and changes in Humala
                                                                 15                                       Humala August
himself.
                                                                 10                                       2010 poll (12%)
First, the economic growth rate over the past decade and
especially over the past several years should have                          5
demonstrated to the country the benefits of a market-based              0
economy. The annual growth rate in per capita GDP over                  Apr-05                                    Jun-05               Aug-05           Nov-05              Jan-06            Mar-06
the past three years for the country as a whole was an
annualized rate of 5.2%. Since some regions have grown                                                                       Humala         Garcia      Flores        Paniagua
faster than others, it is important to consider the growth in
                                                                                                  Source: Apoyo
areas where Humala has had strong support in the past.
Figure 1 shows GDP/capita in 2006, the percentage of the                       Figure 2 - GDP/capita, growth, and support for Humala, by region
vote Humala won in 2006, and the subsequent growth rate,
by region. (Peru is composed of 24 geo-political regions,                                         12.0%
which were previously called departments.)
                                                                                                  10.0%
                                                                 A nnual grow th rate 2006-2009




The graph shows that growth has been far from uniform in                                                                                                         Size of bubbles represents
Peru, with the worst region growing at 0.2% while the best                                        8.0%                                                           % vote for Humala in 2006
                                                                                                                                                                 1st round
grew at 10.1%. Yet, we were happy to see that the growth
rate seemed largely independent of the starting level of                                          6.0%
income; it is clearly not the case that only wealthy districts
profited from Peru’s economic boom. Moreover, some of
                                                                                                  4.0%
the regions where Humala received large numbers of votes
in 2006 have grown at impressive rates. It seems
reasonable to expect that Humala would lose votes in                                              2.0%
regions that have grown at more than say 3%. Meanwhile,
poverty rates in the country are also falling. In 2005, 49%                                       0.0%
of Peruvians were poor, very close to the percentage of                                                   0        2,000       4,000       6,000      8,000        10,000     12,000     14,000
votes Humala received in the second round in 2006. At the                                                                                   GDP/capita in 2006
end of 2009, poverty levels had fallen to 35%.                                                            Source: Peru’s Instituto Nacional de Estadistica e Informatica




                                                                                                                                                                                                  9
Global Economic Research                                                                                     September 10, 2010

                                                                                                                    Capital Points

                                                                                                                   Joe Kogan (212) 225-6541
Emerging Markets (continued)                                                                                    joe_kogan@scotiacapital.com

Second, Humala will face tougher electoral competition this time around. Part of what helped Humala in the 2006 election was his
competitors’ inability to draw support from outside of Lima. Alberto Fujimori was successful at doing this in the 1990s, whether by
targeting government spending in the south of Peru or by simply flying around the country and distributing food and clothing — a
surprisingly effective strategy for buying votes. Fujimori hoped to return to power in 2006 but spent the election in a Chilean prison
awaiting extradition to Peru. Polls at the time showed that Humala won over disaffected voters who would otherwise have voted for
Fujimori. This time Humala will have no such luck, as he faces Alberto Fujimori’s daughter Keiko in the first round. Keiko currently
leads Humala, often by very large margins, in four of six geographic regions, and lags only in the South. Similarly, she leads Humala in
every one of five socioeconomic classes, also by wide margins. It is hard to see how Humala can make up for this difference.

Third, perhaps in response to some of these changes, Humala seems to have moderated his discourse. In an interview he gave
earlier this summer, he declined to be characterized as either from the left or the right. Instead, he talked about nationalism,
corruption, and inequality. Three of the five news stories on his party’s website are about sovereignty over the country’s gas
reserves, and a fourth, about foreign investment, uses the gas industry as an example. It seems he is staying away from less popular
themes like renegotiating free trade agreements. Humala is also learning from past mistakes, for example, this time he is careful to
avoid any association with Chavez. All of that may well be a good thing for his chances. Less helpful is the fact that he is now too
well known to be considered an outsider. The romanticism and sense of rebellion that probably helped in 2006 are gone.

The changes are also evidence that Humala is the wrong leftist candidate. The resistance to electing a radical candidate seems
stronger than before, and Humala as a moderate is unconvincing. During our three days in Lima last month, an idea we heard
frequently was that a more moderate and more charismatic leftist candidate would have a much better chance in the future than
Humala has in the current election. When we asked local analysts to estimate the probability that Humala makes it to the second
round, we got responses ranging from 0% to 30%; none of the analysts we spoke to thought that Humala could wind a second
round. Instead, the more left-leaning analysts hoped for the emergence of a Lula-like figure who could actually win an election.

We could see some radical-left victories in upcoming regional and municipal elections on October 3rd, though in a small enough number
such that they should not affect foreign investor sentiment. The three leading Presidential candidates differ little with regards to policy
positions that portfolio investors care about. As a result, Presidential elections in Peru will not matter much for fixed income markets.

                                                                                                                Tuuli McCully (416) 863-2859
International Markets                                                                                         tuuli_mccully@scotiacapital.com

Credit Rating Upgrade In Sight For Russia; Inflationary Pressures Start Re-Emerging

Russian sovereign credit prospects are brightening; Fitch Ratings revised the outlook for Russia’s “BBB” long-term foreign
currency rating to “positive” on September 8th. The rating agency assesses that the country’s financial vulnerabilities are
diminishing on the back of a recent decline in inflation, a shift to a more flexible exchange rate policy, stronger private sector
balance sheets, banking sector stabilization and rising foreign reserves (currently at US$477 billion). Major weaknesses weighing
on Russia’s credit rating are the country’s poor governance and corruption, a weak business climate, exposure to commodity prices
and a history of high and volatile inflation. Among other major rating agencies, Standard and Poor’s rates Russia similarly to the
“BBB” category, while the rating assigned by Moody’s Investors Service is one notch higher, “Baa1”.

In terms of governance issues, little change can be expected over the coming years, with power continuing to be concentrated on very
few people. With a year and a half left until the next Russian presidential election, speculation regarding the ruling United Russia
party’s candidate is intensifying. Prime Minister Vladimir Putin hinted once again this week that he may consider running for president
in the March 2012 election; Mr. Putin was the president of Russia in 2000-2008 and was banned by constitution from running for
office after two consecutive terms. Standing President Dmitri Medvedev has indicated that he and Mr. Putin will not race against each
other, but will make a joint decision on the presidential candidacy. Policy continuity is discounted regardless of the election result.

The Russian economy is on a solid growth trajectory; output expanded by 5.2% y/y in the second quarter of 2010, led by the
manufacturing sector, taking the annual output growth in the first six months to 4.2%. We expect the economy to reach a close to
5% expansion in 2010, followed by a slight easing to 4½% in 2011. The recent disinflation process has come to an end as higher
food prices resulting from the most severe drought in a half century are starting to feed inflation; consumer price inflation jumped to
6.1% y/y in August from 5.5% the month before. Accordingly, the central bank’s monetary easing process has likely reached its
bottom; the benchmark interest rate is currently 7.75%.


                                                                                                                                           10
Global Economic Research                                                                                      September 10, 2010

                                                                                                                         Capital Points

                                                                         Mary Webb (416) 866-4202               Nathan Joshua (416) 866-5338
Fiscal Policy                                                          mary_webb@scotiacapital.com            nathan_joshua@scotiacapital.com

The Fiscal Impact of U.S. Health Care Reform — Initial Estimates                                                          Medicare
While health expenditures remain an area of potential risk for most developed nations as               federal funding,
they struggle to attain a sustainable fiscal path this decade, for the United States, potential        annual % change
                                                                                                  16
changes from the legislated health care reform are immense. In Washington, the Office of                     forecast
the Actuary in the Centers for Medicare & Medicaid Services has compared its February
                                                                                                  12
2010 forecast of national health expenditures through 2019 under prior law to an updated                                 February 2010
September forecast with the legislated reforms. For the U.S., grappling with the highest                                 Projection
level of health care spending relative to GDP among the major developed nations, the top          8
line result indicates that total private- and public-sector health outlays will climb from an
estimated 17.3% of GDP in 2009 to 19.6% by 2019, slightly higher than the 19.3% share             4
                                                                                                                               September
under prior law, but not a huge increase. Under the proposed reforms, the 2.0% forecast
rise in total spending in 2019 would insure an additional 32½ million residents, raising the      0
projected share of the population insured from 83.0% under the prior system to 92.7%.                  07    09e    11f    13f     15f      17f   19f
The overall spending estimates mask considerable shifts in the underlying funding. From
2010 through 2013, introducing high-risk insurance pools for citizens with health
                                                                                                                Medicaid and Children's
conditions and providing coverage for dependents under age 26 are expected to cost just
                                                                                                               Health Insurance Program
over US$10 billion. In 2014, national health spending is forecast to jump 9.2% (+US$278                 federal, state and local funding,
billion) as health insurance exchanges are established to help expand individual and small-             annual % change
                                                                                                  16                               September
group coverage and Medicaid is extended to all individuals under age 65 with household                        forecast
incomes up to 138% of the federal poverty level. In 2018, many organizations are
expected to lower the value of their employer-sponsored plans as an excise tax on high-           12
cost insurance plans is introduced.
                                                                                                   8
Yet substantial uncertainty remains with respect to the bottom line impact for both
Washington and the State governments. Not only could a newly elected Congress                                        February 2010
                                                                                                   4                 Projection
implement amendments, but a wealth of detail awaits clarification through new
regulations. The behavioural response of businesses and households, in part drawn from
Massachusetts’ experience, may be substantially different from the forecast assumptions.           0
Additional federal and State administrative costs appear inevitable and many State                     07    09e 11f        13f    15f      17f   19f
                                                                                                       Source: Office of the Actuary, Centers for
governments remain uneasy, not just with their oversight role for the health insurance                 Medicare & Medicaid Services
exchanges, but also with their longer-term share of the eventual Medicaid costs.




                                                                                                                                                        11
Global Economic Research                                                                                    September 10, 2010

                                                                                                                 Capital Points

                                                                             Graham Chubb (416) 945-4080       Roger Quick (416) 863-7236
Fixed Income Markets                                                       graham_chubb@scotiacapital.com    roger_quick@scotiacapital.com

What is Priced In?

The table below shows what the short-term interest rate markets in various countries have priced in for central bank rates over the
next 6 to 10 months. The calculations are based on Fed Funds Futures in the case of the US market, and Overnight Indexed Swaps
(OIS) in the other markets. The rates shown in the table are break-even forward rates, which do not include any term risk premi-
ums.

The Canadian market is pricing 12 bps of another rate increase on October 19th, or close to a 50% probability of a quarter point
increase. The market is not fully pricing a quarter point increase until March of next year.


 Implied Central Bank Rate Ex pectations (Break Ev en Forwards)
 Canada                1.00%                              AU                    4.50%
                                       Cumulative                                             Cumulative
  Meeting Date      Forward Rate                           Meeting Date      Forward Rate
                                        Change                                                 Change
   19 Oct 10           1.12%              12.1                 5 Oct 10         4.58%              8.4
    7 Dec 10           1.18%              17.7                 2 Nov 10         4.62%             11.8
   18 Jan 11           1.20%              19.6                 7 Dec 10         4.67%             16.8
    1 Mar 11           1.27%              26.9                 1 Feb 11         4.73%             23.4
   12 Apr 11           1.34%              33.5                 1 Mar 11         4.78%             28.0
   31 May 11           1.36%              36.2                 5 Apr 11         4.83%             32.5


 US                    0.25%                              JP                    0.10%
                                       Cumulative                                             Cumulative
  Meeting Date      Forward Rate                           Meeting Date      Forward Rate
                                        Change                                                 Change
   21 Sep 10           0.23%               2.3               5 Oct 10           0.07%             3.0
    2 Nov 10           0.18%               6.8              16 Nov 10           0.07%             3.1
   14 Dec 10           0.20%               5.0              21 Dec 10           0.07%             2.6
   26 Jan 11           0.20%               4.5              25 Jan 11           0.08%             1.8
   16 Mar 11           0.23%               1.6              17 Feb 11           0.09%             0.6
   27 Apr 11           0.27%               1.6              15 Mar 11           0.10%             0.4
 * Effective Fed Funds rate is 0.21%
 UK                    0.50%                              EU                    1.00%            0.43%
                                       Cumulative                                             Cumulative
  Meeting Date      Forward Rate                           Meeting Date      Forward Rate
                                        Change                                                 Change*
    7 Oct 10           0.49%               0.5                 7 Oct 10         0.45%              2.5
    4 Nov 10           0.49%               1.1                 4 Nov 10         0.53%              9.7
    9 Dec 10           0.49%               0.7                 2 Dec 10         0.59%             16.3
   13 Jan 11           0.51%               0.9                 13 Jan 11        0.61%             18.6
   10 Feb 11           0.53%               2.8                 3 Feb 11         0.65%             22.0
   10 Mar 11           0.55%               5.0                 3 Mar 11         0.72%             29.1
                                                          * Over the 1 week EONIA rate of 0.43%
 Data Source: Bloomberg, Calculations: Scotia Capital Fixed Income Research
 Data are overnight indexed swaps, except for the US, which is based on Fed Funds Futures.




                                                                                                                                        12
Global Economic Research                                                                                                                  September 10, 2010

                                                                                                                                                        Capital Points

                                                                       Camilla Sutton (416) 866-5470                                        Sacha Tihanyi (416) 862-3154
Foreign Exchange Markets                                             camilla_sutton@scotiacapital.com                                     sacha_tihanyi@scotiacapital.com

USDCAD Versus the Taylor Rule
Perhaps one of the most relevant fundamental drivers of CAD in the late summer was the sharp deterioration in the market’s
previously high degree of confidence that the Bank of Canada would increase rates on September 8th. The deterioration in US
economic prospects has been a key culprit, and with Canada’s heavy trade dependence on the United States, a weakening CAD was
the logical market response. The Bank’s decision to increase rates was welcomed by CAD bulls, though the future remains clouded.
Indeed, Scotia’s view is that the Bank will proceed with caution and elect to hold rates at 1% through the end of 2010 before
beginning to hike once again in Q1 of 2011. During a time of significant uncertainly over the pace of growth in Canada’s most
important trading partner, how much should the uncertainty over the Bank of Canada’s ability to continue to forge its own monetary
path be priced into CAD? Will and should the US economic connection be factored into CAD's ability to gain against the USD,
independent of Canada’s currency fundamentals?

Scotia Economics forecasts that the Bank of Canada will continue to move independently of the Federal Reserve, pushing the
policy rate differential from the current 0.75% (using the Federal Funds target rate) to 1.5% by the end of Q3 2011. However,
currency markets are much more volatile and subject to influence from higher frequency economic data, pricing in new data results
that reflect more the immediate present and past, rather than a longer term forecast view that is inherently uncertain. In an effort to
cut through this uncertainty, we look at an objective and empirical monetary policy rule for Canada and the US vis-à-vis what is
“priced in” to USDCAD to infer where the risks from monetary policy lie for the currency pair.

Our findings in brief; the market has tended to underprice CAD relative to the USD based on Scotia’s outlook for the Bank of
Canada and Federal Reserve. An objective assessment of relative policy pressure based on the Taylor Rule supports this dynamic
and suggests that there is a good deal more rate support left to be priced in to CAD. Indeed, during periods of risk aversion the
market tends to vacillate quite rapidly away from support for future Bank of Canada rate hikes, weakening CAD. This runs counter
to Scotia’s rates view, which is supported by our Taylor Rule analysis. Unless weakness is borne out of a dynamic that significantly
shifts the Bank’s outlook, via a significant and sustained spike in the unemployment rate from the current 8.1% or a drop in core
inflation from the current 1.6%, there exists a mis-pricing of CAD that represents a value opportunity.

THE TAYLOR RULE                                                            Chart 1
To this effect, we have constructed a Taylor rule for Canada and the     10
                                                                              %

                                                                                                        US vs. Taylor Rule
US in order to benchmark where policy lies relative to the levels of      9

                                                                          8

cyclical macro variables like inflation and output/unemployment. We       7


use the “unemployment-gap” version of the Taylor rule rather than         6

                                                                          5
the original output gap version, where the policy rate is set based on    4

the deviation in inflation from the monetary policy target level, and     3
                                                                                    Taylor Rule Implied
the deviation between current unemployment and NAIRU (non-                2         Fed Funds Rate
                                                                                    Actual Fed Funds
                                                                          1
accelerating inflation rate of unemployment). To do so, we make           0

assumptions regarding the natural real rate of interest in Canada and    ‐1


the US, as well as the levels of NAIRU in both countries, taking         ‐2

                                                                         ‐3

guidance from empirical research into these subjects. Additionally,       1995    1996   1997   1998   1999   2000   2001   2002   2003   2004   2005   2006   2007   2008   2009   2010



we assume that the monetary authority is as equally concerned with Source: Scotia Capital, Bloomberg
the deviation of inflation from its target as it is the deviation of employment from NAIRU. Finally, one should keep in mind that
the Taylor Rule is simply an objective “rule of thumb” and does not provide an exact prescription for monetary policy. However it
is instructive to examine what it implies for policy in order to gauge where the pressure is for future policy direction.

Chart 1 plots our construction of the Taylor rule for the United States. The most obvious feature of this chart is that currently, based
on unemployment (cyclically high) and inflation (cyclically low), it appears as though policy settings are far too restrictive.
However this is reflective of the zero-bound on the nominal effective policy rate and the key motivation as to why the Federal
Reserve has undertaken a program of bond purchases through the creation of reserves (quantitative easing). Without complicating
matters by introducing an overly abstruse theoretical framework, it is impossible to assess just how close actual policy under
quantitative easing is to the implied Taylor rule setting, but it is certain that policy is at least somewhat looser than what is implied
by Chart 1 given that the Taylor Rule does not take into consideration the rest of the yield curve. They key implication for the USD
is that US policy settings are currently more biased to the downside, and without any real pressure for reversal in the near future.
This is consistent with both market rate pricing and Scotia’s view on the Fed. Thus at the very least, any CAD weakness vis-à-vis
the USD should not be borne out of an implied catch-up on the part of US monetary policy, but rather on the weakening outlook for
Canadian monetary policy. This brings us to the Canadian Taylor rule.


                                                                                                                                                                                           13
Global Economic Research                                                                                                                                             September 10, 2010

                                                                                                                                                                                      Capital Points

                                                                        Camilla Sutton (416) 866-5470                                                                      Sacha Tihanyi (416) 862-3154
Foreign Exchange Markets                                              camilla_sutton@scotiacapital.com                                                                   sacha_tihanyi@scotiacapital.com

Chart 2 depicts current policy settings and the “recommended”            Chart 2
level implied by our construction of a Canadian Taylor rule. Even         9              %

                                                                                                                                            Canada vs. Taylor Rule
after this week’s interest rate increase, it is obvious that Canada       8


finds itself in quite the opposite position as the US, with current       7


policy settings a fair degree looser (around 1 percentage point)          6

than implied by contemporaneous inflation and unemployment,               5

consistent with the Bank of Canada’s characterization of the              4

policy rate as being “extremely simulative” in recent
                                                                          3
communications. This has important implications for any short
                                                                          2                                                Canada Target
term FX market reactions that price rate premium out of CAD in                                                             Rate
                                                                                                                           Taylor Rule
reaction to new data showing economic weakness in the US and/             1
                                                                                                                           Implied Rate

or general market vacillations (risk aversion). If current monetary       0
                                                                           1995                     1996    1997    1998      1999     2000     2001      2002    2003       2004     2005    2006    2007    2008     2009    2010

policy settings are around 1% less than what is implied by the
                                                                         Source: Scotia Capital, Bloomberg
Taylor Rule, then one can certainly say that unlike in the US,
Canadian monetary policy has a bias to be tighter than current           Chart 3
settings. After Canada exited the recession, before the Bank of            4
                                                                                      %
                                                                                                                           CAN Taylor Differential ‐ US Taylor Differential

Canada began to hike rates, the difference between the policy rate
                                                                           3
and the Taylor-implied policy rate was as much as 2%, far more
                                                                           2
than the +/- 1.4% standard deviation that has held over the past 15
years (with a mean of near 0).                                             1


                                                                           0


PUTTING IT TOGETHER                                                       ‐1


This leaves the question of where the market currently prices             ‐2

Bank of Canada rates over the next year in comparison with                ‐3

Scotia’s view and the indication from the Taylor rule. The Taylor
                                                                          ‐4
gap differential between Canada and the US (Chart 3) has, in the             1995                    1996   1997     1998       1999   2000     2001       2002    2003       2004     2005    2006    2007     2008    2009    2010


past 15 years, never been as extended as it is currently, arguing        Source: Scotia Capital, Bloomberg
once again for the relative rate support view. However, this only
                                                                         Chart 4
translates to a strategically bullish CAD view if the market is not
already pricing in this relative rate dynamic. Given the difficulty
in assessing what is priced in to a currency based on short term
fluctuations, we appeal to the level of rates priced into the
overnight interest rate swap market and assume that the FX
market takes its guidance from the OIS market. Chart 4 show that
the OIS market is currently under-pricing the likelihood of a
CAD-favorable rate gap relative to the official Scotia view, and
certainly relative to the Taylor rule implied differential by
approximately 60bps and 175bps respectively.

Thus we can conclude that a rate premium is currently absent
from CAD. We also note that, at 150bps by the end of Q3 2011,
the market consensus forecast for the Canada-US policy rate              Chart 5
differential is more pronounced than Scotia’s 75bp call, an even                                                   Monthly Change in US ‐ CDN Rate Differentials*
more CAD-bullish indication. When looking at the monthly                                                                  vs Monthly Change in USDCAD
                                                                                                                                                                    8


performance of USDCAD versus changes in shorter term US-                                                                                                            6


Canadian rates during months following the end of the most                                                                                                          4
                                                                           % Change in USDCAD




recent two recessions (see Chart 5), we find an obvious positive                                                                                                    2



relationship, boding well for CAD's ability to appreciate against                               - 1.25        -1           - 0.75       - 0.5          - 0.25
                                                                                                                                                                    0
                                                                                                                                                                         0          0.25        0.5          0.75         1            1.25


the USD under Scotia’s relative rates forecast scenario. Our view                                                                                                  -2




is that USDCAD’s downward trend is reestablished in 2011 as the                                                                                                    -4




Bank of Canada’s rate increase momentum builds once again,                                                                                                         -6


                                                                                                                                                                   -8
pushing USDCAD to 0.98 by the end of Q4.
                                                                                                                                                                  - 10

                                                                                                                                        Change in Rate Differentials (%)

                                                                         Source: Scotia Capital, Bloomberg



                                                                                                                                                                                                                                       14
Global Economic Research                                                                                   September 10, 2010

                                                                                                                Capital Points

Estimates for the week of September 13 – 17

           Canada

Date      ET      Indicator                                               Period           BNS    Consensus      Latest
09/14   (08:30)   New Motor Vehicle Sales (m/m)                            Jul             1.0        1.0         2.5
09/14   (08:30)   Productivity (q/q a.r.)                                  Q2               --       -0.5         0.8
09/14   (08:30)   Capacity Utilization (%)                                 Q2               --      75.7         74.2
09/14             Governor Carney Gives Lecture at Bundesbank in Berlin, Germany (10:45)
09/15   (08:30)   Manufacturing Shipments (m/m)                           Jul              -0.3      0.2          0.1
09/15   (10:00)   Wage Settlements (y/y)                                  Jul               --        --           --
09/15             BoC Deputy Governor Lane Speaks in St. John's Newfoundland (11:45)




           United States

Date      ET      Indicator                                               Period         BNS      Consensus      Latest
09/13   (14:00)   Treasury Budget ($ bn)                                   Aug            --        -98.0       -103.6
09/13             Fed's Lockhart Moderates Q&A for British Ambassador in Atlanta (12:30)
09/14   (07:45)   ICSC Chain Store Sales - Weekly (w/w)                   Sep. 11           --        --         -0.4
09/14   (08:30)   Retail Sales (m/m)                                       Aug             0.2       0.3          0.4
09/14   (08:30)   Retail Sales ex. Autos (m/m)                             Aug             0.3       0.3          0.2
09/14   (10:00)   IBD/TIPP Economic Optimism Index                         Sep              --       44          43.6
09/14   (10:00)   Business Inventories (m/m)                                Jul             --       0.5          0.3
09/15   (07:00)   MBA Mortgage Applications (w/w)                         Sep. 10           --        --         -1.5
09/15   (08:30)   Import Prices (m/m)                                      Aug              --       0.2          0.2
09/15   (08:30)   Export Prices (m/m)                                      Aug              --        --         -0.2
09/15   (08:30)   Empire State Manufacturing Index                         Sep             9.0       8.0          7.1
09/15   (09:15)   Industrial Production (m/m)                              Aug             0.3       0.2          1.0
09/15   (09:15)   Capacity Utilization (%)                                 Aug             75.2     75.0         74.8
09/16   (08:30)   Initial Jobless Claims (000s)                           Sep. 11          457      460          451
09/16   (08:30)   Continuing Claims (mn)                                  Sep. 04          4.47       --         4.48
09/16   (08:30)   PPI (m/m)                                                 Aug             0.2      0.3          0.2
09/16   (08:30)   PPI ex. Food & Energy (m/m)                               Aug             0.1      0.1          0.3
09/16   (08:30)   Current Account ($ bn)                                    Q2               --     -124         -109
09/16   (09:00)   Foreign Portfolio Flows ($ bn)                            Jul              --     42.0         44.4
09/16   (10:00)   Philadelphia Fed Index                                    Sep            -1.0      1.0         -7.7
09/16             Fed's Duke Speaks at Public Hearing at Chicago Fed (9:30)
09/17   (08:30)   CPI ex. Food & Energy (m/m)                              Aug             0.1       0.1          0.1
09/17   (08:30)   CPI ex. Food & Energy (y/y)                              Aug             0.9       1.0          0.9
09/17   (08:30)   CPI (m/m)                                                Aug             0.2       0.3          0.3
09/17   (08:30)   CPI (y/y)                                                Aug             1.1       1.2          1.2
09/17   (09:55)   U. of Michigan Consumer Sentiment                       Sep-P             --      70.0         68.9
09/17             Fed's Tarullo Speaks on Regulation at Brookings




                                                                                                                                 15
Global Economic Research                                                                                September 10, 2010

                                                                                                             Capital Points

Estimates for the week of September 13 – 17

 Europe

Date      ET      Indicator                                               Period         BNS   Consensus      Latest
09/13   (02:45)   FR Current Account (EUR bn)                              Jul            --       --          0.0
09/13   (05:00)   EC Industrial Production (m/m)                           Jul            --      0.2          -0.1
09/13   (19:01)   UK RICS House Price Balance (%)                          Aug            --     -12.0         -8.0
09/14   (01:30)   FR CPI - EU Harmonized (m/m)                             Aug           --       0.3         -0.3
09/14   (01:30)   FR CPI (m/m)                                             Aug           --       0.3         -0.3
09/14   (04:30)   UK CPI (m/m)                                             Aug           --       0.3         -0.2
09/14   (04:30)   UK DCLG House Prices (y/y)                               Jul           --       8.4          9.9
09/14   (05:00)   GE ZEW Survey (Current Situation)                        Sep           --      50.0         44.3
09/14   (05:00)   EC ZEW Survey (Economic Sentiment)                       Sep           --      15.0         15.8
09/14   (05:00)   GE ZEW Survey (Economic Sentiment)                       Sep           --      12.5         14.0
09/14   (05:00)   EC Labour Costs (y/y)                                    Q2            --        --          2.1
09/14             ECB's Weber Speaking in Berlin (11:00)
09/15   (04:00)   IT CPI (y/y)                                             Aug           --       1.6          1.6
09/15   (04:30)   UK Jobless Claims Change (000s)                          Aug           --      -3.0         -3.8
09/15   (04:30)   UK Unemployment Rate (%)                                 Aug           --       7.7          7.8
09/15   (05:00)   EC Employment (q/q)                                      Q2            --        --          0.0
09/15   (05:00)   EC CPI (m/m)                                             Aug           --       0.2         -0.3
09/15   (05:00)   EC CPI (y/y)                                             Aug           --       1.6          1.6
09/16   (04:30)   UK Retail Sales (m/m)                                    Aug           --       0.2          0.9
09/16   (05:00)   EC Trade Balance (EUR bn)                                Jul           --       1.3          2.4
09/16   (05:00)   IT Current Account (EUR mn)                              Jul           --        --        -2698.0
09/16             UK CBI Monthly Industrial Trends Survey
09/17   (02:00)   GE Producer Prices (m/m)                                 Aug           --       0.3          0.5
09/17   (04:00)   EC Current Account (EUR bn)                              Jul           --        --         -4.6
09/17             ECB's Orphanides Speaking in Rotterdam (3:00)




 Asia/Oceania

Date      ET      Indicator                                               Period         BNS   Consensus      Latest
09/14   (00:30)   JN Industrial Production (m/m)                           Jul            --       --           0.3
09/14   (00:30)   JN Capacity Utilization (m/m)                            Jul            --       --          -2.1
09/14             BOJ Deputy Governor Nishimura to Speak in Tokyo (20:00)
09/15   (17:00)   NZ RBNZ Official Cash Rate (%)                                         --      3.25         3.00
09/15   (19:50)   JN Tertiary Industry Index (m/m)                         Jul           --       0.8         -0.1
09/15             Speech by RBA Assistant Governor Philip Lowe in Sydney (23:45)
09/16             BOJ Chief Shirakawa to Speak at Japanese Brokerages' Meeting (02:00)
09/17   (01:00)   SNG Exports (y/y)                                        Aug           --      16.8         18.2




                                                                                                                              16
Global Economic Research                                                                                                 September 10, 2010

                                                                                                                                 Capital Points

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