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President Trump’s executive order of 25% tariffs on all imported goods from Canada (except for 10% on energy products), was not a complete surprise, but the immediacy of the policy will now require markets to recalibrate prices across all asset classes. Additional tariffs on imported goods from Mexico and China, as well as retaliatory aspects from all three countries affected, suggest that barring a quick climbdown, a prolonged trade war measured in months or quarters could be at hand, affecting all economies materially, particularly those in North America. Importantly, Canada is not yet retaliating dollar-for-dollar, providing Trump and his administration an off-ramp of sorts with some de-escalation pathways available to the administration.
The impact of the retaliatory tariffs on the US economy is potentially less severe, but it will not be completely unaffected. The US economy has been running at a solid pace, and so the US can afford to take a growth hit more than Canada or Mexico. Well-publicized numbers suggest the US Federal Reserve’s models put the impact of the tariffs at a -1.2% reduction in real GDP growth and a 0.7% increase in inflation. The Fed, therefore, will likely be slower to adjust its federal funds rate, so we should expect little to no change in the rate in the short-term due to tariffs. If economic growth slows more than expected and the US unemployment rate rises, then we could see expectations shift lower for Fed policy rates.
The Bank of Canada (BoC) met recently and provided insight around how it might react if the US levied significant tariffs, with Canada responding in kind. Tariff wars can lead to stagflation: the combination of higher inflation and lower real growth. The BoC will likely embrace a view that the economy’s “output gap” will widen over the medium-term, causing unemployment to rise, wages to fall, and eventually prices to fall. If so, the BoC may forecast an increasing chance that the economy will fall into a moderate or severe recession over the coming 12 months with real GDP growth turning negative. In that case we would expect the BoC to start lowering rates no later than its March meeting, and a rate cut larger than 25bp would not be a surprise.
The Canadian dollar, already hit hard by the threat of tariffs over recent months, has dropped an additional 1% in early Monday trading. The Canadian dollar’s ultimate reaction to tariffs will depend on:
- Whether tariffs are permanent or transitory. Tariffs could get rolled back pre-implementation, potentially due to negotiations around a Canadian border bill. They could also prove short-lived, either due to a US-Canada bilateral deal over the next few months, or to legal challenges around Trump’s use of the International Emergency Economic Powers Act. In both cases, the Canadian dollar should retrace most of its recent losses. On the other hand, if these “emergency” tariffs lead to an acrimonious renegotiation of the USMCA, the fair value exchange rate for the Canadian dollar would find a new equilibrium below $0.67 USD.
- Whether Canada (and other countries) retaliate against US tariffs. Unbalanced tariffs — universal tariffs from the US, targeted tariffs from Canada — put additional pressure on the Canadian dollar. Canada’s use of export restrictions on oil as a retaliatory measure (unlikely due to Albertan opposition) would lead to even more Canadian dollar weakness. On the other hand, aggressive tit-for-tat import tariffs from Canada and other targeted countries could help stabilize their currencies against the US dollar.
- Whether the US moves from bilateral to universal international tariffs. The Canadian dollar has been disproportionately punished by markets because Canada has been an early primary target of Trump’s trade aggressions. If Trump shifts from a bilateral focus to universal global tariffs, pressure on the Canadian dollar would likely ease. In that scenario, the currencies of countries with severely unbalanced non-energy trade accounts with the US — China, the European Union, Taiwan — could bear the brunt of the pressure from FX markets.
The possible range on the Canadian dollar over the next few months is vast. Canadian concessions leading to a resolution of the Canada-US trade war would probably cause the Canadian dollar to retrace to above $0.71 USD. We should not fully discount that scenario, as evidenced by Trump’s complete about-face in his dispute with Colombia last week, going from threats of 50% tariffs to a deal with the Colombian president within 24 hours. On the other hand, permanent tariffs on Canada without full retaliation would likely have the weak Canadian dollar hold well below $0.67 USD for the foreseeable future.
Risk assets globally have been enjoying a post-US election honeymoon phase that was fueled by hopes of lower taxes, deregulation and a more pro-business US administration. The anticipation of strong US growth was fueling optimism for global economic growth despite the looming threat of a trade war. The decision by President Trump to begin the start of a broad-based trade war with Canada, Mexico and China has created enough uncertainty to call into question the unbridled enthusiasm for risk assets like equities. While the intent is to shift manufacturing to the US from their trading partners, the short-term dislocation of supply chains is likely to lead to upward inflationary forces and slower economic growth around the world. The combination of these factors suggests that a more volatile backdrop for financial markets is to be expected.
Canadian stocks will be impacted in the short-term as the uncertain path of tariffs takes hold of the Canadian economy, forcing delays in capital investment and expansion, as well as potential job losses in the hardest hit industries, such as manufacturing. But it is also important to recognize that the medium-term risk could be mitigated through a potential bilateral trade deal with the US, and homegrown fiscal and monetary support — all these factors have a high level of uncertainty to quantify but in the case of fiscal and monetary support are highly likely.
Canadian fixed income will be faced with the competing forces of a weakening domestic economy and short-term inflationary forces from tariffs. As detailed above, we expect the Bank of Canada to support the Canadian economy with easier monetary policy than is currently priced in, putting continued downward pressure on short-term interest rates. At the same time, expected fiscal packages, both federally and provincially, would lead to higher bond issuance at the longer end of the yield curve. Corporate credit could begin to face the headwinds or slower growth and declining credit quality.
Politically, the “Canada Stands Together” narrative is resonating strongly based on anecdotal evidence from news reports, and social media. There are growing calls to bring Parliament back into session to show unity across the political spectrum. Parliament’s return would support passing the $1.3 billion border security bill that was sidelined when Parliament was prorogued, or, if needed, passing a fiscal stimulus bill to aid corporate Canada and potentially individuals in the hopes of preventing large-scale unemployment and recession. Currently there are no indications that Prime Minister Trudeau will recall Parliament, suggesting that he has the tools needed already at his disposal. This fiscal policy story is an important factor going forward for rate cut decisions by the BoC, which will want to avoid adding significant monetary stimulus at the same time, thereby stoking inflation as we saw happen post-pandemic.
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