Market Brief: Currency Markets Retreat as Tariff Nerves Fray

Currency traders are suffering from whiplash after Donald Trump made volatility great again in his first day back in office. The dollar is on the offensive and currencies like the peso, Canadian dollar, and euro are down after the president said he plans to impose 25 percent tariffs on products from Canada and Mexico on February 1.

In an unscripted conversation with reporters last night, Trump said the United States’ closest neighbours were allowing “mass numbers of people to come in and fentanyl to come in,” calling Canada “a very bad abuser”. Trump also warned he “may” impose a universal tariff on all imports, saying that “essentially all countries take advantage of the US,” while threatening China and the BRICS* group of nations with 100-percent tariffs if they move forward with plans to replace the dollar in trade.

Markets had rebounded earlier in the day on hopes that the administration would apply tariffs in a more gradual and discerning fashion. Trump signed an executive order directing federal agencies to deliver a broad-based review of US trade relationships by April 1**, but stopped short of applying new import taxes immediately—as he had promised in a series of interviews, campaign appearances, and social media posts over the preceding months—and avoided directly discussing trade imbalances in his inauguration speech.

If followed through on, the president’s plans could inflict serious pain on both the Canadian and Mexican economies, where substantial shares of activity are devoted to cross-border commerce. The two countries have said they’ll retaliate against American goods if Trump slaps tariffs on them—and this could scramble energy, auto, and food supply chains—but both are more vulnerable than the US to a protracted battle. Our estimates suggest that the loonie and peso could each fall by another 5 percent if the “NAFTA 2.0” agreement negotiated under the first Trump presidency is discarded and new tariffs are formally announced.

But the moves could also bring the United States closer to waging an all-out trade war against most of its major partners—a war that the country could easily lose. One-to-one retaliation against American exports by all affected trading partners—a precedent established during the implementation of the Smoot Hawley Tariff Act in the thirties, and in virtually every protectionist squabble thereafter—would ultimately impact a bigger share of US gross domestic product than in other countries.

Markets might ultimately act as a disciplining mechanism, helping limit the new president’s most extreme policy instincts, but signs thus far have not been promising. An abiding faith among investors in the eventual triumph of cooler heads has dulled any signal outside the foreign exchange and fixed income spheres, and Trump has not yet been confronted with a clear-cut repudiation of his plans from major equity indices. That reaction could take days or months to arrive, and the ride will remain bumpy until then.

Here in Canada, tariff fears are dominating headlines, but domestic economic developments are also playing a role in determining market direction. Data released this morning showed inflation decelerated by more than expected last month, slightly raising market-implied odds on a rate cut at next week’s Bank of Canada meeting. Data released by Statistics Canada this morning showed the Consumer Price Index rising 1.8 percent on a year-over-year basis in December, slowing down from the pace recorded in November and below consensus expectations that had been set closer to 1.9 percent. On a month-over-month basis, prices fell -0.4 percent, matching forecasts.

Excluding shelter costs, prices rose just 0.7 percent relative to a year prior, and core inflation—computed as the average of the two price measures now preferred by the Bank of Canada (trim and median)—increased 2.45 percent over the same period last year, down from 2.65 in the prior month. Core measures strip out highly-volatile categories, and are often used to develop a better understanding of price pressures in the underlying economy.

We think the odds favour another rate cut at the Bank’s policy meeting next week. With a simple measure of restrictiveness—the difference between the benchmark overnight rate and the central bank’s preferred measures of core inflation—sitting at 1.3 percent, interest rates are likely still at levels that act to slow growth, especially given Canada’s extraordinarily-high debt burden. Further easing is needed to bolster consumer sentiment, reduce slack in the economy, and help shelter business investment against the uncertainty unleashed by the current inhabitant of the White House.

Survey data released yesterday showed businesses and consumers turning slightly more hopeful in the fourth quarter as borrowing costs began to recede. Sentiment among businesses polled by the Bank of Canada’s researchers remained “subdued,” and most were worried about the impact that a trade war with the United States could have, but many reported carrying a sense of cautious optimism on the outlook for demand and investment over the coming year. A smaller number of households reported a deterioration in their personal finances than previously, and more said they thought access to credit was improving, reflecting “recent interest rate cuts,” and “expectations of further cuts”.

*Which the president appears to believe that Spain is a member of.

**Interesting timing.

***Please note: The vagaries of in-flight wifi could interrupt distribution of the Market Briefing tomorrow morning. If so, we will return on Thursday morning.

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