Market Brief: 'Tariff Man's' Return Rocks Currency Markets

Donald Trump’s threat to raise consumption taxes on a range of goods imported from Canada, Mexico, and China is still sending shockwaves across currency markets.

The dollar is up roughly a percentage point against its North American and European counterparts after the president last night said he would impose tariffs of 25 percent on all imports from Canada and Mexico, along with an additional 10 percent on Chinese goods, accusing the countries of allowing illegal migrants and drug traffickers into the US. In a break with long-standing Republican orthodoxy - most clearly under Ronald Reagan - this would raise trade costs to levels last seen in the run-up to the Great Depression. Hopes that Scott Bessent - the president-elect’s nominee for Treasury Secretary - might act as a stabilising force in the new administration are fading, putting upward pressure on yields and sapping some of yesterday’s equity market gains.

The president-elect’s broadside comes after a distinct dimming in the Canadian dollar’s prospects. Elevated household borrowing costs, cool labour markets, lacklustre consumer spending, soft commodity prices, and weak business investment were already pushing the dollar exchange rate toward a four year low, and a sustained rise in implied volatility could magnify the damage, putting the 1.43 threshold in scope before year end.

The plan, however, also looks like an own-goal. Putting Mexico aside, US imports from Canada are heavily concentrated in products that make up a big share of middle class consumption baskets - oil, natural gas, motor vehicles, food, and building supplies - meaning that tax increases will be highly visible. On the flip side, exports to Canada are often of the higher value-added kind (especially in the energy sector, where Western Canada ships unrefined products to the US and Eastern Canada imports refined products, on net) - suggesting that a vast range of businesses in battleground states could be negatively impacted. If the US raises tariffs by the amount threatened - and if Canada responds in kind - the domestic political blowback could derail a range of important policy projects.

As such, investors don't expect Trump to follow through. Canadian Prime Minister Trudeau has already shown signs of capitulating to Trump’s demands, and the president-elect’s history would suggest that last night’s post simply represented an opening gambit in the negotiation process. The Canadian dollar seems poised for modest reversal to the upside once traders assess the situation from a more nuanced perspective.

But, in a bitter irony, Trump’s tariff threats are highly likely to widen deficits by redirecting capital flows into the United States from abroad. By menacing other economies, the president-elect is giving global investors little choice but to deploy funds into US financial markets, increasing net borrowing levels, keeping the dollar stronger than it otherwise would be - boosting imports while suppressing exports. The currencies of US trading partners are likely to trade at a discount until the policy-by-social-media era draws to a close again, and the current account deficit could grow larger.

And with the second Trump administration quickly outstripping the first in delivering sheer economic predictability, policymakers will be forced to move more cautiously. Today will see a fairly neutral release of minutes from the last Federal Reserve meeting, but the next meeting is likely to see officials raising “dot plot” estimates for the future path of inflation and interest rates. The dollar could climb further yet, endangering the administration’s avowed goals.

In response to a question submitted by a reader yesterday: An end to the war in Ukraine would have a minimal effect on the US fiscal outlook. The sums spent by the federal government on aid to Ukraine (especially in the direct* sense) thus far have paled in comparison with the overall budget, representing little more than an accounting error** from a broader economic perspective.

*Direct aid goes directly to the government of Ukraine, while a significant share of indirect aid goes to manufacturers of military equipment in the United States.

**Literally: the Pentagon currently can't account for 63 percent of nearly $4 trillion in assets, often spends billions on hardware that is outdated or surplus to requirements, and regularly loses track of vehicles, aircraft, and weapons - including nuclear bombs.

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