Market Brief: Tariff Threats Offset Signs of Improving Fundamentals

The US dollar looks set to close out the week with its strongest performance since the middle of November after President Donald Trump reiterated his threat to impose tariffs on Canada and Mexico by tomorrow. The loonie and peso are both down more than a full percentage point on the week, North American equity indices are setting up for a subdued open, Treasury yields are pushing higher, and high-beta currencies remain on the defensive.

Inflation pressures in the US remained stable at the end of last year. Data released by the Bureau of Economic Analysis this morning showed the core personal consumption expenditures index rising 0.2 percent from the prior month in December, and matching market forecasts. On a year-over-year basis, core prices were up 2.8 percent. The overall personal consumption expenditures index rose 0.3 percent relative to the prior month, rising 2.6 percent from a year ago. Personal income rose 0.4 percent month-over-month, and inflation-adjusted household spending climbed 0.4 percent, suggesting that consumer fundamentals remained strong. According to a separate release, the Federal Reserve’s favoured measure of wage gains—the Employment Cost Index—climbed 3.8 percent in year-over-year terms in the final quarter of 2024, marking the slowest pace in three years.

Here in Canada, the economy gained momentum at the end of last year. According to data just released by Statistics Canada, the economy suffered its deepest contraction since December 2023 in November—shrinking by -0.2 percent against expectations for a -0.1 percent loss—but an advance estimate pointed to a modest 0.2-percent rebound in the following month as growth in retail spending, manufacturing and construction industries helped lift quarterly annualised growth estimates toward the 1.8-percent mark. Taken in combination with previously-released gross domestic data and yesterday’s numbers on hours worked, it appears as if the Bank of Canada’s easing efforts are translating into a modest recovery in the economy—something that should, in theory, help narrow rate differentials in the Canadian dollar’s favour.

But for the Canadian dollar—and the Mexican peso—economic fundamentals will be drowned out by political uncertainties for now. In wide-ranging comments to reporters in the Oval Office yesterday afternoon, Trump said he planned to announce 25-percent tariffs on Canada and Mexico “for a number of reasons,” including the “people that have poured into our country so horribly and so much,” the “drugs, fentanyl and everything else,” and “the massive subsidies that we’re giving to Canada and to Mexico in the form of deficits”. The president also claimed that raising import taxes wouldn’t harm the American economy, saying: “We don’t need the products that they have. We have all the oil that you need. We have all the trees you need.”

Trump’s propensity for taking aim at Mexico may make sense from a political perspective, but his focus on Canada remains strategically nonsensical. Illegal immigration flows from Canada remain a small fraction of those seen on America’s southern border, and it simply isn’t true that the country is a major source of imported fentanyl*. Canada’s failure to develop its own transportation and refinery infrastructure has meant that oil and gas shipped south typically sells for below-global market prices, and helps displace US production so that it can be exported to global markets (including back to Canada) at a premium. Outside the energy sector, Canada runs a trade deficit with its northern neighbour, with US manufacturers selling more to Canada than vice versa. In the United States, a symmetric trade war will subtract from corporate earnings, raise inflation, and hurt people at the bottom of the income distribution, many of whom voted Trump into office for a second time.

It is impossible to predict how negotiations will play out. Just as in Trump’s first administration (when years of turmoil resulted in a new North American trade agreement that closely resembled the one it replaced) market participants, businesses, political leaders—and even members of the administration itself**—remain in the dark as to what the president is trying to achieve. Even if an announcement is made tomorrow, it simply isn’t clear whether tariffs will be implemented at the proposed levels, what carve-outs will be put in place, what concessions should be offered by the Canadian and Mexican governments, or how long the process will last.

Counter-intuitively, this could mean that volatility remains more subdued than one would expect. There is little doubt that exchange rates will react to the elevated uncertainty that will slow all three economies, but for currency market participants, the case for shorting the Canadian dollar or peso is surprisingly flimsy, given that it could take one phone call or symbolic display of obeisance for tariffs to be lifted and reversed.

Against this backdrop, we think corporate hedgers would be wise to consider putting tail risk protection on—using option-based collars, for example—and working to communicate this strategy internally, so that a potentially-dangerous overreaction to alarming news headlines is avoided. Note that options markets, which function more like coolly-rational insurance companies than hot-blooded sports-betting syndicates, are bracing for a short period of turbulence followed by gradual Canadian dollar gains this year.

*A Congressional commission came to this conclusion in 2022: https://www.rand.org/pubs/external_publications/EP68838.html

**Incoming Treasury Secretary Scott Bessent, Commerce department head Howard Lutnick, Vice President JD Vance, and many others have presented wildly-differing rationales for tariffs—while also outlining internally-inconsistent off-ramp opportunities.

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