Canadian Dollar: Trade war escalation threatens recent strength – MUFG

MUFG's Derek Halpenny argues the Canadian Dollar’s (CAD) reaction to the new US tariffs on USD 20bn of Canadian exports will hinge on escalation risks rather than the initial measures. CAD has underperformed in G10 after talks broke down, and Halpenny warns that tit-for-tat tariffs and fading support from higher Oil could intensify CAD downside if the dispute remains unresolved.

Tariff spiral risk weighs on Canadian Dollar

"There was always a risk of a breakdown in negotiations on reaching a deal to avoid a US import tariff on USD 20bn worth of Canada exports, so we are unlikely to see a large sell-off of the Canadian dollar in response to the breakdown, confirmed late on Friday night. However, CAD is the clear underperformer in G10 so far today."

"The medium-term FX and broader market response in Canada will be dictated not by this breakdown but by the evidence that this could escalate quickly and end with investors pricing greater economic harm for Canada. By promising to match dollar for dollar that risk of spiral is real."

"At this juncture the tariff of 50% on USD 20bn worth of US imports from Canada account for just 5% of Canada’s exports to the US. The tariffs took effect on Saturday morning at 12:01am applying to a range of goods from beer, wine, spirits, milk products and hockey equipment."

"Covering the post-covid period, starting in 2022, USD/CAD and the 2-year swap rate spread has moved very tightly together over most of that period and the current 2-year US-CA swap spread suggests USD/CAD has over-extended to the downside and should currently be trading a little above the 1.4000 level, or around 2.0% higher than the spot close on Friday."

"A quick retaliation by the US will undoubtedly force PM Carney to follow “dollar for dollar” that could see investor confidence hit more severely. CAD downside risks will intensify the longer there is no resolution to this escalating trade war."