By Douglas Porter

November 29, 2024

“Looks like I picked the wrong week to quit being cautious on Canada.” Steve McCroskey from Airplane! (Paraphrasing)

During the recent U.S. election campaign, the topic of Canada came up all of once as far as we can discern in the months and months of rhetoric and debate, and that once was about water. There was never a mention of singling out America’s largest export market with any specific trade action, or about spiking the USMCA. Accordingly, the sudden threat by the incoming President that Canada and Mexico could face a whopping 25% tariff on all products on day 1 of the new Administration next January was a shock—even if the protectionist leaning was of little surprise. Previously, the biggest question was over whether Canada would even be subject to the proposed broad 10% import tax. Coming like a bolt from the blue, the post late Monday initially battered the Canadian dollar and the Mexican peso, and spurred a thousand headlines, not to mention even more recriminations.

Amazingly, financial markets quickly shrugged off the initial hit, and promptly got back to business. For example, after the smallest of flutters on Tuesday, the TSX began to forge higher again and was reaching fresh records by Friday morning, hovering 0.6% above a week ago. In a similar vein, the loonie largely brushed off the initial drop, and was holding just above $1.40/US$ (71.3 cents), barely 0.3% weaker on the week. The one market that did adjust, however, was Canadian fixed income. GoC yields tumbled by 25-30 bps across the curve, outdistancing even a powerful rally in Treasuries (U.S. yields fell by a bit more than 20 bps in a shortened week). A soggy reading on Q3 Canadian GDP of just 1.0%, as well as mild 0.1% gains in September and October, helped extend the domestic bond rally, as did the impending hefty coupon payment on Monday.

Not to make light of an incredibly serious situation, but it was almost as if the markets went through six stages of grief in less than six days:

• Denial and shock: “25%? He must mean China, not Canada! This can’t be true.”
• Pain: “What have we done to deserve this? Sell the Canadian dollar, sell export-dependent stocks, sell the automakers.”
• Anger: “What kind of friend does this? What about the USMCA; didn’t he sign that? We won’t stand for this, we’ll retaliate. U.S. consumers are going to pay the price.”
• Bargaining: “What is it that he wants? Border security… sure, that’s good for us too. A crackdown on drugs… sure all for that too. Surely, we can come to some agreement. Look even Mexico’s President Sheinbaum had a ‘wonderful conversation’ with him. We can work this out.”
• Depression: “Gosh, even if we can avoid this 25% tariff, we could face something similar on any other perceived misstep. Under this ‘tariffist’ we may never have unfettered access to the U.S. market. This is going to depress business investment for years.”
• Acceptance: “We’re just going to have to learn to live with this persistent noise and uncertainty and focus on what we can control for the next four years.”

The generally mild net reaction by financial markets—to wit, the peso is currently stronger than it was a week ago—suggests that almost no one believes that the 25% tariffs will actually be enacted. From our perspective, that is a very brave assumption to be making. Regardless of what economists and analysts believe, it is quite obvious that the President-elect views tariffs as some kind of magic economic elixir, which only causes good for the U.S. economy, and any pain is for others to absorb (the latter may be true for some products). And, as noted in the “Depression” stage, even if the two U.S. neighbours are spared this time, the threat of aggressive/hostile U.S. trade actions will linger, depressing capital spending plans in both Canada and Mexico.

What if? A 25% across-the-board tariff would be extremely damaging for the Canadian economy; on that, there is no debate. One well-respected academic economist has estimated that it could cut the level of Canadian real GDP by around 2% in 2025 with no retaliation. For perspective, our baseline call is for 2.0% growth, which would be erased by the trade hit. However, there are other policy levers and market responses that could somewhat mitigate the blow.

• First, the Canadian dollar would act as a partial shock-absorber, and its initial drop was a taste of what could come. In a full-25% world, with limited retaliation, a 5-10% further depreciation in the currency is entirely fathomable. At around $1.50/US$ (or 66.7 cents), the exchange rate could lessen the revenue blow for domestic producers.
• Second, the Bank of Canada would likely lean to even lower interest rates, essentially to support the parts of the economy it can support—i.e., domestic spending. We had been expecting the Bank to take its overnight rate down to 2.5% (from 3.75% now), but a 1.5% terminal rate, or even lower, would be more likely in a tariff scenario. Clearly, this is not an ideal situation for the Bank, as it risks inflating the housing market again, and firing up consumer borrowing. But desperate times…
• Third, fiscal policy would almost certainly loosen up further to provide support for the economy, if not to also meet demands on the defence spending front. Ottawa’s anchor of $40 billion budget deficits, and moving to less than 1% of GDP, already looked to have been cut free. And, a 25% tariff world would justify a change in stance… “desperate times” again. Roughly speaking, a fiscal loosening of around 0.5% of GDP (or about $15 billion) would not be out of the range of possibilities.
• Fourth, and perhaps a bit more on the dreamy side, individual Canadians may choose to spend more at home and aim for domestic producers, egged on by a much weaker currency.

Taking all these mitigants into account, the damage could be limited to around 1% of GDP, at least in the first year. But it would entail a combination of a lower standard of living through a cheapened currency, damaged government finances, and an even heavier skew to spending/housing and away from investment/exports. There may even be some upside inflation risk from the weak loonie and firmer housing market, despite weak overall growth. Moreover, at the micro level, there would be entire sectors under intense pressure, which could face years of heavy challenges.

The deep frustration for policymakers is this direct trade threat lands at a time when it looked like the economy was at last poised to emerge from the struggles of the past few years. While Q3 GDP growth was dull at 1.0%, the consumer showed notable spark with a 3.5% annualized advance, and even housing managed to rise. With further rate cuts in train, it looked as if the economy was well past the point of maximum risk from high inflation/high interest rates. Fiscal policy was primed to add some additional modest support to growth—even if the particular measures were not exactly an economist’s dream choices. And, even history looked better, as StatCan did indeed revise up the level of real GDP by a hefty 1.5% since 2020, meaning the economy actually rose by about a half a point faster than first advertised in each of the past three years. We even bumped up this year’s growth estimate a couple ticks to 1.3% due to the firmer starting point.

Alas, all of these better tidings could be readily washed away if the tariffs are indeed imposed on Canadian exports. Markets and seemingly the vast majority of analysts and commentators appear to believe that the tariffs won’t actually happen, that it is all bluster, and/or a negotiating tactic. One simple response to that otherworldly calm could be: “And what exactly are we negotiating?”

Douglas Porter is chief economist and managing director, BMO Financial Group. His weekly Talking Points memo is published by Policy Online with permission from BMO.