Tariff Parallax

Trade policy whiplash returned last week as Donald Trump announced tariffs on Canadian and Mexican goods on February 1, only to reverse course by February 3 following intense pushback from both countries’ officials. Though the immediate threat has faded, the episode has the world on edge given Trump’s much more aggressive focus on trade policy than indicated during the campaign.

This also means there’s no undoing the uncertainty damage. Whether viewed through the lens of the fluid and wide-ranging motivations behind the announced tariffs, the decision to target two allies—including Canada, arguably America’s closest—or Trump's willingness to reverse course based on already-made concessions, his reaction function is far less predictable than many assumed on January 20. One of the immediate effects will be a significant weakening of business investment in Canada. This impact will materialize through both direct channels (e.g., delayed capital expenditures) and indirect channels (e.g., higher corporate borrowing costs as lenders factor in risk, or increased capital goods costs due to a weaker currency given that half of capital goods are imported).

It is mildly encouraging that Canada and Mexico can still influence Donald Trump. The fact that Trump reversed course—rather than escalating as he had threatened in response to retaliation—suggests they retain some negotiating leverage. However, what's unusual is that this leverage stemmed from promises related to border security rather than trade. Our deep dive on sectoral vulnerability highlights the US's lack of self-sufficiency and limited short-term substitutes in areas like oil and gas, steel and aluminum. At face value, the fact that tariffs in these sectors were reduced to 10% seems an acknowledgement of this dependency. But with Trump ready to justify tariffs on a broad list of objectives—e.g., boosting domestic production and raising the contribution of allies to military spending and border security—Canada and Mexico's influence will be tested. As a result, our next forecast will assume tariffs taking effect at the beginning of Q2, rather than the Q4 scenario we had assumed pre-inauguration.

Risks to the outlook are now firmly skewed to the downside. As we noted following Trump’s initial announcement, early tariff implementation would eliminate the temporary inventory buildup effects included in our baseline. This tailwind was evident in Canada’s December trade report, which contributed to a small upward revision in our Q4 2024 growth estimate. Without this tailwind—and with earlier labour market repercussions—our 2025 forecasts will be revised downwards, regardless of whether tariffs are eventually set at 25% or at some lower rate. The hardest-hit sectors will include auto manufacturing, aerospace, machinery, primary metals and lumber (already subject to 14% duties). In Quebec, we estimate these vulnerable sectors represent 25% of GDP, with an even higher share in Ontario due to the dominant auto industry.

A still-open question is how financial markets factor into Trump’s decision-making. Announcing the tariffs on a Saturday may have been a deliberate attempt to limit immediate market turmoil. Markets responded negatively on Monday morning, with Canadian auto and parts stocks hit particularly hard. However, US stocks, despite early losses, rebounded and trended higher throughout the week, largely brushing off other geopolitical headlines. The bond market reaction was more pronounced: Canadian bonds rallied sharply, pushing the Canada–US 10-year yield differential to a record low (-149.9bps) on Tuesday, which dragged the loonie down close to our previously out-of-consensus 1.48 USDCAD call for Q4. While Trump is unlikely to care about Canadian market developments, the thumbs-up from US equities—after his decision to hold off—may provide some feedback for his future policy decisions, for instance on the magnitude of eventual tariffs.

But regardless, Canadian policymakers must use the 21 days until March 1 to prepare for the worst. In upcoming Economic Viewpoints, we will analyze emergency fiscal responses from the past two recessions (COVID-19 and the Global Financial Crisis) and assess which measures could be adapted for a tariff shock and which past mistakes should be avoided. The tendency to “fight the last war” has not always served policymakers well; we’ll argue that long-term thinking must take precedence this time. The same applies to the Bank of Canada. While we do not see the need for an inter-meeting rate cut—since this is a macro shock rather than a financial crisis—the Bank will need to shift into mildly accommodative territory before long. Our forecast update next week will reflect this shift, though we maintain that rates need not be slashed to the floor given the Canadian economy’s strong sensitivity to interest rates in both restrictive and accommodative settings.