Currency markets remain firmly rangebound even after President Donald Trump warned “no extensions will be granted” to his August 1 tariff date, threatened to raise levies on copper and pharmaceutical imports to 50 percent and 200 percent, respectively, and said at least seven additional countries would receive updated trade letters this morning, with the European Union getting one in two days. Stock futures are little changed, Treasury yields are flat, and US copper futures are holding around 10 percent higher after punching upward in yesterday’s session.
The dollar climbed earlier in the week when Trump postponed the rollout of his so-called reciprocal tariff regime to August, but has since struggled to build momentum. If fully enacted, the proposed tariffs are projected to raise the average US import tax to between 14 and 18 percent by summer’s end—by any measure, the highest since the early 1930s. While there is considerable debate over the timing and scale of the consequences, most credible economic forecasts suggest that any boost to domestic manufacturing will be largely offset by broader economic headwinds. These include higher consumer prices, reduced export competitiveness, rising unemployment, and slower real gross domestic product growth over the long term. Taken together, these developments are expected to erode ‘US exceptionalism,’ narrowing long-standing performance gaps between the American economy and its global peers, and potentially bolstering a move toward greater geographic diversification among the world’s investment managers.
Markets could remain placid today as Trump releases his letters, particularly if they pertain to smaller trading partners, but the potential for violent price action certainly exists, and we would urge hedgers to keep protection—and market bids—in place in case there are unexpected moves.
The Federal Reserve is still in wait-and-see mode. Minutes taken during the central bank’s last meeting—due for release this afternoon—will undoubtedly illustrate increasing disagreement among participants on the likely policy trajectory, but could also reinforce market expectations for an extended period on the sidelines as policymakers weigh upside inflation risks against downside labour market vulnerabilities. The “dot plot” summary of economic projections submitted at the latest meeting showed the median official still expecting two rate cuts this year, yet this concealed considerable dispersion, with two in favour of moving three times, eight seeing two cuts, two seeing one move, and seven (up from just four in March) expecting to leave policy settings unchanged. Despite this, we think broader opinion shifted toward a more moderate path ahead for the economy between the May and June meetings, with extreme price and growth outcomes looking less likely—primarily reflecting a dialling-down in tariff rhetoric from the administration, but also aligning with an improvement in overall financial conditions**.
Across the 49th, the Canadian dollar is losing altitude as uncertainty ratchets higher, consolidating its status as the worst-performing major currency against the dollar this year.
The outlook for the Canadian economy has turned far more optimistic in the past few months as last year’s Bank of Canada cuts have translated into an easing in financial conditions, Mark Carney’s government has announced a series of spending initiatives and competitiveness-boosting measures, and effective US tariff rates have declined from the levels threatened in early February. Market participants have pushed rate cut expectations further into the autumn months in the belief that the Bank of Canada will avoid pushing rates further below neutral levels in the near term—and better-than-forecast jobs numbers on Friday could add more weight to this view.
We are nonetheless wary of downside risks. We expect the greenback—the primary determinant of the loonie’s value—to find its footing in the coming months as hopes for aggressive Fed easing are disappointed, shifts in hedging behaviour among real-money investors outside the United States run their course, and real rate differentials reassert themselves as major currency market drivers. Estimates from the Yale Budget Lab suggest that Canada’s growth outlook has taken the hardest hit from the trade war thus far***— the economy is expected to be 1.86 percent smaller in real terms over the long run—and output remains vulnerable to further weakness as heightened uncertainty levels exert drag on business investment and push the unemployment rate higher over time. Canadian real estate investors have received a generational shock, suggesting that price momentum and activity levels are unlikely to return to the levels seen in years past. If inflation numbers resume their gradual moderation and domestic demand continues its long softening, the Bank of Canada could ease more than markets currently anticipate.
Taken in sum—and with a very large grain of salt****—we’re inclined toward expecting further loonie weakness in the near term, even if the economic portents are pointing toward some appreciation over a longer time horizon. A move closer to 1.39 could play out in the run-up to the early autumn’s typical volatility blowout, before reversing through 1.35 by early next year.
*Copper is a critical input in industrial processes across the US economy, and there is no reasonable expectation that more domestic supply can be brought online within the next few years. Mines typically take ten to fifteen years to plan and build.
**Financial conditions indices are designed to measure the extent to which markets are creating headwinds or tailwinds for economic activity, and include factors like bond yields, lending spreads, mortgage rates, exchange rates, and stock market valuations. When rates are rising and stock markets are falling, the financial sector is generally believed to be restricting growth, while the opposite set of conditions tends to boost the economy.
***This is, perhaps ironically, mostly due to Canada’s retaliatory measures, which we hope to see ratcheted back over time.
****Seriously, FX forecasts should not be a major input into the currency hedging process. A layered, mechanistic approach remains the best way to lower volatility over the long run.