Optimism Over U.S. Tariff Impact Best Reflected in Canadian Dollar, Says Mitsubishi UFG

07:12 AM EDT, 03/28/2025 (MT Newswires) -- While there are signs of increased risk aversion on Friday, the overall financial market reaction to the 25% global tariff on autos and auto parts continues to be relatively muted, with most G10 currencies still stronger against the US dollar (USD) since United States President Donald Trump's announcement, said MUFG.

The yen (JPY) and the Canadian dollar (CAD or loonie) were the two worst-performing G10 currencies on Thursday with both key auto producers in the U.S. market, wrote the bank in a note to clients. There is also a growing view that the actions from Trump this week and again next Wednesday may curtail the appetite within the Bank of Japan for additional rate hikes.

For the Canadian dollar, while it underperformed on Thursday, the performance continues to be resilient, which must surely be questioned, stated MUFG. Can the Canadian dollar avoid a sharper depreciation given the elevated risks to the Canadian economy from increased trade tariffs from the country where exports account for around 80% of total exports, asked the bank.

It appears there is still optimism that Trump will prove constrained given the interlinkages between the two economies, pointed out the bank. Thursday, media in Canada reported that Ontario Provincial Premier Doug Ford had held a call with U.S. Commerce Secretary Howard Lutnick that would ultimately lead to the U.S. watering down tariffs against Canada.

That optimism is also evident in the OIS market pricing on rate cuts from the Bank of Canada through the remainder of the year, added MUFG. Markets expect 42bps of cuts compared to 63bps of cuts by the Federal Reserve. The BoC has already cut by more than the Fed explaining this divergence, but nonetheless, if tariffs do remain in place for longer the economic impact will require more cuts than implied by market pricing.

The BoC in January published its economic impact analysis based on a scenario of a 25% increase in tariffs on all imported Canadian goods into the U.S. and a retaliation by Canada doing the same for all U.S. imported goods to Canada. The BoC estimated a 2.5ppt drop in gross domestic product in year one and a 1.5ppt drop in year two relative to the baseline of no tariffs.

Inflation would be higher given the scale of retaliation but not initially due to excess supply and falling commodity prices and the BoC has stated that its focus would be more on the GDP hit than the medium term inflation risks and so implies more active rate cuts than what is priced now, according to the bank.

The two-year US-CA swap spread co-movement with USD/CAD is very tight and if the market optimism over trade tariffs fades, MUFG expects a renewed widening of the spread that should see USD/CAD adjust higher back toward the 1.5000 level.

Thursday, there were reports that for the first time since being sworn in as Prime Minister, Mark Carney had spoken to President Trump. However, this was quickly denied. How this relationship evolves would be important in determining the risks of a trade war escalation.

A parliamentary election takes place in Canada on April 28 and the Liberal Party's support in the polls has surged on Carney's tougher rhetoric that suggests Carney will be wary of looking weak ahead of the election.

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