With markets in flux as Donald Trump does what he said he’d do, one question looms large for America’s northern neighbour.
If Trump and Congressional Republicans get everything they want — tax cuts, infrastructure spending and a border-adjustment tax — what happens to Canada?
According to Deutsche Bank AG macro strategist Sebastien Galy, this trifecta of policies would force the Bank of Canada to cut rates and warn that quantitative easing might be needed to support the economy. Quantitative easing would see the Bank of Canada buy bonds and other financial assets from commercial financial institutions to further increase the money supply.
The negative effect on exporters and competitiveness will likely dwarf any benefits stemming from the boost to U.S. aggregate demand.
“The Border Tax Adjustment would have a disproportionately negative impact on the Canadian economy, depending on the degree of substitution away from Canadian goods, income effect of American demand and the currency,” Galy wrote in a Jan. 30 note about the House Republican plan to give preferential treatment to exports and place a levy on imports.
On balance, the 20 per cent tax on imports, the key tenet of a GOP proposal Trump has reportedly warmed to, would “depress Canadian exports by 8 per cent,” he estimates.
And Canada’s fiscal-policy levers to respond to protectionism might be more limited than you’d expect, argues Galy. The federal value-added tax — which functions in a similar manner to a border-adjustment tax — was already trimmed to 5 per cent by Prime Minister Justin Trudeau’s predecessor, Stephen Harper.
Which leaves the Bank of Canada.
Monetary easing isn’t something that traders see in the cards. Overnight index swaps suggest markets are betting tightening is more likely than easing this year, with the odds of a cut peaking at just 3.5 per cent for April’s meeting.
Indeed, the story in markets since the November election Betexper has been one of convergence, much to Bank of Canada Governor Stephen Poloz’s chagrin.
The governor cited Canada’s historically strong financial and economic links to its southern neighbour as the cause of the rises in the dollar and government bond yields, which have been highly correlated to their U.S. counterparts in recent months.
Poloz deemed the lofty loonie as a headwind for exports — but this rewriting of Canada’s terms of trade by way of a U.S. border-adjustment tax could have a far more precipitous effect on southbound shipments. In theory, currency markets would quickly adjust to fully offset the relative change in prices caused by the shift in U.S. tax policy. But the Bank of Canada won’t be content to rely on the textbooks, Galy reckons, and will need to respond with action and words — cutting its benchmark interest rate to 0.25 per cent and threatening to pursue unconventional asset purchases “when the U.S. measures become highly probable.”
This combination would be enough to push the Canadian dollar 10 per cent lower and protect the competitiveness of the nation’s exports, he estimated.
“The threat of quantitative easing would drive a wedge between Canada and the U.S. Treasury that would mechanically depress the currency,” Galy said.
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