Canadian Dollar Extends Losses after Kudlow Hints at Trump NAFTA Termination and Mexico Gears Up for Tariff Retaliation

- CAD falls as oil prices slide and fears over NAFTA grow larger.

- Kudlow talks "bilateral" deals, Mexico readies retaliatory tariffs.

- Prospect of a US withdrawal from NAFTA now seen rising by the day. 

© The White House

The Canadian Dollar slumped heavily on Tuesday after White House economic advisor Larry Kudlow suggested President Donald Trump is contemplating scrapping the North American Free Trade Agreement in favour of bilateral deals with Canada and Mexico.

"Yesterday we met with the president a couple times and he is very seriously contemplating kind of a shift in NAFTA negotiations. His preference now, and he asked me to convey this, is to actually negotiate with Mexico and Canada separately," Kudlow told Fox & Friends. "I think the important thought here is he may be moving quickly towards these bilateral discussions."

The comments come just days after President Trump told reporters; "I wouldn't mind seeing a NAFTA where you go by a different name, where you make a separate deal with Canada and a separate deal with Mexico. Because you're talking about a very different two countries."

Kudlow emphasised the White House is not looking to actually terminate the deal but is considering replacing current multilateral talks with bilateral talks and, potentially, replacing NAFTA with separate bilateral agreements that have the same or similar effect. 

However, taken together, the two sets of comments appear to have prompted renewed fears the White House is coming close to announcing a US withdrawal from NAFTA, which could have significant implications for the Loonie. 

Concerns over NAFTA were already running high Tuesday after it was reported Mexico is gearing up to retaliate against metals tariffs announced by the White House last week.

The retaliatory tariffs are expected to be levied against imports of American pork products worth just more than $1 billion annually, and will follow Canada's decision to impose symetric retaliatory tariffs on US metals.  

"Having been one of the victims of Trump’s steel tariffs last week it looks as though Mexican officials have given up on the idea of any progress on NAFTA and instead are considering retaliatory tariffs," says Chris Turner, head of foreign exchange strategy at ING Group. "The news comes on the same day the US Senate Majority whip suggested that there was no time in the US political calendar for NAFTA discussions this year."

When you’re almost 800 Billion Dollars a year down on Trade, you can’t lose a Trade War! The U.S. has been ripped off by other countries for years on Trade, time to get smart!

— Donald J. Trump (@realDonaldTrump) 2 June 2018

Senate Majority Whip John Cornyn's proclamation follows an earlier warning from House Majority leader Paul Ryan that if negotiations were not concluded by May 17, the deal could not be contemplated by lawmakers until January when US electoral maths may have changed in a way that makes passing any bill at all much more difficult.

"These moves will fan fears that Trump will announce the US pulling out of NAFTA. At the same time Mexico is headed towards Presidential elections on July 1st, where the populist AMLO has a commanding lead in the polls. As we’ve seen in Italy, market complacency over an expected populist government can quickly be unwound," Turner adds.

China already charges a tax of 16% on soybeans. Canada has all sorts of trade barriers on our Agricultural products. Not acceptable!

— Donald J. Trump (@realDonaldTrump) 4 June 2018

The NAFTA stakes are high for the Loonie because some analysts have estimated the currency could fall as much as 20% if the White House goes for the nuclear option and announces a US withdrawal from the agreement.

This would set the clock ticking on a six month termination period, during which the deal could still be saved, that would leave the Canadian Dollar under a cloud of uncertainty. 

“The combination of stringent US proposals, a lengthening timeline of talks, and President Trump’s persistent threats of termination and campaign motives have raised the risk that Trump triggers Article 2205, setting off a six-month notice of termination,” says Brittany Baumann, a macro strategist at TD Securities.

TD Securities forecasts a modest hit to economies across the NAFTA area under a scenario where a withdrawal notice is seen largely as a negotiating tactic, although this would come largely at the expense of market expectations for further rate hikes from the BoC, the full cost of which would in turn be borne by the Canadian Dollar.

“Market rate hike expectations in Canada would fall but not fully price out tightening and price in termination,” says Baumann. “Wider rate spreads would drive CAD to weaken by 8-10% based on the elasticity in our fair value model.”

A Tougher Mexican Stance

July's vote in Mexico will see incumbent President Enrique Pena Nieto replaced with ruling Institutional Revolutionary Party (PRI) candidate Jose Antonio Meade or by opposition candidate Andres Manuel Lopez Obrador (AMLO), who has campaigned heavily on an anti-corruption ticket and has a 20 point lead over his nearest rival in opinion polls.

Obrador has previously called for NAFTA talks to be suspended until after the election because the "weak" incumbent president is in danger of "selling out" the country, suggesting Mexico's stance may harden in July if Obrador is succesful in his campaign for the presidency, increasing the risk of President Trump simply withdrawing from NAFTA.

Tuesday's commentary on NAFTA comes at a time when Canada's economy is recovering from a first-quarter slowdown that hampered growth the developed world over and barely a week after the Bank of Canada (BoC) signalled it might raise interest rates for the fourth time in a year this July. 

The Canadian Dollar was lifted by the BoC's statement last week, which saw interest rate derivatives markets shift to such an extent that pricing now implies a more than 80% probability of an interest rate rise when the bank's next meeting concludes on July 11.

However, the BoC has repeatedly cited tensions over international trade as a serious threat to its forecasts for the Canadian economy and therefore, the outlook for monetary policy as well.

Should concerns over the survival of NAFTA intensify over the course of June then financial markets could soon mark down the probability of a July rate hike from the BoC, which would be a further negative for the Loonie. 

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