How Trump Could Push the Bank of Canada to the Brink of QE

  • Border-tax adjustment would hit exports, says Deutsche’s Galy
  • Bank of Canada would need to respond with action and words

QuickTake: Trump’s Trade Plans

With markets in flux as Donald Trump does what he said he’d do, one question looms large for America’s northern neighbor.

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. 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 percent tax on imports, the key tenet of a GOP proposal Trump has reportedly warmed to, would "depress Canadian exports by 8 percent," 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 percent 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 percent for April’s meeting.

Indeed, the story in markets since the November election 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 neighbor 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.

On Tuesday, the U.S. dollar fell below 1.30 Canadian for the first time since September.

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 percent 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 percent lower and protect the competitiveness of the nation’s exports, he estimated.

"The threat of quantitative easing would drive a wedge between Canada’s and U.S. Treasury that would mechanically depress the currency," Galy said.

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