Trump and tariffs

In his inaugural address President Trump stated that “instead of taxing our citizens to enrich other countries, we will tariff and tax foreign countries to enrich our citizens.” The president has proposed imposing 25% tariffs on Mexico and Canada by February 1. The currency impact is important because a stronger dollar could do some of the lifting in terms of enhancing the purchasing power for U.S. importers. Against both the Mexican peso and the Canadian dollar, the U.S. dollar has gained more than 3% since the election.

Mexico and Canada are two of American’s top trading partners. After the European Union, which is an amalgamation of 27 sovereign nations, Mexico is the largest source of U.S. imports. The United States imported around $500 billion worth of merchandise from Mexico in the past twelve months through November, while another $410 billion or so came from Canada. Together, Mexico and Canada account for just under 30% of all U.S. goods imports, though the share is higher for specific categories, such as autos & parts for example where just over half of all U.S. auto imports come from the two countries. Canada is also an essential source of crude oil imports for the United States.

President Trump can impose tariffs immediately through the International Emergency Economic Powers Act of 1977, which allows the president to regulate trade transactions if he declares a national emergency. Trump declared two national emergencies on Monday, one on energy and the other at the Southern border of the United States. It is unclear if the president can/will utilize these emergencies to impose Mexico/Canada tariffs or declare another emergency. Trump also has the ability to lean on legislation used in his previous term to impose tariffs, but those Acts require investigations by other agencies meaning it will take longer to enact tariff policy. It is worth noting President Trump also directed agencies to investigate U.S. trade deficits and current trade agreements on Monday and to have them report back by April 1, so the proposed Mexico/Canada tariff-timing remains uncertain. It’s also sensible to believe the two countries would retaliate. For example, outgoing Canadian Prime Minister Justin Trudeau reiterated his intent to retaliate in the wake of Trump’s recent announcement.

To put it directly if not particularly diplomatically, U.S. trade matters a lot more for Mexico and Canada in terms of economic growth than trade with Mexico and Canada matters for the United States. While U.S. exports to the two countries are equivalent to just 2.5% of U.S. GDP, exports to the United States represent more than a quarter of Mexico’s output, and about a fifth of Canada’s GDP. On the other side of the ledger, imports from the United States account for a little less than half of total Canadian imports (~14% of GDP), while U.S. imports represent around 43% of Mexico’s imports (~15% of GDP).

Having said that, it is not as though the United States can impose tariffs upon its neighbors with impunity for the U.S. economy. If the U.S. imposes a 25% tariff on all imports from Mexico and Canada beginning February 1, and the two countries retaliated in kind, the United States will experience slower domestic economic growth and higher consumer price pressure, all else equal. An example can be helpful in understanding how the impact to the U.S. economy can be so large even when the importance of trade is so small. Take the Chevrolet Silverado. One of America’s most beloved pick-ups is constructed in Flint, Michigan, Fort Wayne, Indiana, Springfield, Ohio, and Silao, Mexico. Some engines for the Silverado and a number of parts and components come from a plant in Oshawa, Ontario, Canada. The integration of supply chains makes the process of disentangling production a costly endeavor.

Dollar valuation could play a role in mitigating the potential price impact of tariff policy. In the event the United States imposed a 25% tariff on Canada and Mexico, the U.S. dollar would strengthen broadly, not just against the Mexican peso and Canadian dollar. To see how this foreign exchange story plays out, start by looking through the lenses of the central banks directly involved.

For the Bank of Canada (BoC) the forecast is a terminal rate of 2.25%, and for the Central Bank of Mexico (Banxico), a terminal rate of 8.50%, both to be reached by the middle of this year. Should tariff threats become reality, policymakers at each central bank would reconsider easing cycles, but in a way where BoC and Banxico take diverging paths for interest rates. In that sense, while Canadian goods exports to the United States have declined over time, Canada maintains a strong trade relationship with its southern neighbor. Should the Trump administration impose tariffs on Canadian goods, we would expect downward pressure on Canada’s economy to build. Although tariffs may result in modest inflationary pressures in Canada, BoC policymakers would respond by turning more dovish. Canadian inflation is currently below the BoC’s target, meaning tariff-related inflationary pressures may be something BoC policymakers look through, or possibly view as transitory. Avoiding recessionary conditions may take priority, and in an effort to avoid economic contraction, BoC policymakers would respond with a more aggressive easing cycle.

Banxico is another story. Tariffs would also have an impact on Mexico’s growth trajectory and new levies could result in capital outflows from Mexico. Currency volatility would likely ensue and a weaker peso could result in Mexico importing inflation. Policymakers there would likely turn less dovish in an effort to defend the value of the peso and prevent a period of above-target inflation. In response, Banxico policymakers would likely end the easing cycle early.

Generally speaking, tariffs and tariff threats generate uncertainty across financial markets, and with the U.S. dollar still the pre-eminent safe haven currency, the greenback would likely strengthen not just against currencies of impacted countries but also against most G10 and emerging market currencies.

To be sure, U.S. dollar strength would apply relative to the Canadian dollar and Mexican peso. As far as the Canadian dollar, a more dovish Bank of Canada against a less dovish Fed would likely place depreciation pressure on the Canadian dollar for an extended period of time. Combined with investor sentiment toward Canada that would likely also soften, widening interest rate differentials, likely means the USD/CAD exchange rate can test CAD1.5000 by early 2026. Risks around our Canadian dollar outlook would also be tilted to the downside (i.e., more CAD depreciation).

Currency depreciation could be more extreme in Mexico. While Banxico could end the easing cycle early and preserve healthy carry relative to the U.S. dollar, risk appetite toward Mexico would likely be eroded. From a valuation perspective, we can make an argument that the Mexican peso is overvalued. The current Real Effective Exchange Rate (REER) is above its long-term average by a wide margin, a sign that if risk sentiment worsens, the peso’s adjustment back to “fair value” could result in a rather significant selloff. Mexico is also struggling with local idiosyncratic risks that could compound market participants avoiding Mexico and peso-denominated assets. Those country-specific developments include a widening fiscal deficit, governance challenges and rising local political risk, which could also contribute to peso depreciation pressures. As of now, the USD/MXN exchange rate can hit MXN22.50 by YE-25; however, tariff risks present clear downside risks, i.e., weaker Mexican peso, to the outlook.

Trump will continue to seek fair trade for the U.S. and after he has dealt with Mexico and Canada, China is next and after that Europe. During his first term, Europe was left alone, and it is now time for Trump to deal with Europe. After all, the EU is the U.S. largest trading partner. They have many trade advantages compared to the U.S., with unfair tariffs. This will be another key area of focus for Trump in 2025 and it will most certainly create friction and potentially a trade war.