Whenever things happen that seem likely to move currencies significantly, there are two things to bear in mind. The first is whether the event has been anticipated, and hence ‘priced in’. The second is whether the currency will continue to respond, even if it is priced in, because the event is so significant that it necessitates what we might term a ‘fundamental’ move in the currency in addition to any expectations-led shift.

If all this seems a bit theoretical, think about US tariffs. And here we are specifically thinking about US tariffs on Canada. We’ve picked out Canada for two reasons.

The first is that it stands to be the hardest hit of the developed countries if the 25% tariffs on steel and aluminum are compounded by the enactment of the 25% tariff threat that hangs over all of Canada’s exports to the US on March 4th.

The second is that, as a member of the USMCA, the free trade deal between the US, Canada and Mexico, we might have expected the country to have had some protection from US tariffs before Trump started launching his threats. Putting these two together it is looking as if the country that we might have expected to get off lightly could be hit the hardest. As these threats came, so the Canadian dollar has slipped. It stood around 1.38 against the dollar on US election day and fell to a low of near 1.48 in early February. A ten-cent move makes it seem that the market has priced in a lot of bad news for the country around tariffs.

Indeed, the recovery in the Canadian dollar, to around 1.42, when the 25% tariff threat was suspended, attests to this. No doubt there will be more volatility in the currency as sentiment ebbs and flows on tariffs with much of this, of course, down to the whims of Donald Trump. It may seem most likely that the general 25% tariff won’t be introduced from March 4th, at least given how the market is reacting.

However, we would caution that a stay of execution for Canada might not ‘stay’ for long. If the tariffs were to go on, and indeed tariffs put on other countries, would the impact on the FX market be negligible because tariffs are still (mostly) priced? Or will this ‘expectations’ effect that we have already seen be turbocharged by the ‘real’ or ‘fundamental’ effect.

What do we mean by this? If we take tariffs from the US, there is both theoretical and evidential reason to believe that they will lift the dollar and weigh on tariffed countries, like Canada. This is not down to any expectations effect but because tariffs have real consequences for trade. If 25% tariffs on Canada price Canadian exports out of the US market then US firms’ demand for Canadian dollars will fall as imports will be hit.

Another ‘theoretical’ argument we’ve talked about before relates to the fact that the US’s trade deficit is a reflection of deficient domestic savings (relative to investment). If tariffs don’t change this imbalance, which seems unlikely, the trade deficit cannot improve via tariffs and it will be stopped from improving by a currency offset, as the dollar rises to counterbalance the tariffs.

Evidence does suggest that this currency offset occurs, such as the slide in the renminbi when the US imposed tariffs during Trump’s first term. In other words, even though there might be an initial dollar rally driven by this expectations effect, there should be an additional rise related to the ‘real’ effects of the tariff. If that’s the case, and if the US does impose tariffs on Canada from March 4th – and others besides – their currencies should weaken again.

In other words, we should not anticipate that tariffs have been fully absorbed by the expectations effect alone. Of course, a good part of the full impact of tariffs might be captured by this expectations effect, but not the full amount. What does this mean in dollars and cents? We think it implies that if the US does go ahead with tariffs on Canada early next month it will provoke a rise in dollar/Canada that, in time, goes far beyond the 1.48 high we saw earlier this year. We think it could be as far as the 1.50-1.55 range and we would apply the same reasoning to other currencies where tariffs have not been applied yet. This being said, just as tariffs are thought to produce a one-time lift to US inflation, so the lift to the dollar may prove temporary and not permanent.