Canadian dollar versus Donald Trump #CanadaFinance

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The Canadian dollar has been steadily declining over the past couple of months — a drop many economists and currency experts have linked to the rising expectations of a Donald Trump victory in the lead up to the U.S. election. The loonie is down just over four per cent against its U.S. counterpart since late September, and 1.5 per cent since Nov. 5. It slumped nearly a half per cent after Trump announced that, on day one of his presidency, he would impose a 25 per cent tariff on all goods entering the United States from Canada and Mexico.

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With the loonie currently hovering around 71 cents U.S. and Trump’s inauguration still two months away, Canadians are wondering just how low it might go. Here’s a breakdown of the factors working against the Canadian dollar as the so-called Trump trade — a combination of deregulation, tax cuts, higher deficits and inflation — plays out.

Trump tariffs

Given our highly integrated trade relationship with the U.S., the currency markets’ trigger response to Trump’s tariff throwdown is understandable, said Bipan Rai, managing director and head of ETF and structured solutions strategy at BMO Global Asset Management.

While the Canadian dollar dropped dramatically after Trump posted his tariff threat on social media, Rai thinks that a few days out from the main event, the “risk” to the loonie has already been discounted. “The foreign exchange market, especially the spot market, is quicker than most in doing that,” Rai said, looking back to late September when the loonie started to slump in line with Trump’s rising odds of winning.

“You could ascribe some degree of weakness in the Canadian dollar to the possibility that Trump could become president and levy these tariffs,” he said. “There is a certain amount of pricing in that’s (already) been done. Where we are now is where we were late last week,”

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Shorting of the Canadian dollar also provides proof, in Rai’s opinion, that the tariff shock is accounted for. “We have a fair bit of the market that is already short Canadian dollars,” Rai said, meaning a lot of investors are already betting the loonie will fall. “When you get to that point, you have to ask yourself where is that additional short going to come from?”

Looking back 10 years “it’s not often we are at these levels,” he said. With Trump’s tariff shocks potentially priced in, Rai thinks it’s important to look at other factors driving the loonie’s value relative to the U.S. dollar.

No currency is an island

We can’t think of currencies in isolation: ultimately they are all pairings. In the Canadian dollar’s case, its most significant pairing is with the greenback, especially given that 77 per cent of Canada’s exports are sent across the border to the U.S. —  our biggest and (until now) most reliable trading partner.

Just like human relationships, not all currency pairings are equal.

“There is a natural overweight dollar footprint given that the U.S. dollar is the world’s reserve currency,” said Sarah Ying, head of FX strategy and fixed income, currency and commodity strategy at CIBC Capital Markets, during a webinar on currency outlooks for the new year.

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“Under (a) Trump White House, we do think dollar dominance can rise even further,” Ying said. CIBC is basing that prediction on the ongoing risk of tariffs, their potential impact on growth and inflation, and what that could mean for the U.S. Federal Reserve and interest rates.

With more global uncertainty in the cards — even if it’s generated by Trump — investors will scurry to the U.S. dollar for shelter, spelling further downside risks for the loonie.

The interest rate affect

On the campaign trail, Trump touted several policy initiatives, including lower corporate taxes, no taxes on tips or some forms of social assistance, and tariffs. If Trump makes good on his tariff threat, inflation is expected to rise as businesses pass on the increased cost of goods to their customers rather than take a hit on their profits. The rising prices of goods will in turn fuel inflation, making it harder for the Fed to continue cutting interest rates. And you can’t talk about the value of the loonie against the U.S. dollar without talking about interest rates.

A country’s policy rate affects the value of its currency, as higher interest rates attract investors looking for a better return, which increases demand for that country’s currency and its value. (Conversely, lower rates stunt demand.) Right now, in an interest rate head to head, the U.S. dollar is the winner. The Fed’s funds rate sits in the range of 4.5 to 4.75 per cent, 100 basis points at the upper bound compared with the Bank of Canada‘s benchmark lending rate of 3.75 per cent. That spread between the two sets of rates is called divergence, and the more interest rates diverge, the greater the chance the Canadian dollar will fall against its U.S. counterpart.

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Historically, Bank of Canada and Fed rates have typically diverged anywhere from 75 to 100 basis points, Rai said. In the current cutting cycle, Rai thinks the spread could go as high as 125 basis points, but he doesn’t think this will become clear until spring, when the Bank of Canada’s end rate comes into view.

From there, investors are expecting U.S. and Canadian policymakers to diverge further, with markets betting the Fed will cut next month and only three times next year, Karl Schamotta, chief market strategist at Corpay Currency Research, said in a note last week. Economists are predicting the Bank of Canada will cut rates a further 100 to 150 basis points depending on forecasts for this cycle’s terminal rate.

“This outlook makes the Fed one of the advanced world’s most hawkish central banks, and is enough to keep both real and nominal interest rates dramatically tilted in the (U.S.) dollar’s favour,” Schamotta said.

Where the dollar goes from here

The Canadian dollar took a half-cent hit as currency players digested what a 25 per cent tariff could mean for Canada’s economy. “Given the downside risks to each economy from potential changes in U.S. trade policy, we judge that those moves are a sign of things to come,” deputy chief North America economist at Capital Economicssaid in a note, also referencing the outlook for the Mexican peso and Chinese renminbi.

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Brown is calling for the loonie to weaken six per cent against the greenback by the end of 2025, to 66 cents U.S. Also at the bottom end of predictions, David Rosenberg at Rosenberg Research is calling for the loonie to fall to $1.36 or 68 cents U.S.

Rai, for his part, thinks it’s tough to make currency predictions due to too many changing factors. “It’s very similar to predicting the weather,” he said. “I can tell you it’s going to be cold in December. I just can’t tell you what the temperature is going to be.”

Rai prefers to look at ranges for the loonie’s future value. He thinks the Canadian dollar will move into a new range of $1.37 to $1.41 per U.S. dollar (73 cents U.S. to 71 cents U.S.) based on the interest rate divergence story, after being locked into a range of $1.34 to $1.38 (75 cents U.S. to 72.5 cents U.S.) for most of 2024.

Ying, at CIBC, has a more conservative outlook, saying the bank expects the Canadian dollar will “hover around 1.40 to 1.41 over the coming months, despite spot price volatility in the wake of Trump’s tariff threats.” However, by then end of 2025, CIBC predicts the loonie will drop to $1.37, as growth in Canada picks up and the “Trump trade” loses steam.

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