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NAFTA Breakdown Poses Downside Risk to Canadian Dollar vs. Pound and US Dollar

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A breakup of the NAFTA block could see the USD/CAD rate go past 1.3225 which, in turn, which could help push GBP/CAD exchange rate much higher.

Canadian Dollar buyers could be 'quids in' over coming months according to economists eyeing the potential for the implosition of the 23-year-old North American Free Trade Agreement.

Donald Trump's election victory saw negotiations over NAFTA start anew, as the President believes both Canada and Mexico have benefited from the free trade agreement to the United States' detriment. 

Trump's declarations that NAFTA was a "disaster" and the "worst trade deal in history" saw the U.S., Canada and Mexico sit down to renegotiate the treaty, with commentators suggesting talks are ultimately doomed to fail and throw the existence of NAFTA into doubt.

NAFTA matters for Canada and its currency; the most up-to-date data shows since 1993, U.S. and Mexican investments in Canada have tripled. U.S. investment, which accounts for more than half of Canada’s FDI stock, grew from $70 billion in 1993 to over $368 billion in 2013.

The implications of a break-down in NAFTA will likely lower the potential velocity in both investment and trade in and out of Canada which would in turn have implications for economic growth rates.

Negotiators agreed in October to extend talks into the New Year, but markets have increasingly downgraded the threat of a NAFTA disruption to the point where current pricing suggests investors could be oblivious to the prospect of a NAFTA meltdown.

“President Donald Trump’s views on trade are clearly not gaining much notice in financial markets,” says Avery Shenfeld, chief economist at CIBC Capital Markets. “A recent Wall Street Journal survey of economists showed them putting barely more than 25% odds of a US pull-out from the pact.

But there are few grounds for optimism that the deal can be successfully renegotiated, according to Shenfeld, which presents a risk to the Canadian Dollar and all companies and individuals with exposure to it.

“The president and his negotiating team appear bent on a strategy aimed at failing to reach a deal, sticking with demands that would, for Mexico and Canada, make NAFTA a hollow vehicle or worse than no deal at all,” says Shenfeld.

The Trump administration is pushing for changes to various aspects of the NAFTA agreement that are geared toward reducing the US trade deficit by bringing more manufacturing work back into the US.

“As he did on the Iran nuclear deal, Trump might instead throw it to Congress to decide if the US should put its partners on notice of its intent to pull out of NAFTA (and the earlier Canada-US deal). Or he could issue that declaration on his own,” Shenfeld says.

Washington also wants a five-year sunset clause that will enable the renegotiated agreement to be reviewed and, potentially, renegotiated again further down the line, something which will only prolong uncertainty over the fate of the deal.

“Either way, markets and CEOs are going to be adding a lot more weight to these downside scenarios in the months ahead,” Shenfeld adds.

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CAD Market "Not Ready" for this Kind of Adjustment

Positioning in the currency market still implies a heavy bet by traders that the Canadian Dollar will rise over the months ahead, belying the risk of a NAFTA breakdown.

“Investors should protect themselves against NAFTA termination risk given the level of complacency in the USD/CAD market,” says Bipan Rai, a foreign exchange strategist at CIBC.

The Pound-to-Canadian-Dollar rate was quoted 0.05% higher at 1.6845 during early noon trading Friday while the USD/CAD rate was marked 0.07% higher at 1.2765.

Pound-to-Canadian-Dollar shown at weekly intervals. Captures 2016 and 2017.

Neither the Pound or the US Dollar has been able to make meaningful headway against the Loonie so far in 2017, given the greenback has shed around 5% during the year to date, while Sterling has risen only 2% against the Loonie. 

USD/CAD shown at weekly intervals. Captures 2016 and 2017.

Stock markets also show Canadian, American and European carmakers relatively unaffected by growing doubts over the deal even though these firms have the most to lose if NAFTA falls apart.

“While we still think that some form of the NAFTA agreement will hold when the dust settles, the odds that negotiations become very contentious are still high. That implies that volatility should follow suit as well,” Rai adds.

If the Canadian Dollar falls sharply relative to the US Dollar and the same fall is not replicated in the GBP/USD rate, this would push the Pound-to-Canadian Dollar rate higher.

“In the event of a termination announcement, the CAD should sell-off aggressively,” says Rai. “The CAD market is not prepared for this type of adjustment at the moment given that positioning and sentiment still remain elevated in favour of the loonie.”

Rai and the CIBC Capital Markets structuring team are recommending to clients that they buy protection, in the options market, to guard against an upward move that takes the USD/CAD rate past 1.3225.

If USD/CAD goes to 1.3225, this could push the Pound-to-Canadian-Dollar rate as high at 1.7458, assuming that the Pound-to-US-Dollar rate holds steady around the 1.3200 level.

This is because the Pound-to-Canadian-Dollar is a cross rate that, in its simplest form, is calculated by dividing the GBP/USD rate by the CAD/USD rate.

Of course, most modern dealers will make markets directly in the cross rate today however, price deviations away from the above model’s output are swiftly arbitraged away.

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