The escalating U.S.-China trade war threatens to sideswipe Canada’s economy and the Canadian dollar.

The impact may not be huge, but it comes at a crucial time as Canada tries to pick up after a temporary slump. And the trade spat is just what the Bank of Canada is fretting about at this point.

Which could well play into what the Federal Reserve and Bank of Canada do further with interest rates, the former having already trimmed its benchmark and the latter watching and waiting.

“A re-escalation of trade tensions magnifies the key downside risk for the BoC’s outlook, and also likely keeps the Fed pursuing further cuts this year (we expect another 25 basis points in September),” said Veronica Clark, associate, U.S. economics at Citigroup.


"While we continue to expect that the BoC will remain patient as it waits to see if downside risks materialize in softer data, global trade uncertainties do support rates remaining at accommodative levels."

This comes amid the escalating trade battle between Washington and Beijing, with President Donald Trump firing the latest shot, that being a vow to put 10-per-cent tariffs on a further US$300-billion of Chinese goods come September.

Brett House, Bank of Nova Scotia's deputy chief economist, and his colleague, economist Juan Manuel Herrera, have three scenarios for how this plays out, and how it could affect Canada:

Scenario No. 1: Mr. Trump proceeds with the 10-per-cent tariff on goods not already hit in the trade battle.

This would cut economic growth by 0.14 of a percentage point next year in the United States, and in Canada by 0.11 per cent, with little impact on inflation and the Bank of Canada’s benchmark overnight rate.

"Though the immediate macroeconomic impact of these new 10-per-cent tariffs would be relatively limited, their longer-term effect on business activity and consumer confidence could be more pronounced than we have reflected in our model," Mr. House and Mr. Herrera said in their study.

Scenario No. 2: Mr. Trump raises that 10-per-cent tariff to 25 per cent in the third quarter, meaning all Chinese imports would be subject to the higher level, and Beijing retaliates, also at 25 per cent.

Economic growth would suffer to the tune of a cumulative half of a percentage point in 2019-20, prompting the Fed to trim interest rates again.

"In Canada, the Sino-U.S. dispute translates into a reduction in GDP growth of 0.17 of a percentage point in 2020 relative to our latest forecast," Mr. House and Mr. Herrera said. "Inflation is little affected, nor is the BoC’s policy rate."

Scenario No. 3: Mr. Trump slaps 25-per-cent tariffs on all goods entering the U.S., including Canadian products, despite the recently negotiated trade pact, taking a trade war to the rest of the globe.

"Given otherwise still-solid fundamentals in the U.S. economy, it would take this scorched-earth trade war to push the U.S. into recession: The U.S. economy would contract by 0.7 per cent in 2020," Mr. House and Mr. Herrera said.

“The Fed would be forced to cut the Fed funds target rate by 100 to 125 basis points beyond the 75 basis points in cuts during 2019 already programmed in our baseline forecasts. Under this global trade-war scenario, Canada also falls into a deep recession that sees GDP contract by 1.6 per cent in 2020. This sharp downturn forces the Bank of Canada to cut its policy rate to its effective lower bound by end-2020.”

Then there’s the Canadian dollar.

The loonie is again "vulnerable given renewed trade policy uncertainty," said Shaun Osborne, Scotiabank's chief foreign exchange strategist, and his colleague Eric Theoret.

"Global trade policy uncertainty has returned as a dominant driver for the CAD," Mr. Osborne and Mr. Theoret said, referring to the loonie by its symbol.

"Yield spreads have narrowed considerably over the past week or so, reflecting a significant repricing in expectations for the Fed and a less significant repricing for the BoC," they added.

"There may be some scope for further adjustment in the outlook for the BoC, given the aggressive moves in U.S. rates as well as the meaningful tweet-driven decline in oil prices."

They were referring to the marked drop in crude after Mr. Trump’s tariff-related tweet last week.

The economic outlook, of course, now becomes all that much more clouded, with a risk to Canada.

“Markets are becoming increasingly concerned about global growth prospects and the demand for major commodities, with clearly negative impacts on Canada,” said Toronto-Dominion Bank economist Brian DePratto.

“The benchmark U.S. crude-oil contract, for example, dropped roughly $3 per barrel in the wake of President Trump’s announcement. All of this is to say that while domestic conditions are healthy at present, still more external speed bumps are forming on the road ahead.”

Beijing is halting purchases of American agricultural goods, but lacks powerful ammunition with which to fight back, said Julian Evans-Pritchard, senior China economist at Capital Economics.

"As such, policy makers are likely to focus on broader measures to offset the drag from tariffs," he said.

"We expect them to allow further currency depreciation, which will shore up export revenues," he added.

"But much of the support will need to come from old-fashioned stimulus and we expect both fiscal and monetary policy to be eased more than most currently anticipate."

Scotiabank's Mr. House and Mr. Herrera didn't see this latest escalation coming given the goods it targets.

"To this point, the White House’s tariffs have been specifically designed to avoid directly affecting the prices of bread-and-butter goods that households buy on a daily basis," they said.

“This new round of tariffs would imply immediate price increases on key consumer products, such as toys, sports gear, games, clothing and shoes, which are important to President Trump’s voting base in the run-up to the Christmas buying season,” they added.

This Globe and Mail article was legally licensed by AdvisorStream.

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