Breakthrough Trade Deal a Major Sigh of Relief

Last night’s agreement in principle to update NAFTA under the new banner of the US-Mexico-Canada Agreement (USMCA) may yet contain some surprises buried in its fine details. But, similar to the immediate investor response, we are breathing a sigh of relief this morning. The deal is far from perfect, but other, decidedly more negative potential outcomes – such as Canada’s exclusion from a revised agreement, a “zombie” NAFTA, and steep tariffs on Canadian auto exports to the U.S. – have likely been avoided.

Facing a major U.S. swing towards protectionism, Canada negotiators had clearly set out to limit the damage and buy some security with the U.S. and they appear to have achieved that goal.

• Notably, two of three dispute mechanisms – Chapter 19 and Chapter 20 – have been preserved in the deal, which is a win for both Canada and Mexico. The former lays out a special appeals process through an independent panel to challenge anti-dumping or countervailing duties, while the latter allows one country to sue another if it believes terms of the agreement are not being complied with.
• A third dispute mechanism – Chapter 11 – that allows companies to sue the government if it believes it has been mistreated – was eliminated for Canada, and mostly for Mexico with the exception of certain industries. Ironically, it was the U.S. that demanded Chapter 11 be scrapped even though its companies had more frequently sought damages under that mechanism.
• Canada and Mexico have won assurance that the U.S. administration won’t levy steep auto tariffs under Section 232 national security provisions. Similar to Mexico, Canada has signed a side letter that exempts auto and parts exports of Section 232 tariffs below specified quotas, which are well above current production levels. Even if quotas are exceeded, the tariffs won’t apply if it is shown that the countries meet revised rules of origin. In short, the Canadian auto sector appears well positioned to weather these changes.
• On the flip side, the steel and aluminum tariff issue was not addressed in yesterday’s agreement. That issue has been left for another day.

As expected, Canada had to make some concessions. Most importantly, it agreed to provide U.S. dairy farmers access to about 3.5% of its dairy industry, though that access is well below the 10% that some had feared. Canada will also eliminate its controversial Class 7 pricing system.

A similar story holds for the de minimus threshold, which is the level below which goods are given exemption from duty and sales tax. The duty limit was raised from $20 to $150 (exemption for sales tax is raised to $40), which will not be welcomed by the Canadian retail sector. However, given that the comparable U.S. duty level is $800, it could have been worse. Lastly, Canada did concede some expanded intellectual property rights that will benefit the U.S., including prescription drugs where protection increases from 8 to 10 years.

On the winning side, there was no change to government procurement rules, which had been an early demand of the U.S. administration. Also, it appears to be very much business as usual for Canadian cultural protections as well as financial services regulation.

There are no doubt likely to be some surprises hiding in the details. For example, it appears that the U.S. administration added a provision that would effectively bar any of the three members from negotiating a trade deal with a “non-market economy.” This could hinder Canada’s exploration of an FTA with China.

A downside of the agreement is that it appears to have created a more complex regulatory burden around trade in goods and services rather than making trade more seamless. Case in point are the new rules around the local content in the auto sector.

Next steps

By reaching the deal on Sunday, the goal is to provide Congress with the full text to meet the 60 day notice period and allow Mexico’s outgoing president to sign by November 30th before he leaves office. However, Congress will still need to ratify the agreement which will occur in the New Year. Congressional passage is not a slam dunk, especially since there may be a shift in political winds post mid-terms. In Canada, Quebec’s incumbent government, which faces an election today, has vowed to challenge the deal in court.

Economic and financial market implications

Despite that deal’s pitfalls and hurdles that it could face before implementation, general reaction has been swiftly positive. By removing a significant cloud of uncertainty around trade, it is very likely to be growth positive, especially for Canada and Mexico.

The deal could open the door to a faster pace of rate increases in Canada in 2019. The Bank of Canada had embedded a trade risk discount into their growth forecast of around half a percentage point. With this risk removed, a rate hike later this month looks virtually cemented, while we see the balance of risks shifting toward three additional hikes in 2019 (from two). Fixed income investors have come to the same view, as evidenced by a backup in yields – Canada government 10-year yield is up 6 bps today and 40 bps from late-June lows. That said, since the central bank is data dependent, officials will remain in a “believe-it-when-I-see it” mode when it comes to the investment data and the impact of reduced trade risk on overall growth.

The Canadian dollar is already benefitting from the news, reaching a four-month high of 78 US cents. In the coming days, it could test its fair value of roughly 80-82 US cents if the trade discount gets further reversed and if more rate hike expectations are priced in.

From a broader global risk perspective, this weekend’s announcement spells good news. It shows that the U.S. can negotiate a trade deal rather than merely toss around threats and impose duties. It builds on recent positive signals around negotiating with Europe and Japan.