The Canadian dollar has dropped sharply after the United States announced a new 35% tariff on Canadian imports. This rate is an increase from the prior 10% and 25% rates. It’s unclear if trade under the USMCA will get any exemptions. This tariff is different from specific tariffs that are already in place. If Canada works with the US to address the fentanyl issue, the tariff rate could be lowered. The tariff may change based on the relationship between the US and Canada. The new rate will take effect on August 1. This single 35% tariff contrasts with the earlier split rates of 10% and 25%, which depended on the type of goods and their compliance status. The old system offered some flexibility based on USMCA standards. Uncertainty about whether this flexibility will continue creates immediate challenges for pricing contracts and setting premiums in North American currencies. As the August 1 start date approaches, demand for short-term US dollar contracts is rising. Companies and investors are preparing for a drop in the Canadian dollar (CAD). Major announcements like this often lead to initial liquidity issues, especially in longer-term options, where it’s tough to accurately assess risks for the Canadian dollar. The language used around this policy change suggests there may be room for negotiation, possibly based on joint efforts to manage issues like fentanyl. This doesn’t signal confusion; rather, it indicates that pricing for future contracts must now include a variable risk premium. This premium will react not only to domestic economic data but also to diplomatic signals between the two countries. As a result, trading volume for near-term CAD puts is already on the rise, especially for contracts around the August 1 date. We expect these changes will impact the distribution of open interest in the IMM currency futures series. While we can see direct effects on the spot market, they don’t fully reflect the widening volatility on the downside. This suggests that ongoing pressure is expected, rather than just a single repricing. Consequently, models that depend on linked interest rate expectations will need updates, especially if cross-currency basis spreads misjudge potential disruptions in capital flows. Volatility dealers are not the only ones who need to adjust. Hedgers with positions rolling into the third quarter face unequal exposure risks, particularly if tariff exemptions do not happen. Therefore, managing gamma exposure in CAD/USD pairings should avoid relying on past correlations, which may not be meaningful in the current politically charged environment. Some might seek alternative exposure by increasing investments in northern European currencies or looking at short CNH pairings, where volatility might offer better advantages. However, this strategy should be approached carefully, as risks could spill over into North American equities, impacting demand for local currencies. Given the current inconsistency in tariff guidance, it’s wise to avoid calendar spreads without adding contingent options. Moreover, the potential adjustments to tariffs based on non-commercial cooperation make any straightforward predictions unreliable. While there may not be issues with dollar liquidity, that doesn’t mean free-flowing forward pricing for the Canadian dollar. We plan our strategy to stay flexible, ready for future pricing changes as new fiscal insights surface through diplomatic channels.

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