Canadian dollar, TSX hit by reports that U.S. may pull out of NAFTA

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The Canadian dollar, government bond yields and a number of blue-chip stocks sank on Wednesday after reports that the United States is considering withdrawing from the North American free-trade agreement, raising questions about how Canadian exporters and the domestic economy will respond if the deal is terminated.

The loonie, which began the day comfortably above 80 cents against the U.S. dollar, fell more than half a cent to 79.7 cents, marking its lowest level this year. Mexico's peso also fell sharply.

"Trade uncertainty was just kicked up a notch," Priscilla Thiagamoorthy, economic analyst at BMO Nesbitt Burns Inc., said in a note.

She added: "Today's large movements highlight the sensitivity of currencies to any trade news and we could see more wild swings as the spat continues."

The reversal follows a report from Reuters that said unnamed Canadian government officials believe that the United States could signal its intention to withdraw from the trade agreement with Canada and Mexico.

While that doesn't mean that NAFTA is dead – negotiations could continue – it does raise uncertainties as trade representatives embark upon the sixth round of negotiations later this month in Montreal.

Financial players, including Bank of Montreal strategists and Royal Bank of Canada's chief executive officer, have also noted this week that NAFTA is looking increasingly fragile.

However, Wednesday afternoon marked the first time that financial markets reflected the increasing possibility of a U.S. withdrawal from the trade agreement.

Government bond yields, which had been rallying in anticipation of interest rate hikes by the Bank of Canada this year, promptly reversed course.

The yield on the the two-year Government of Canada bond fell to 1.74 per cent, down six basis points.

Stocks were also caught up in the shifting outlook.

The benchmark S&P/TSX composite index, which was higher in morning trading, ended the day down 71.29 points or 0.4 per cent, closing at 16,247.95.

Some of Canada's largest exporters and companies key to the movement of Canadian exports to the United States fell the hardest.

Auto-parts giant Magna International Inc., which analysts believe could be particularly vulnerable to changes in the trade agreement given that its parts are used by U.S. auto manufacturers, fell 3.2 per cent.

Canadian National Railway Co. fell 2.7 per cent and Canadian Pacific Railway Ltd. fell 3.1 per cent. According to estimates from BMO Nesbitt Burns, both railways derive about 30 per cent of their revenue from trade between the United States and Canada.

Financial markets also readjusted their outlook for Canadian interest rates.

Markets now see a 75-per-cent chance that the Bank of Canada will raise its key interest rate next week, down considerably since Wednesday morning when markets reflected an 88-per-cent chance of a rate hike next week.

"The existing Bank of Canada forecast had assumed no change in trade relationships, so this is a negative for their outlook," Avery Shenfeld, chief economist at CIBC World Markets, said in a note.

While Mr. Shenfeld still expects the Bank of Canada to raise its key rate next week, he is sticking to his view that the central bank will then hold rates steady until the third quarter, amounting to just two quarter-point hikes this year.