What happens to Canada if CUSMA is not renewed?

The Canada-United States-Mexico Agreement (CUSMA) is currently being reviewed, with its future hanging in the balance. Related uncertainties, compounded by earlier tariffs imposed by the U.S., have already hurt Canada’s economy, as evidenced by delayed investment and weak hiring by firms. In this Economic and Financial Market Update, we look at possible CUSMA scenarios and what those could mean for the economy going forward, including the Bank of Canada’s policy rate.

U.S. tariffs are hammering the Canadian economy

Statistics Canada recently estimated that about 16% of Canada’s GDP and 12% of jobs depend on the production of exports destined for the U.S. So, trade negotiators know very well what’s at stake as they attempt to strike a deal to renew the Canada-United States-Mexico Agreement (CUSMA).

In fact, we already got a taste of what life could be without protections afforded by CUSMA. Exporters of autos and parts, steel, copper and aluminum products are still struggling to deal with sectoral tariffs imposed a little more than a year ago by the White House by virtue of Section 232 of the U.S. Trade Expansion Act of 1962. That, coupled with confusion about CUSMA compliance, has caused exports of non-energy goods and overall business investment to decline. Those challenges contributed to the contraction of Canada’s real GDP in three of four quarters since U.S. tariffs were imposed (Figure 1), while employment has also stagnated.

It’s too early to say if the C.D. Howe Institute, the arbiter of business cycles in Canada, will refer to this current rough patch as “recession”, whenever it makes its pronouncement. But semantics aside, there’s little debate that this is a significant slowdown.

Figure 1: Economy has slowed markedly since U.S. tariffs were imposed

Sources: Statistics Canada, FCC Economics

While growth likely bounced back in Q2 (based on the GDP increase reported by Statistics Canada for April), it’s unclear if that rebound can be sustained in the second half of 2026. For instance, consumers, restrained by a weak labour market and the resulting softness in real disposable incomes, continued to tap savings to maintain their lifestyles, with the savings rate falling again in Q1 to 3.5%, the lowest in two years. That can’t be sustainable, especially if employment prospects do not improve. The stagnation of overall investment is also unlikely to end considering continued trade-related uncertainties and persistently weak business confidence (Figure 2). The economic outlook is further muddied by ongoing CUSMA negotiations.

Figure 2: Optimism is relatively low according to Survey of Business Conditions

Sources: Statistics Canada, FCC Economics

CUSMA hangs in the balance

Indeed, the Canada-United States-Mexico Agreement, which came into effect on July 1, 2020, included a 16-year “sunset clause”, meaning the trade deal will expire in 2036 unless the three countries agree to extend it after a joint review every six years. We’re now at that six-year mark, which explains why markets as well as businesses and households across North America are holding their breath.

An extension of the agreement for another 16 years (to 2042) and removal of tariffs, are ideal from an economic standpoint because that would provide clarity to businesses and governments, facilitating planning and the deployment of capital. But considering the apparent nationalist bent of this White House, we believe this scenario has a low probability of materializing.

Another low probability scenario in our view is the outright termination of the agreement by at least one of the three countries (presumably the U.S.), with a six-month notice. Given how integrated supply chains are in North America, this scenario would unleash unprecedented economic disruptions, which U.S. politicians will be keen to avoid ahead of November’s mid-term elections.

We believe the most likely outcome is something in the middle of the two above-mentioned scenarios. One example of that could be the refusal by the U.S. to agree to a clean extension of CUSMA, which would trigger mandatory annual reviews, while keeping some tariffs in place e.g., the above-mentioned Section 232 sectoral tariffs. This would mean CUSMA remains in effect under the original 16-year term (expiring in 2036), with tariffs on some sectors, and a requirement that the three trade partners meet every year to resolve grievances.

Table 1: What options do trade negotiators have?

While better than outright termination of CUSMA, this “In the middle” scenario is still fraught with challenges for Canada not only due do the continued drag of U.S. tariffs on some sectors, but more notably because annual reviews would create uncertainties for businesses and potentially curtail long-term investments. Indeed, without guarantees that American tariffs won’t change for the worse in the future, exporters eyeing the vast U.S. market may be reluctant to build new production facilities in Canada.

Tariffs here to stay, and likely to cost the Canadian economy dearly

Simply put, CUSMA-related grievances won’t be entirely settled come July. That means tariffs will continue to weigh on the Canadian economy through the rest of the year and beyond.

It’s always tricky to quantify those economic impacts when there’s so much uncertainty. That, however, does not prevent us from doing simulations to gain some insights. We made some assumptions and, thanks to the GTAP model, were able to come up with some estimates.

Again, note that those are simulations and not our forecasts of what will happen in the future. Assuming U.S. tariffs end up averaging 10% for Canada and Mexico, and 20% the rest of the world, Canada’s GDP would be about 2% lower over the next year compared to the no tariff scenario. To put this in perspective, the damage, according to those simulations, could amount to more than $60 billion over the next 12 months, which is a significant shock to an already vulnerable economy.

The federal government’s efforts to diversify trade away from the U.S. and to raise public investment, will take time to generate benefits, and as such won’t fully offset the above-mentioned hit to the economy. In other words, barring a favourable development on CUSMA, look for GDP growth to remain soft not just this year, but also in 2027.

Outcome of CUSMA negotiations could impact interest rates

The Bank of Canada knows it cannot influence those trade dynamics and the resulting structural changes to the economy. But it can certainly use monetary policy to smooth out economic cycles, while aiming for stable inflation. The central bank recently hinted at how it could react to an unfavourable outcome on CUSMA: “If the United States imposes significant new trade restrictions on Canada, we may need to cut the policy rate further to support economic growth.”

But absent an escalation of U.S. trade restrictions, the likelihood of a reduction of the overnight rate this year by the central bank seems to be quite low. In fact, the Overnight Index Swap market is pricing in some probability of an interest rate increase by the Bank of Canada later this year.

And that’s because of the energy shock stemming from the U.S. war in the Middle East, and related surge in prices of gasoline and fuel oil. The headline inflation rate has indeed climbed by a full percentage point since February’s cycle trough to reach a two-year high of 2.8% in April. And the central bank has warned that it could tighten monetary policy to quell inflationary pressures, which may well have swayed market expectations.

Economic slack is keeping underlying price pressures under control

But we remain skeptical about the need to raise the overnight rate this year. Economic slack, or excess supply, has developed after several quarters of weak growth, and we think that will help keep Canadian inflation manageable. True, the annual inflation rate will continue to rise in coming months because of the energy shock, but we expect it to stabilize and remain below 4% through the second half of the year, before dropping off in 2027 (see Summary of forecasts of key economic variables, at the end of this report).

The Bank of Canada is well aware of how headline inflation can be temporarily skewed by energy, and that’s why it tends to also look at “core” measures of inflation, which exclude volatile items. Those measures offer a more accurate picture of underlying price pressures in the economy.

Turns out that those underlying price pressures are well contained. In April, the major measures of core inflation fell to a five-year low (Figure 3). Note this isn’t only due to year-over-year comparisons, because more recent trends in core prices have also been very mild e.g., the three-month annualized rate of the CPI excluding food and energy was a meagre 0.3% in April, the lowest in almost six years. Those low numbers for core inflation should not surprise anybody considering the above-mentioned excess supply situation prevailing in Canada.

Figure 3: Core inflation rates are at a 5-year low

Source: Statistics Canada, FCC Economics

Simply put, ample economic slack buys the Bank of Canada some time, which it will welcome as it assesses the impacts on the economy of the energy shock and ongoing CUSMA negotiations. As such, assuming inflation expectations stay anchored, we continue to expect the central bank to remain in pause mode i.e., keep its overnight rate at 2.25% through the rest of the year.

That means yield disadvantage with the U.S. - the BoC policy rate is currently about 150 basis points below the Fed policy rate - will remain wide and incentivize the flow of capital towards the U.S., restraining the Canadian dollar in the process. So, the loonie should continue trading in the 72-74 U.S. cents range for the rest of the year, although we acknowledge that bouts of volatility could temporarily take the currency outside of that range.

Canadian bond yields may come down a bit as markets pare back expectations of hikes to the overnight rate but are likely to remain elevated due to ongoing concerns in the Treasury market (which influences Canadian bond yields) about U.S. inflation and public finances stateside. Those elevated long yields will continue to exert pressure on borrowers, especially the hundreds of thousands of Canadian households renewing their fixed rate mortgages this year and next.

Bottom line

Canada’s economy has been severely battered by U.S. tariffs since their implementation in April last year. With ongoing CUSMA negotiations unlikely to yield a deal that scraps tariffs entirely, economic pain can be expected to extend through the rest of 2026 and next year. The resulting slow and below-potential GDP growth should keep the economy in excess supply territory and take the edge off the current energy-driven inflation push. That could give the Bank of Canada enough room to be patient and extend its pause, instead of raising its policy rate the way swap markets are currently expecting.

Summary of forecasts of key economic variables

Sources: Bloomberg, FCC Economics

Krishen Rangasamy

Manager, Economics, Principal Economist

Krishen is the Manager, Economics and Principal Economist at FCC. His insights and leadership help guide research on topics related to macroeconomics and agriculture, which FCC and external clients use to support strategy and monitor risk.

Prior to joining FCC in 2023, Krishen spent over fifteen years as a macroeconomic specialist on Bay Street, including at two major Canadian banks, where he advised trading desks and helped lead economic research and forecasting. He also regularly appeared on leading business TV channels and written media with his insightful commentaries on financial markets. Before going into investment banking, Krishen worked as an analyst in the energy industry in Western Canada. Krishen received his master of arts degree in economics from Simon Fraser University.