Synopsis:

Goldman Sachs argues that markets have gone too far in unwinding the tariff premium in USD/CAD following the recent extension. They see a higher and more lasting risk of tariffs on Canada than what is currently priced and recommend long USD/CAD as a hedge against escalating trade tensions.

Key Points:

1. Tariff Risks Remain Underpriced in USD/CAD:

   • While tariffs are not Goldman’s base case, they estimate the probability of tariffs on Canada at 40%.
   • Options markets only assign a 25% chance of USD/CAD revisiting Monday’s intraday highs and just a 10% probability of hitting 1.50 in the next three months—too low in their view.

2. Market Has Unwound Too Much of the Tariff Premium:

   • The market reaction to the extension of tariff deadlines has led to a sharp reversal in USD/CAD, unwinding the risk premium built up in Q4.
   • Given the persistent uncertainty around trade policy, they believe a higher and more lasting tariff premium should be priced in.

3. Long USD/CAD Has Been a Reliable Hedge:

   • Historically, long USD/CAD has performed well during periods of tariff escalation.
   • With the risk of renewed tariff threats on Canada, Goldman sees long USD/CAD as an effective hedge for investors concerned about trade tensions.

Conclusion:

Goldman Sachs believes the market has underestimated the probability of US tariffs on Canada, leading to an excessive unwinding of the tariff premium in USD/CAD. They recommend long USD/CAD as a hedge, as it has historically provided strong protection when trade tensions escalate.