USD/CAD hit a new intra-day high on Tuesday of 1.4516 -- the first breach of the 14500 level since March 2020 when the global pandemic was having its biggest impact on risk appetite in the financial markets, noted MUFG.

However, USD/CAD then retraced that move and ended the day close to unchanged, wrote the bank in a note to clients. The recovery in USD/CAD certainly suggests to MUFG that investors are optimistic that United States President Donald Trump won't follow through with a 25% tariff on all imports from Canada.

Trump suggested Feb. 1 as the possible date although he didn't seem 100% committed to that date but if so leaves about nine days for negotiations to take place to either cancel the threat of diluting the tariff rate or agree on carve-outs for certain sectors -- crude oil and autos for starters, pointed out the bank.

Given the impact a 25% tariff would have from combined Canada/Mexico imports on the U.S. economy there is certainly a logic to investors believing this threat will be changed in some way before implementation, stated MUFG. Trump did threaten Mexico with increased tariffs in his first term in office but an agreement was reached to avoid the tariff.

The good news for Canada is that inflation is notably lower than in the U-S. which could mean there is a bigger incentive in Canada to retaliate which could too prompt a rethink from the Trump administration, added the bank.

Inflation data was released on Tuesday and the headline annual rate was a touch softer than expected at 1.8% in December. The December data confirmed that annual inflation in Canada has been at the 2.0% target or below for five consecutive months underlining the prospect of the Bank of Canada having achieved its goal.

Still, the data was flattered by a one-off tax holiday impacting prices while there are some signs of a pick-up in underlying inflation on a three-month basis.

Canada's inflation backdrop looks more favorable than in the U.S. and if Canada did retaliate the BoC would be in a relatively position than the Federal Reserve to lower rates to help support the domestic economy to offset the inevitable hit to external demand from U.S. import tariffs, noted MUFG.

Retaliation seems likely with Prime Minister Justin Trudeau stating that he supports a plan to retaliate "dollar-for-dollar" but the bank will have to gauge developments over the coming days. If there's no sign of negotiations or progress in negotiations and Trump keeps repeating his plans, it expects to see USD/CAD and USD/MXN jump notably higher.

MUFG's USD/CAD forecasts for Q1 and Q2 (1.4500 & 1.4400) didn't incorporate a broad-based 25% tariff. The 2020 high (1.4668) and 2016 high (1.4690) would likely be taken out quickly and a move into a 1.5000-1.6000 range (last seen in 2003) would come into play.