-CAD slumps after Trueau rejects Trump's demands on dairy sector.

-Trump says "no political necessity" for Canadian NAFTA participation.

-Deal-or-No-Deal has singificant implications for BoC policy and CAD.

© Pavel Ignatov, Adobe Stock

The Canadian Dollar slumped Friday after Prime Minister Justin Trudeau rejected a key US demand in talks to renegotiate the North American Free Trade Agreement, later drawing angry statements from President Donald Trump alongside a direct threat to terminate the accord.

Prime Minister Trudeau said in a televised address that he knows Americans want to end tariffs on Canadian imports of US dairy products but "we do not intend to do that" Friday. Ending subsidies of the dairy sector has been a key demand of President Donald Trump in recent months.

WATCH LIVE as Prime Minister Justin Trudeau delivers remarks in Oshawa, Ont. https://t.co/s3lDi9gmEQ pic.twitter.com/xsyEQX06bO

— CTV Toronto (@CTVToronto) August 31, 2018Meanwhile, Foreign Minister Chrystia Freeland said "we are not there yet" when asked about progress in the talks to renegotiate the North American Free trade agreement. After agreeing a new deal with Mexico earlier this week, US negotiators had given Canada until Friday to sign up to the same terms or thrash out something different with them.

NAFTA has been up for renegotiation for more than a year after President Donald Trump threatened to withdraw the US from it unless terms more palatable to his administration could be agreed.

Trump's criticisms of the existing pact are, for Canada and Mexico at least, as numerous as they are contentious. Since Trudeau's statements, Trump has made his sentiments toward Canada and its participation in the deal clear in a post on Twitter.

There is no political necessity to keep Canada in the new NAFTA deal. If we don’t make a fair deal for the U.S. after decades of abuse, Canada will be out. Congress should not interfere w/ these negotiations or I will simply terminate NAFTA entirely & we will be far better off...

— Donald J. Trump (@realDonaldTrump) September 1, 2018"This week’s break below 1.3000 in USD/CAD suggests that the market has started to price in a positive outcome from NAFTA talks – so CAD will be particularly sensitive to any negative headlines. Support is located at 1.2880, with 1.3024 serving as resistance," says Adam Cole, chief currency strategist at Toronto-headquartered RBC Capital Markets.

The USD/CAD rate was quoted 0.67% higher at 1.3072 following the statements, after extending an earlier 0.15% gain, suggesting markets may now preparing for the worst of all outcomes.

The Pound-to-Canadian-Dollar rate was 0.23% higher at 1.6934 after more than reversing an earlier 0.11% loss. The Loonie was lower against all other G10 currencies except the risk-sensitive Australian Dollar.

"The most likely outcome is that Canada strikes a NAFTA deal but we suspect a "buy the rumor, sell the fact" outcome, suggesting to buy USDCAD between 1.2870/1.29," says Mark McCormick, North American head of FX strategy at Toronto-headquartered TD Securities, in a note Friday.

Estimates of what this might mean for the Canadian economy and currency vary widely, although analysts at TD Securities have previously said a US withdrawal would lead to a 20% fall in the value of the Loonie as markets would be forced to mark down their assumptions about longer term growth and interest rates.

"Two of the red lines for Canada have been erased by the US-Mexico preliminary agreement (the sunset clause is written in a way that it will not have a negative impact on investment and almost all the investment protection chapters-Chapters 11, 19, 20-were kept). Canada has to make concessions, most likely in dairy," says Carlos Capistran, an economist at Bank of America Merrill Lynch. "If no trade deal involving at least Canada and the US is reached soon, if negotiations break apart, the market is likely to price hikes away and the central bank is likely to slow hikes."

Friday's deadline follows closely behind GDP data for the second quarter, which showed Canadian economic growth picking up sharply from that seen at the start of the year, albeit by a fraction less than was expected by the market.

The Canadian economy grew at an annualised pace of 2.9% during the second quarter, up from 1.3% previously but below the consensus for a 3% expansion. Although small, this difference has led analysts to abandon the little hope they had of seeing an interest rate rise in Septmber and to instead favour just a single additional rate hike in October.

"The in-line GDP figures, and flat June, are enough reason for the Bank of Canada to wait until October to hike again, particularly if we don't get a clear and favourable outcome to NAFTA and the tariffs on steel/aluminum are left in place," says Avery Shenfeld, chief economist at Toronto-headquartered CIBC Capital Markets.

The Bank of Canada raised its interest rate by 25 basis points to 1.5% back in July, citing mounting inflation pressures as well as a robust and improving performance from the economy. Canadian inflation hit 3% during the same month, which is substantially ahead of the BoC's 2% target.

Canada's central bank has raised interest rates twice in 2018 and four times in the last 12 months. Pricing in interest rate derivatives markets, which enable investors to protect themselves against changes in interest rates while providing insight into monetary policy, implies an October 24, 2018 cash rate of 1.70%.

"We expect the Bank of Canada to remain on hold in September with the overnight rate target at 1.5%. But the BoC needs to continue hiking because inflation is above the target, the economy is growing above potential and the labor market is tight, yet the real rate is still below neutral," says Bank of America's Capistran. "We expect the BoC to hike at least five more times from now to the end of 2019 to put the overnight rate target at 2.75%. We see upside risks to our call."

Changes in interest rates, or hints of them being in the cards, are only normally made in response to movements in inflation but impact currencies because of the push and pull influence they have on international capital flows and their allure for short-term speculators.

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