Reshma Kapadia

The trade dispute between the U.S. and Canada is morphing into a bigger rift that could further strain a critical relationship that accounts for nearly $900 billion in trade between the two countries. The next signs of how far this could spiral may emerge in coming weeks, starting with whether Canada's retaliatory tariffs go into effect on Tuesday.

Relations between the two neighbors have turned frosty this year amid the review of the U.S.-Mexico-Canada trade agreement signed during the first Trump term. The U.S. decided not to renew it this summer, pushing the agreement into a limbo period of negotiations with the two countries that have surpassed China as America's biggest trading partners.

While U.S. officials have held several discussions with Mexico, they have held no formal talks with Canada. The 11th-hour breakdown of trade talks last month, the ensuing tariff threats, and heated rhetoric have exacerbated tensions, especially as President Donald Trump ordered Lake Ontario renamed Lake America and described Canada as one of the worst countries to deal with-even worse than China. Canada's Prime Minister Mark Carney this week told Trump to "stop throwing shade" on the trade relationship and said talks could resume if Washington "becomes serious about negotiations."

"This has metastasized into the biggest trade dispute in my adult lifetime. It has been about a century since U.S.-Canada relations were quite this acrimonious," says Graeme Thompson, a senior analyst at Eurasia Group focusing on Canada. "What began as a technical trade conversation has morphed into a political and economic one, with some in Canada seeing their sovereignty in the mix. American policymakers and the public don't quite understand how deeply angry and upset and emotional the Canadian public is about this issue right now."

That gives Carney some political leeway even as the moves hurt in the interim-and room to wait and see whether the U.S. gives ground amid rising inflation and upcoming elections.

The U.S. imposed 50% tariffs on $20 billion in Canadian goods in late August, citing discrimination against U.S. alcohol, dairy, and motor vehicles last month. Canada unveiled its own tariffs of 15% to 50% set to go into effect on $20 billion of goods ranging from steel and electronics to dairy, pulp and paper on Tuesday if the two sides don't find an off-ramp.

The U.S. Chamber of Commerce says higher tariffs would hurt both economies, raise costs, and risk 13 million U.S. jobs reliant on trade under USMCA.

The industries most at risk, according to a report by the Canadian American Business Council, include metals, machinery, autos, transportation equipment, and wood products, while Michigan, Indiana, Washington, Arizona, Texas, Iowa, Kansas, Utah and Alabama could face the greatest fallout.

"There are plenty of offramps but there isn't a desire at the moment on either side to take the off-ramp," says MaryScott Greenwood, head of geopolitical consultancy Ottawa Street Strategy and a former diplomat. Whereas Canada's baseline is zero tariffs, as is laid out in USMCA, zero tariffs isn't where this Trump administration is starting from. "You have to work through that before you can get to solutions."

In the interim, Greenwood sees several events ahead that could spark further escalation. Analysts are monitoring how Trump responds if Canada's retaliatory levies go into effect Tuesday. Shortly after they were unveiled, Trump said he would hit back with another round of tariffs, though he set an effective date in January.

Two other events could raise the temperature further: Carney's investment summit from Sept. 14 to Sept. 16, which is aimed at drawing investors to the country with a slate of large projects, and Carney's plans to speak to the European Parliament this fall. Analysts will be watching to see whether he doubles down on his call in January for smaller countries to unite against the economic coercion of countries like the U.S. and China.

The market is relatively sanguine about this tiff, but that could change if further escalation results in Trump starting the 30-day notification process to withdraw from USMCA, rather than keeping the pact in limbo. That could set the stage for a bilateral trade pact with Mexico, which would hit Canada hard, since it could be stuck with higher duties that put it at a disadvantage to Mexico as both countries compete to become hubs for investment and reindustrialization, Greenwood says.

The U.S. could also effectively kneecap USMCA without formally withdrawing by removing tariff exemptions for certain Canadian products, Thompson says.

A breakdown of USMCA could shave more than $1 trillion from U.S. GDP over a decade and C$271 billion from Canada's, while reducing annual economic growth by about 0.4% and 1%, respectively, according to the Canadian American Business Council.

Canada is the second-largest U.S. goods and services trade partner, the largest supplier of U.S. energy imports, from crude oil to electricity, and the third-biggest source of foreign direct investment.

But Canada is more dependent on the U.S., where it sends nearly three-quarters of its exports. Even as Carney shores up other trading partners as he seeks to double Canada's exports elsewhere over 10 years, analysts say those markets still won't be able to replace the U.S.

The best shot at an off-ramp, Thompson says, may be a politically choreographed step back, as neither side can look to give ground politically. A dial-back in rhetoric by trade negotiators would be one sign of an easing in tensions, he adds.

Until then, the uncertainty could keep the Bank of Canada's interest rate moves on hold. But Canada's economy is likely to stay resilient despite the recent trade escalation, given cyclical and structural drivers of growth and the possibility of fiscal stimulus to offset the hit from the trade war, according to a recent note from David Doyle, head of economics at Macquarie Group. Even with the trade volatility, the iShares MSCI Canada ETF is up 14% so far this year, outperforming the State Street SPDR S&P 500 ETF Trust.