Mexican Standoff.

This is a dramatic escalation that will likely make it impossible for Mexico to continue cooperating with [Trump] on trade or on controlling asylum flows from Central America. Mexico has negotiated in good faith throughout on the USMCA, and has tried to work with the administration on migration. Unless this tariff is quickly reversed, it will kill cooperation on both.

That’s from Edward Alden, a senior fellow at the Council on Foreign Relations, quoted on Friday by Bloomberg in the wake of Donald Trump’s bizarre decision to slap Mexico with tariffs even as his administration pressures Congress to expedite ratification of the USMCA.

Perhaps the most important thing to understand about the latest escalation from Trump, is that tariffs are now just part of the policy tool box. We talked about this on Thursday evening, when the tariffs were first announced, but in case it got lost in the fog of war, it’s worth reiterating.

In addition to tariffs being used to push the administration’s broader agenda, priorities like “national security” are now wielded to gain leverage in trade negotiations (e.g., Huawei with China). In other words, this goes both ways. The administration treats Trump’s agenda as a unified vision, rather than a set of discrete policy priorities to be advanced separately, using means appropriate to a given end. Tariffs are used to advance the national security agenda and national security is used to gain leverage in negotiations with America’s trade partners. The reportedly imminent crackdown on Hikvision suggests the administration will now cite “human rights” as an excuse to blackball a number of Chinese companies with the ultimate aim of extracting trade concessions from Beijing.

This approach is a Pandora’s box. “Trade policy and border security are separate issues. This is a misuse of presidential tariff authority and counter to congressional intent”, Chuck Grassley said, in an irritated statement.

Importantly, this is likely to backfire on the White House, perhaps in spectacular fashion. Trump undoubtedly believes this is just “the art of the deal”, but he may well find that other countries simply stop negotiating with him. After all, if Mexico bent over backwards to renegotiate Nafta even as Trump incessantly berated the country over immigration, and all they got for their efforts was across-the-board tariffs (which will become progressively more punitive on a set schedule), what utility will the Europeans see in engaging Trump in talks around prospective auto tariffs?

Talks with Europe were already going nowhere. The Mexico news won’t help. And what is Canada supposed to think about this?

Read more: Nowhere Fast: Trump Bogged Down As US Wades Into Multi-Front Trade War

Further, it’s entirely likely that Beijing will view the Mexico escalation as more evidence to support the contention that the Trump administration always negotiates in bad faith. Xi will also view it as proof that even if China were to strike a deal, Trump would find an excuse to break it so he can slap the country with still more tariffs.

It would be supremely ironic is “Tariff Man”‘s Waterloo turns out to be duties related to illegal immigration.

The peso erased its YTD gain in the wake of Trump’s decision. MXN is down some 3.6% in May, the worst month since October. One-month implied vol. surged.

As far as the mechanical impact, US imports from Mexico were roughly $345 billion in 2018. That means that initially, the 5% tariff would amount to a ~$17 billion tax, rising to as much as $86.2 billion in October if the tariff rate ultimately rises to 25%.

But, as BofA reminds you, “the effective tariff could be much higher than the nominal tariff because many parts cross the border several times during the production process.” The bank goes on to note that “some motor vehicle parts cross the border back and forth up to 20 times [so] production processes would have to be changed in substantial ways to reduce the impact of the tariffs.”

So far, Mexico is taking the high road.

President Andres Manuel Lopez Obrador on Friday said Mexico won’t respond “in a desperate way”, but reminded Trump that the country has to respect human rights when it comes to curbing illegal immigration. He also said tariffs won’t solve trade problems and are ultimately a road to nowhere. “[Mexico] doesn’t deserve to be treated this way”, he lamented.

Those comments came hours after a letter to Trump he posted to Twitter. “From [the] start, I express that I don’t want confrontation”, AMLO said. But he cautioned that “‘America First’ is a fallacy.”

Analysts are still trying to sort out the implications of Trump’s left-field broadside. “On average, we estimate that Mexico comprises 4-5% of manufacturing (although there are some major outliers with far higher exposure) for US multi-industry companies, and 2-3% of their sales”, Barclays wrote Friday. “Simplistically, in a ‘worst case’ scenario, assuming a 25% increase in tariffs for a company with 20% of its COGS in Mexico (and assuming that company has ~29% gross margins, such as LII and RBC), of which 80% are exported to the US, and no decline in the Mexican peso against the US$, or any offsets from pricing / productivity / sourcing efforts, would imply a reduction to its gross profits of ~10%, or an EBIT impact of ~20%”, the bank added.

Deutsche Bank calls this “a serious downside risk to the US economy.” “Looking carefully at the trade data between the US and Mexico shows that 67% of all imports from Mexico are related-party trade which is another way of saying intra-company trade”, the bank’s Torsten Slok said Friday. “What this means is that US companies are using Mexico for production [or] put differently, most of the trade between Mexico and the US is the global supply chain.”

For their part, JPMorgan notes that Trump’s move may run into legal problems. That’s “especially” true given “the relevance that trade with Mexico has for key states in the US.”

This is, theoretically anyway, legal. But it’s a highly dubious use of emergency powers, which makes it par for the course for Trump.

“Mexico has taken advantage of the United States for decades”, the president tweeted on Friday morning, in a largely hapless effort to explain himself.

Unsurprisingly, he blamed Democrats. “Because of the Dems, our Immigration Laws are BAD”, Trump went on to say, before claiming that Mexico “makes a FORTUNE from the US” and insisting that “they can easily fix [the immigration] problem.”

Note that Trump continues to insist that fixing the “problem” is “easy”, despite it having become materially worse over the course of his presidency. His bombast and on-again/off-again crackdowns have, if anything, encouraged illegal immigration. His frustration stems at least in part from the fact that what wasn’t a crisis before he took office, has now become a crisis on his watch. His make-believe border emergency is now real and he’s unwilling to come to terms with his own role in that situation.

One circuit breaker for the peso could be the central bank. “Mexico last intervened in the currency in March 2017, with a $20 billion program offering foreign-currency hedging – essentially backwards NDFs – which amounted to selling dollars. It’s one of two reasons why the peso has been relatively robust since the 2016 US election”, Bloomberg’s Sebastian Boyd wrote Friday, adding that “the country has higher dollar reserves than it did then, so there’s space for intervention.”

As far as the USMCA goes, BofA says you can “forget it, at least for now” – that is a direct quote.

“Despite encouraging news up to May 30 in the morning with the three countries sending the USMCA to their respective legislatures for ratification, if the US follows through with blanket tariffs to goods exported by Mexico, the Mexican Senate would find it hard to ratify the USMCA”, the bank warned on Friday, adding that Trump’s tariffs will be “one more reason to add to an already large list” of concerns Democrats on Capitol Hill have about ratifying the deal.

And it’s not just Democrats. “This would seriously jeopardize passage of USMCA”, Grassley said. “I support nearly every one of President Trump’s immigration policies, but this is not one of them”.