The market has had time to digest the language around the Bank of Canada’s jumbo interest rate cut on Wednesday. Now the looming threat of US President-elect Donald Trump’s proposed tariffs is the most significant wild card for where rates will go.
The Bank’s 50-basis-point cut brought its policy rate to 3.25%, the upper limit of its neutral range of 2.50%-3.25%. However, the Bank also signaled a shift in its approach, stating that it “will be evaluating the need for further reductions in the policy rate one decision at a time.” Unlike previous announcements, there was no explicit commitment to future cuts—a stark change that caught analysts’ attention. Despite this, many still expect additional cuts in 2025, albeit of more modest sizes.
The switch in tone has prompted economists to be more guarded, wanting to see how the Trump tariff threat plays out and how the rate cuts that have been made flow through the economy. The central bank says it will monitor the impact of cuts, but in its policy announcement, it said US tariffs could throw a spanner in Canada’s economic recovery.
Tariffs’ Impact on the Economy
Trade policy with the United States is critical for Canada, with roughly 75% of Canadian exports destined for the country’s southern neighbor. Canada is the top trading partner for 30 states. “A tariff on Canadian imports to the US could potentially put upward pressure on inflation and lower GDP growth,” says Ashish Dewan, senior investment strategist at Vanguard Canada. “To stimulate economic activity, the Bank of Canada will consider cutting rates to combat lower GDP, but will also have to be mindful of keeping inflation in check.”
Monetary easing typically works with a lag. Thus, a faster-than-intended moderation in inflation could push Canada toward a recession. “Canada is not yet on the brink of recession, and government stimulus [in the form of rebate checks and tax holidays] should ensure a false dawn for growth before the year-end,” says Nick Rees, senior FX market analyst at Monex Canada. However, he adds that Trump tariffs and Ottawa’s clampdown on immigration could exacerbate a broader economic slowdown, making a recession “a very real possibility” in 2025.
Dustin Reid, chief fixed-income strategist at Mackenzie Investments, echoes these concerns but says US tariffs “would likely have a short-term impact of higher prices, [and] the Bank of Canada would likely look through it and focus more on the expected erosion in aggregate demand.”
Two million Canadian jobs are directly or indirectly impacted by trade with the US, and Dewan warns that the negative impact of higher tariffs could result in the Bank of Canada easing faster. “A global slowdown in economic growth, geopolitical tensions, and rising unemployment—particularly as population growth outpaces job creation—are some of the other risks that could lead the Bank of Canada to continue easing well into 2025,” he says.
Rachel Siu, head of Canadian fixed-income strategy at BlackRock, strikes a relatively sanguine note, asserting things won’t be as bad when the dust settles. “Our view is that the ultimate implementation will likely be more moderate than the initial headline,” she says. Still, she concedes that “the uncertainty can weigh on businesses and investment spending” in the interim.
Policy Divergence Risk for the Canadian Dollar
This year, the Bank of Canada has cut its policy rate by 175 basis points, while the US Federal Reserve has cut its rate by just 75 basis points. Rees believes this gap should close, since the Fed will likely cut its rate next week. However, the gap could widen again next year, since the Bank of Canada is expected to continue unwinding its monetary policy (albeit at a slower pace). “We think there is a real risk that this is the last Fed cut before an extended pause,” Rees says. He expects the rate differential to expand in the new year.
This could create strong headwinds for the loonie, which Rees forecasts dipping to C$1.50 against the US dollar by the end of 2025. David Doyle, head of economics at Macquarie Group, says the value of the Canadian dollar could be a casualty in a tariff tiff. “US tariffs would likely result in further Canadian dollar weakness,” he says, adding that if the tariffs are implemented, “this could trigger the Bank of Canada to ease more aggressively.”
Doyle forecasts that the Canadian dollar will fall to C$1.45 in the third quarter of 2025. Apart from US tariffs, other potential risks he sees to the loonie include “a greater-than-expected moderation in inflation in the first half of 2025 (resulting in more interest rate cuts), growth impacts flowing from ongoing challenges from mortgage rate resets, and further widening in the output gap, should unemployment in Canada continue to rise.”
Opportunities for Investors Amid Uncertainty
Diverging policy rates have caused the gap between Canadian and US yields to widen. For example, the yield of the 10-year Government of Canada bond is more than 100 basis points lower than that of the equivalent US Treasury bond. “This is an apt time to expand the opportunity set into global sectors,” argues Siu, who prefers securitized assets, European credit, and select US high-yield and emerging markets.
“Now is the time to lock in global yields at these [high] levels, especially in the front-end [short-term bonds] and belly of the curve [medium-term bonds], given attractive carry-to-volatility [risk/return] ratios,” Siu says. She adds that while credit spreads are narrow, particularly in investment-grade and high-yield bonds, the overall yields are attractive, and strong fundamentals remain supportive.
Dewan sees particularly alluring opportunities in higher-yielding US aggregate bonds compared with Canadian bonds. “We anticipate a 2025 year-end Bank of Canada rate of 2.5% versus a 4.0% policy rate for the US Fed,” he says. “That divergence could make US bonds more attractive.”
Declining rates also support the stock market. “Lower rates result in a lower cost of capital, which should benefit both stocks and bonds,” says Dewan, “We see US value stocks as undervalued and feel developed ex-US equities offer good return potential, given attractive valuations and strong dividend payout ratios.” He thinks utilities, banks, and REITs could be some of the biggest beneficiaries of a declining rate environment.
Further, improved consumer spending and more manageable household debt could breathe new life into the real estate market. More than 4 million mortgages are expected to be renewed in the next two years, most of which are locked in at historic low rates from 2021 and 2022. “Monetary policy easing will have a beneficial impact on these homeowners,” he says.
Lower rates are expected to lure prospective homeowners, long sitting on the sidelines spooked by sky-high mortgage rates, back into the property market. “For real estate markets, the rate cut is likely to make housing more affordable on the margin and spark further activity in the sector,” says Reid.
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar's editorial policies.
