Markets Could Pressure the Bank of Canada into Further Easing if Data Keeps Disappointing

The overall geopolitical situation remains tense, and the United States has continued to assert itself, which may strain its relationships with other advanced economies. The current tariffs—plus the possibility that new ones will be issued under various pretexts—are adding to the tension. Central banks may need to lower their key interest rates further if the economy deteriorates more than expected. Conversely, monetary policy may need to be tightened if inflation spikes due to new tariffs or supply chain disruptions. Geopolitical tensions could contribute to inflation by pushing up the price of some commodities, including oil. We’ll also need to keep a close eye on the threats to the independence and neutrality of key economic institutions in the United States. It’s unclear how the Federal Reserve (Fed) will change its role and monetary policy when Kevin Warsh steps in as Chair. This year, the focus will also be on the Supreme Court’s rulings on the Trump administration’s trade policy, the CUSMA review and the midterm elections, all of which could disrupt the economy. The erosion of US institutional pillars may prompt some global investors to further reduce their exposure to the United States. That said, other parts of the world are facing their own political and sovereign debt issues, particularly Europe and Japan. A sharp correction in the stock market, which is in the midst of an artificial intelligence (AI) boom, could shake confidence and trigger a wealth effect shock, while volatility in bond, currency and commodity prices could weaken the outlook for the global economy.  

Trade‑related uncertainty continues to cloud the outlook for Canadian central bankers. Our baseline assumption maintains that the Bank of Canada will hold rates steady in 2026 and will only begin tightening policy around mid‑2027. That said, the risks to our policy rate projections remain skewed to the downside in the next few quarters and very conditional on trade talks. Further out the curve, strong foreign demand for Canadian bonds should compress term premiums and lead to slightly lower rates by year end. As a result, look for the yield curve to flatten in the coming quarters.

In contrast to the flattening pencilled in for Canada, we expect the US Treasury curve to steepen by year end. The Fed is expected to cut its policy rate twice this year, with risks skewed to even more easing. That said, look for the long end to see limited participation. Weaker global demand for US Treasuries is likely to put upward pressure on term premiums, keeping longer‑end yields elevated.

Developments in AI continue to inject volatility into risk assets, with no end in sight to the uncertainty prevailing over markets. Debt funding tied to higher capex spending should start to put pressure on aggregate credit spreads as the year progresses. Speculation remains as to whether all of the investment in AI will have a tangible, near‑term payoff. Canadian equity indices, with clearer linkages to commodities and a strong banking system, are likely to continue to outperform US equities. The loonie has benefitted from broad US dollar weakness since the turn of the year, but that strength is likely to fade as CUSMA worries take centre stage in the months to come.