Forecast Summary

Canada-U.S. Rates Outlook

Michael Gregory, CFA, Deputy Chief Economist

The Stagflation Two-Step

The Administration’s trade war is complicating monetary policy for both the Federal Reserve and the Bank of Canada by stoking the risks of stagflation. On the faster inflation front, U.S. tariffs and Canadian counter-tariffs lift respective import prices and, potentially, the prices of import-competing goods. On the slower growth side, these higher prices erode purchasing power and weaken real spending, generally. Meanwhile, the tariffs themselves reduce real exports, specifically, which is the dominant growth drag for the Canadian economy. U.S.-bound shipments weigh in at nearly 20% of GDP, with related business investment compounding the exposure. Sporting a much higher average tariff rate, the U.S. economy’s dominant drag is purchasing power erosion, since hardly any jurisdictions have retaliated yet (it’s been only China and Canada, mixing in some non-tariff barriers to boot).

And further complicating monetary policy are the data themselves. The impact of tariffs on the indicators, particularly the ‘hard’ data (prices, sales, and production), are either too preliminary, muddled, or downright delayed. Owing to the erratic implementation of U.S. trade policy, businesses are being extra cautious with their pricing, hiring and capex decisions. Tariff front-running has also been a factor. Amid the uncertainty, both central banks are waiting for the data scale to convincingly sit heavier on the slower growth side, or lighter on the faster inflation side, before taking any next steps.

Federal Reserve: We look for the FOMC to keep policy rates unchanged on June 18, keeping the fed funds target range at 4.25%-to-4.50% for the fourth consecutive confab over the past six months. We reckon the reason proffered for the hold will be comparable to May’s motive. Back then, amid the Administration’s “substantial” policy changes that were still “evolving” with their economic effects remaining “highly uncertain”, policymakers indicated that, not only had uncertainty “increased further” (the adverb was newly added), but it was now judged that “the risks of higher unemployment and higher inflation have risen”. The stagflation risk alarm was rung.

Since then, the eye-watering 145% U.S.-China bilateral tariffs were chopped to 30%, but steel and aluminum duties were doubled to 50% with the return (or further postponement) of ‘reciprocal’ tariffs looming next month. On the other Administration policy fronts, the House passed a budget chock-full of deficit-financed tax cuts (a potential boost to growth and inflation for a few years) with a controversial component that could negatively impact net foreign investment—which the U.S. still requires to cover its ballooning budget deficit and inadequate domestic savings. The One Big Beautiful Bill is now in the Senate’s hands with significant changes anticipated.

True, the stagflation alarm may not be ringing as loudly as it did last month before the average tariff rate was nearly halved. But there’s still a sound, and policy uncertainty is still extremely elevated. This points to a Fed meeting theme akin to the last one. Then, it was all about waiting. Powell said: “For the time being, we are well positioned to wait for greater clarity before considering any adjustments to our policy stance.”

We will get a new Summary of Economic Projections (SEP) and its famous ‘dot plot’. We expect the two quarter-point rate cut profile to remain for this year and next; even though, for this year, it would take only two participants switching to the ‘one-or-none’ camp to turn the median dial to one. Last SEP (March) four folks joined this camp, doubling its size. However, this reflected a hefty stagflation-skewed forecast adjustment, hence a need for more policy caution. The median call for real GDP growth this year was lowered by 0.4 ppts to 1.7% y/y (in Q4) with core PCE inflation lifted by 0.3 ppts (to 2.8% y/y). This time, we expect a similar skew but by only a tenth or maybe two, not enough to flip the median.

On balance, we look for a quarterly, 25 bp rate cut cadence to commence in September, lowering the fed funds target range to 2.75%-to-3.00% by next December. This is just slightly below the FOMC’s median forecast of the neutral level (3.00%). Compared to our previous Rates Scenario (May 15), this represents a slower starting and longer running easing cycle (but the same total of 150 bps), reflecting more expected Fed policy caution.

Bank of Canada: The Bank kept its policy rate unchanged at 2.75% on June 4, for the second consecutive meeting, and after cutting it a cumulative 225 bps over seven straight meetings since June 2024. In the presser, Governor Macklem said: “Uncertainty remains high. The Canadian economy is softer but not sharply weaker. And we’ve seen some firmness in recent inflation data. Against this backdrop, we decided to hold the policy rate unchanged as we continue to gain more information on US trade policy and its impacts.”

Looking past the beneficial removal of the consumer carbon tax, April’s inflation advance was obviously a bother for the Bank. Macklem said: “The Bank’s preferred measures of core inflation, as well as other measures of underlying inflation, moved up in April. There is some unusual volatility in inflation, but these measures suggest underlying inflation could be firmer than we thought.” However, the Governor cautioned not to focus too closely on one month’s data and said the Bank “will be looking closely at the next two CPI reports”. The one for May is due June 25, and for June on July 15, released before the next BoC meeting on July 30. In commenting on the just concluded policy deliberations, Macklem said: “At this decision there was a clear consensus to hold policy unchanged as we gain more information… On balance, members thought there could be a need for a reduction in the policy rate if the economy weakens in the face of continued US tariffs and uncertainty, and cost pressures on inflation are contained.”

We reckon the Bank’s rate reduction criteria should be satisfied by the end of July and look for a trio of quarter-point cuts, starting with the next confab and followed by the meetings in October and January (2025). This will leave the policy rate at 2.00%, just a notch below the Bank's estimate of the neutral range (2.25%-to-3.25%). (In the previous Rates Scenario, we had the same pattern but beginning in June.)

Bond yields: Ten-year Treasury yields averaged 4.42% last month and are on track to average around the same this month. The market has maintained yields above 4.00% for 20 of the past 22 months, with only last August and September slipping below. (At the time, speculation over the FOMC’s inaugural rate cut was running rampant, and then the Fed surprised with a 50 bp action.) Even on a daily basis, yields have closed above the 4.00% mark consistently since October 7. The lowest was 4.01% on April 4, in the wake of reciprocal tariffs being introduced, which fanned fears of U.S. and global recession.

We look for yields to average around current levels (within a 10 bp range) until the Fed resumes rate cuts in September or is widely speculated to do so. However, amid 150 bps worth of cuts, we no longer judge that yields will slip below 4.00% at their coming nadir. Offsetting more of the impact of Fed easing, America’s fiscal fundamentals have deteriorated and are expected to continue doing so. On May 16, Moody’s became the last of the ‘big 3’ credit rating agencies to strip the U.S. of its ‘triple A’ status.

The last straw for Moody’s was where the House of Representatives was headed with the One Big Beautiful Bill, which was passed on May 22. The CBO reckons that by 2034 (one year short of its usual 10-year window), the deficit increase, including interest, would total $3.0 trillion, reflecting the extension of the expiring 2017 tax cuts and the introduction of a bunch of new temporary (until 2029) tax cuts. This could easily top $3.2 trillion on a 10-year tally, adding to the CBO’s baseline of $21.8 trillion worth of accumulated deficits by fiscal 2035. While it’s said that tariffs could generate offsetting revenue, this doesn’t consider the negative impacts of slower growth on other tax revenues and the decline in import volumes (the tariff base), let alone the longevity of the tariffs under the International Emergency Economic Powers Act (IEEPA). The baseline deficit is already projected to average 5.8% of GDP over the next decade, and this is only going to get larger.

Meanwhile, Canada-U.S. yield spreads are on track to average around -110 bps this month compared to -120 bps in May, as Canadas continue to modestly underperform their U.S. counterparts. Spreads averaged a record -139 bps back in February. While some rebound from record levels was expected (in part because the BoC has been pausing policy like the Fed), Canada is seeing some of its own fiscal deterioration. For example, between the cost of the Liberal campaign platform and the newly announced increase in defence spending, the 2025-26 deficit could jump from around 1½% of GDP to a bit above 2% (but still small by U.S. standards). As before, we judge that the Fed is poised to cut rates more aggressively than the Bank of Canada, prodding a trend of less negative yield spreads.

U.S. dollar: The Fed’s broad trade-weighted dollar index is headed for a 1.2% loss on average this month (based on the latest close), after depreciating 1.4% in May. This marks the fifth consecutive monthly decline for a total 6.0% drop from January’s record high. The greenback’s slide is even steeper looking at the daily closes; the record high was hit on January 10 and it’s down almost 7%.

The initial market, and Administration's, narrative was that tariffs would provide a boost to big dollar, but the net depreciation since their introduction reflects the fact that this driver is overshadowed by more hesitant inflows of foreign investment. Elevated U.S. economic policy uncertainty, more attractive prospective investment returns elsewhere (think EU ahead of massive infrastructure and military spending), and ‘quiet’ retaliation against U.S. tariffs could be reasons for the hesitancy. Presuming peak tariff troubles are behind us (this assumes the appeals court and, eventually, the Supreme Court, both rule against using IEEPA to justify tariffs), prospective Fed rate cuts should continue the downward pressure on the U.S. dollar, albeit mildly. By this December, we see the index down more than 7% from January's record high and a further 1½% y/y by December 2026. However, the net risk is that the greenback could weaken much more than this.

Canadian dollar: The loonie is on track to average C$1.367 in June (US$0.731), representing the strongest level in nine months. In the interim, when the U.S. dollar was peaking at its record high in January, the Canadian currency had depreciated to its weakest level in nearly 22 years (C$1.439 or US$0.695). The subsequent broad depreciation of the big dollar has been the loonie’s main driver. However, the Canadian dollar’s gain (5.0%) has fallen slightly short of the U.S. dollar’s broad loss (6.0%). This partly reflects the 50 bps of BoC easing through April, along with heightened concern about Canadian economic exposure to U.S. trade policy.

However, going forward, we judge the loonie should at least keep pace with the broad greenback. The BoC and Fed are now on the same quarterly easing clip with the former to end its campaign sooner. Meanwhile, Canadian economic prospects are getting a big boost from stimulative fiscal policy. We look for the Canadian dollar to average C$1.350 (US$0.741) by December and appreciate further to $1.333 (US$0.752) by the end of next year. And the net risk is that it could be stronger than this.

Overseas

Jennifer Lee, Senior Economist

Patience. Wait it out. Take a seat. You get the picture. That seems to be the theme playing out these days among the major central banks and their thinking on monetary policy.

Take the ECB. It cut the deposit rate 25 bps to 2.00% on June 5, but President Lagarde raised more than a few eyebrows when she noted that “I think we are getting to the end of a monetary policy cycle.” Even though there is still plenty of "high" and "exceptional" uncertainty ahead, the Governing Council feels that it is “in a good position” to deal with whatever comes its way given what it has done so far (200 bps of cuts in just over one year) and where rates are right now (a 29-month low). Post-press conference, Austria’s Robert Holzmann admitted that he was the sole dissenter against the cut (no one should be surprised), but there were also reports that a “clear majority” of voters want to hold rates steady in July, and “a few” are thinking of holding beyond July. That supports BMO’s view that there will be one more cut… 25 bps in September to land at 1.75%. That should also put a floor under the euro and push it towards $1.17 by year-end, and $1.20 by the end of 2026. It also helps that fiscal stimulus plans are in the works, including the EU’s €150 bln loan for weapons fund, Germany’s €500 bln defence/infrastructure fund, and Chancellor Merz’s plan for €46 bln in tax breaks, including: corporate tax cuts, a 30% deduction for companies who buy new M&E, and a generous 75% depreciation of new EVs.

The BoE last cut rates 25 bps to 4.25% on May 8 (for a combined 100 bps in just under one year) and, once again, had the ability to shock and awe market-watchers with its vote. The cut itself was no surprise, but the vote of 5-2-2 was hardly dovish. Of the nine members of the MPC, a thin majority (of 5) voted in favour of the 25 bp cut and the 'majority of that majority' found the decision to be "finely balanced". Two other members voted to keep rates unchanged, while the remaining two opted for a 50 bp cut. BMO's Director & Head, EMEA Rates Strategy, Laurence Mutkin, put it this way: the Bank did not "deliver a panicky response to global trade developments". Now, the views from the top are merging after being on divergent paths for awhile. Chief Economist Pill, who voted to hold in May, cautioned that the BoE was cutting too quickly and that it should be more "cautious". Then, Governor Bailey, who voted for a 25 bp cut, maintained his view that the rate path was still "downwards". However, he now feels that the pace of easing should be "gradual and careful". In fact, the speed is now "shrouded in a lot more uncertainty". It doesn't help that the official data do not inspire confidence. The ONS admitted that the April CPI was overstated as it erred in calculating the number of vehicles that were subject to excise duty rates. This comes on top of problems with the jobs data that the statistical agency is still trying to work through. (Note that the latest figures show a slowing labour market.) Despite that uncertainty, the economy's rough start to Q2 (April's GDP drop of 0.3% was the largest since October 2023) may prompt the BoE to get off the sidelines earlier. BMO still looks for one more 25 bp rate cut, which could come as early as August. But we look for the GBP to rise to around $1.37 by end-2025 and $1.39 by the end of 2026.

The RBA has only eased twice so far, both times by 25 bps, bringing the cash rate to a two-year low of 3.85%. The most recent cut in May was dovish. The Press Release cited uncertainty about the world economy and global trade, which make the "central forecasts subject to considerable uncertainty". In fact, the RBA "considered a severe downside scenario" in May. Governor Michelle Bullock noted during the press conference that there was also discussion about a 50 bp cut, but it "wasn't the strongest argument in the room". It will come down to inflation. Although the latest CPI report for April was unhelpful—the trimmed mean accelerated—and despite the uncertainty caused by the trade war and China's slowdown, we see the RBA trimming rates in July and September, taking the cash rate down to 3.35%. Nonetheless, the AUD will be able to hold its own ($0.66 by end-2025, $0.67 by end-2026) on the back of a weaker greenback.

The BoJ is, perhaps, in the toughest spot. At the start of 2025, it stood out in the crowd as being the only central bank to be very cautiously tightening. But like everywhere else, the trade war is taking a toll on the economy, and because of above-target inflation, households' real cash earnings are declining. Weaker household finances, coupled with higher inflation, is causing some hesitancy to raise rates. Our base case is for no changes to monetary policy this year, but it is important to stress that the possibility of a move cannot be dismissed. The Bank wants to be clear: it intends to bring inflation back to target. On June 10, Governor Ueda said that if the Bank has "more conviction that underlying inflation will approach 2% or hover around that level, we will continue to raise rates." At the same time, given the hefty sell-off of long-term yields recently, there will be intense interest in any announcements regarding its pace of bond purchases (whether it will slow down the pace or not). We expect the JPY to rally to ¥142 by the end of this year and ¥140 by the end of 2026, with the risk of it being stronger if the BoJ tightens.

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