Forecast Summary

Canada-U.S. Rates

Michael Gregory, CFA, Deputy Chief Economist

Diverging This Month, Duplicating Next Year

The Bank of Canada reduced policy rates earlier and more often than the Federal Reserve. Before December, the Bank had cut a total of 275 bps starting in June 2024 and over consecutive confabs apart from six months (between this March and September). The Fed had cut a total of 150 bps beginning in September 2024 with a nine-month pause to start this year. Initially, the difference reflected Canada’s better inflation performance and, later, greater economic risks arising from changes in U.S. trade policy. In the aligned December meetings, a new pattern emerged. The Bank held at 2.25%, with policy rates at the bottom of the neutral range (2.25%-to-3.25%) and the Fed cut 25 bps to 3.625% (target range midpoint). This new pattern is expected to continue next year. As the Canada-U.S. policy rate differentials become less negative, we look for bond yield spreads to do the same and the loonie to gain against the greenback.

Federal Reserve: The FOMC reduced policy rates by 25 bps on December 10, with the target range for federal funds at 3.50%-to-3.75%. This marked the third consecutive action for a total of 75 bps. This year began with a nine-month pause that followed 100 bps of rate cuts in the final three confabs of 2024. And, sticking to the pattern, next year looks like it could also begin with a pause.

This year’s hiatus reflected heightened economic policy uncertainty, and the stagflation risk posed by tariffs. It ended as the labour market was weakening more than inflation was being stubborn. But next year’s break is about the need to be nimbler with policy rates now “within a range of plausible estimates of neutral” (Chair Powell). In the latest Summary of Economic Projections (SEP), the central tendency range for the longer run rate was 2.75%-to-3.50% with a 3.00% median (and the top three forecasts lopped off were in the 3.625%-to-3.875% interval). The two ranges are now touching. Policymakers have long been planning to pull back on the easing reins, but when to execute remaining cuts (if at all) has become more controversial with the maximum employment and price stability goals in “tension”.

December’s vote was 9-3, with two dissents in favour of not reducing rates, and Governor Miran dissenting in favour of a 50 bp cut. The SEP’s ‘dot plot’ showed that, among the remaining seven non-voting participants, four wrote down a policy hold as well. And four of these folks become members next year. The annual rotation of voting regional Fed presidents will see Boston’s Collins, Chicago’s Goolsbee, St. Louis’ Musalem and Kansas City’s Schmid replaced by Cleveland’s Hammack, Philadelphia’s Paulson, Dallas’ Logan, and Minneapolis’ Kashkari in 2026. At the last confab, Schmid and Goolsbee dissented. And based on their recent public comments, Logan, Hammack and Kashkari would have likely done the same.

And we will soon hear from President Trump on who he will nominate to replace Jay Powell as Fed Chair this May. Powell’s tenure on the Fed’s Board runs until 2028, but the precedent has been for individuals to resign in this situation. Whether it is an 'outsider’ (Kevin Hassett, Kevin Warsh) or an ‘insider’ (Governor Waller) who gets the nod, the key is that it takes 7 of 12 votes to change monetary policy.

Our call continues to be for three quarter-point cuts in 2026 (with March, June and September pencilled in). We see the unemployment rate climbing to 4.7% or a bit further as the year unfolds, with core PCE inflation drifting down to 2.5% y/y. With the ‘natural’ jobless rate pegged at 4.2%, both metrics are off by ½ ppt from where they should be, ideally. We judge the Fed will put more weight on the labour market outcomes as policy rates navigate the neutral range.

Note that the October-November employment report did not signal that another rate cut was urgently required. The unemployment rate moved up again to 4.6%, but private payroll growth settled into the 50k-to-70k range. We are publishing ahead of the November CPI report, but we're expecting no material change to the current sticky inflation narrative.

Bank of Canada: The Bank left the policy rate unchanged at 2.25% on December 10, which was widely expected. Prodding these expectations, after back-to-back 25 bp cuts in September-October, the Bank asserted: “If inflation and economic activity evolve broadly in line with the October projection, Governing Council sees the current policy rate at about the right level to keep inflation close to 2% while helping the economy through this period of structural adjustment.” Since the October 29 decision and ahead of the December meeting, the data were firmer, bolstering pause expectations and even stoking (eventual) rate hike speculation. For example, real GDP grew 2.6% annualized in Q3 (when 0.5% was expected), major revisions to the past few years pegged last year’s average growth at 2.0% (vs. 1.6% before), strong job gains helped pull down the unemployment rate by 0.6 ppts in October-November (to 6.5%), and October’s CPI results stayed sticky (the two key core metrics were 3.0% y/y).

Although Governor Macklem acknowledged the “resilience” in the economy and “signs of improvement” in the labour market, the focus was more on the outlook with GDP growth in Q4 “likely to be weak” owing to declining net exports, economy-wide “muted hiring intentions”, and “ongoing economic slack to roughly offset cost pressures associated with the reconfiguration of trade” to keep total CPI inflation close to 2%. He asserted that “a policy rate at the lower end of the neutral range was appropriate to provide some support for the economy as it works through this structural transition while keeping inflationary pressures contained.” (For the record, November’s CPI result supported this containment argument.)

This balance between providing the most economic support possible without prodding inflation could persist for a while... we reckon through next year (we're expecting no moves). Macklem said: “We will be assessing incoming data relative to our outlook. If a new shock or an accumulation of evidence materially change the outlook, we are prepared to respond.” Next year’s fate of the USMCA review stands as a potential massive shock, which pegs the odds of another rate cut above those of a rate hike.

Bond yields: Ten-year U.S. Treasury yields averaged 4.09% in November and, so far this month, they are averaging a slightly higher 4.14%. A 4.00% monthly average has held all year (and for the past 15 months). Even among the daily closes (since early October 2024), the 4.00% line has held except for four readings this October (with 3.97% being the lowest print). Helping draw this ‘line in the sand’, the fiscal fundamentals are deteriorating, and investors are demanding higher yields to compensate. Even accounting for ‘legally questionable’ tariff revenues, deficits, debt, and interest payments—already on unsustainable paths—are poised for worse trajectories. Then there are the lingering concerns about latent inflation risks along with the future of Fed independence and U.S. dollar hegemony.

Looking ahead, additional Fed rate cuts could exert some downward pressure on yields. And, as we have witnessed already, the odd daily close can easily slip under recent lows. However, we judge that the 4.00% monthly mark should hold, short of mounting prospects for chunky Fed rate cuts (>25 bps) or escalating risks of recession, or no abatement in the current per-meeting easing pace (a cut instead of an expected pause at the January 28 meeting).

Meanwhile, Canada-U.S. 10-year yield spreads averaged -93 bps in November and, so far this month, they are averaging -77 bps. This already marks the least negative reading since 2024Q1. Amid the global trend of increasing term premiums, the Bank of Canada's more definitive policy pause, plus Canada’s own fiscal deterioration (on both the federal and provincial sides), have weighed. Canada’s debt and deficit dynamics are still very manageable, but they have deteriorated (although not nearly as badly as those south of the border).

U.S. dollar: The Fed’s broad trade-weighted dollar index strengthened 0.5% in November and 0.9% against the advanced foreign economies (AFE), both posting their second consecutive increase after fading as the Fed resumed rate reductions in September. October’s rate cut did not seem to dent the greenback, but December’s did. Against the AFE, the dollar is down about 0.7% so far this month (per the Wall Street Journal’s Dollar Index). We look for a downtrend to persist as Fed easing continues. Meanwhile, the risk of the Supreme Court ruling against IEEPA-tariffs, along with investor concerns about the tandem of fiscal profligacy and threats to Fed independence should all weigh. We see the broad trade-weighted dollar index down about 2% y/y by the 2026-end and nearly 3% against the majors.

Canadian dollar: The loonie averaged C$1.406 in November (US$0.712), weakening 0.4% against the greenback. It did better than the AFE pack as the Bank of Canada hinted at no further rate cuts in their October 29 announcement. So far this month, the Canadian dollar has strengthened more than the group, to around C$1.386 (US$0.722), or +1.6%, as the BoC doubled down on its ‘long pause’ signal. With another 75 bps of Fed rates coming next year, and with the BoC on hold, we look for the loonie to continue appreciating to C$1.333 (US$0.752, gaining around 4%) by 2026-end. However, the key (net downside) risk for the C$ remains U.S. trade policy, with the review of the USMCA slated for mid-2026.

Currently, U.S.-Canada trade negotiations are suspended and there is a lengthy list of potential Section 232 tariffs being considered that could impact Canada along with steel, aluminum, autos, and lumber. Our working assumption is that the USMCA will still be around by the end of next year (perhaps not yet having been renegotiated) with ‘national security’ sectoral duties being addressed via tariff-rate quotas. Overall, not the best situation from a trade and investment perspective, but it could be much worse.

Overseas

Jennifer Lee, Senior Economist

The BoJ is no longer the lonely hawk in a world of doves. That was so 2025. Now, more central banks look to be finished easing and are gearing up for hikes as 2026 begins. Bear in mind that this report is being released before the December 18-19 ECB, BoE and BoJ meetings.

Let's start with the central bank that has actually been hiking, but slowly. Indeed, the BoJ has taken its sweet time normalizing monetary policy. It began in March 2024 with a 15 bp hike to 0.05%, followed by another 20 bps in August; then, a 25 bp hike to 0.50% in January 2025. Nearly one year later, it is prepared for another increase to a 30-year high of 0.75%. Governor Ueda had been concerned about destabilizing the economy as it grappled with the trade war and, most recently, pressure from PM Takaichi to not raise rates. Enough. Since 2022, core CPI has remained above the 2% target, the JPY has reached levels weak enough to prompt MoF intervention, and labour unions have made larger wage demands (wages were up 5.5% in 2025, the highest since 1993). The Tankan survey also showed that large manufacturers are the most optimistic since 2019. We see two more rate hikes in 2026, bringing policy rates to 1.25%, enough to slow inflation towards the target and bring the JPY back to earth. The Bank needs to stick to its guns. Don’t be shocked, however, if the Bank waters down a hike with a promise to buy more JGBs if yields rise too quickly.

The RBA held its ground in December, leaving the cash rate at 3.60%, citing inflation risks “tilted to the upside” and “signs of a more broadly based pick-up”, some of which may be persistent. The broader economy “continues to recover”, while job market conditions “remain a little tight”. Wages “continue to show strong growth” and gains in unit labour costs “remain high”. Yes, there are uncertainties, particularly on the global front, but domestic activity has been “stronger than expected” and, if maintained, will “likely add to capacity pressures”. It is also very telling that Governor Bullock said rate cuts didn’t come up at the December meeting, while hikes were discussed “quite a lot”. (The opposite of what happened at the December FOMC meeting.) It is also her view that there are likely no cuts “on the horizon”. Besides, no one is comfortable with inflation. So, “when things change, you have to change your view.” Although February is live, we moved up our first rate hike to March, with another in May.

The ECB has halved its deposit rate since mid-2024, cutting the then-4.00% rate 100 bps that year, and another 100 bps in 2025 to 2.00%. It hasn’t changed its policy rate since June, and we look for the ECB to hold at that level through 2026. The Governing Council is ending 2025 with more confidence, saying policy is in “a good place” and patting itself on the back with inflation close to target. Staff forecasts for growth are also expected to be lifted at the December meeting, supporting its stay-the-course stance. Meantime, the reins will be handed to the various governments who have the fiscal room to boost stimulus and increase spending on defence. We are looking at you, Germany. In fact, the Bundestag is in the process of approving about €50 bln in military spending.

The BoE is expected to lower its Bank Rate 25 bps to 3.75% on December 18. After that, it gets a little fuzzy though we lean towards no further moves. Consensus is mixed on whether there will be a follow-up cut in early 2026. Recall that Chancellor Reeves’ Autumn Budget introduced a higher tax take, which helped redeem the government’s fiscal credibility somewhat. Laurence Mutkin, Head of EMEA Rates Strategy, is of the view that the new policy package may—contrary to the government’s aspirations—have actually lowered potential growth, at least over the near term, which suggests that even some modest acceleration in growth could be inflationary. There is, however, a growing list of reasons to support another trim. Let's see... there was that back-to-back decline in U.K. real GDP for September and October. There were some special factors at play, but even a modest bounceback in November may not be enough to avoid a contraction for all of Q4. There were those weak labour market reports. The one from the ONS saw payrolls drop 38k in November, and total employment decline by 16k in the three months to October, lifting the jobless rate 0.1 ppts to a near 5-year high of 5.1%. That was enough to slow wage growth... private sector earnings cooled to a 3.9% y/y pace, the first time below the 4% mark since December 2020. This added to the latest KPMG/REC report for November, which showed weaker demand for staff and placements. Now, we can add cooler inflation to the list. Consumer prices rose just 3.2% y/y in November, down from 3.6% in the previous month, and the lowest since March. Core CPI also climbed 3.2% y/y (was 3.4% in the prior month), the slowest pace so far this year. Services CPI eased slightly to a 4.4% y/y pace (from 4.5% in October), also the slowest pace so far this year, though still too high. But at least it is headed in the right direction! Let's see what the hawks say during the December meeting.

Foreign Exchange Forecasts

Interest Rate Forecasts