Forecast Summary

Canada-U.S. Rates Outlook

Michael Gregory, CFA, Deputy Chief Economist

The Day of the Tariffs

The Trump Administration’s ‘America First Trade Policy’ and its taste for tariffs are throwing curveballs to central banks around the world, including the Federal Reserve. For the U.S. economy and those of its trading partners, tariff increases (and countermeasures) imply faster inflation and slower growth than would otherwise be the case and create offsetting issues for monetary policy. The degree to which inflation and growth deviate from their original trajectories and, ultimately, how these offsetting issues weigh on central banks’ policy scales is highly uncertain. That’s because they’re influenced by many factors including GDP exposures to trade, exchange rate movements, compression of profit margins, elasticities of demand, and retaliatory measures. There are many moving parts here, keeping policymakers nervous and nimble.

Federal Reserve: On March 19, the FOMC kept policy rates unchanged as expected and stated that “uncertainty around the economic outlook has increased”. And the prior reference about the Committee judging that “the risks to achieving its employment and inflation goals are roughly in balance” was dropped. In the presser, Chair Powell said no signal was meant by this. Nevertheless, meaningfully weaker employment and higher inflation outcomes are now lurking on the horizon, at least from a risk perspective.

In the Summary of Economic Projections (SEP) and its ‘dot plot’, participants’ median forecast for the fed funds rate did not change. It still shows 50 bps worth of rate cuts for this year and next. However, despite not turning the median dial, participants’ sentiment towards fewer rate cuts this year increased. The mean forecast increased by 17.1 bps to 4.007%, and we’re now only two participants away from paring back the median call by 25 bps. The Fed has become more cautious—dare we say… more hawkish—faced with the confusing policy mix of faster inflation and slower growth. This is the stuff of increased tariffs.

Elsewhere in the SEP, among the median projections, the forecast changes mirrored the theme of faster inflation and slower growth. For this year (Q4), real GDP growth was shaved to 1.7% y/y from 2.1% and the jobless rate was raised a tenth to 4.4%. Total PCE inflation was lifted to 2.7% from 2.5% with core inflation increasing 0.3 ppts to 2.8%. The slower growth/faster inflation theme to revisions spilled over just a bit into next year. Interestingly, Powell said: “sentiment has fallen off pretty sharply, but economic activity has not yet.”

April 2 is fast approaching with its Administration-advertised raft of reciprocal and sectoral tariff announcements. Participants’ projections factor in the tariffs already in place with some projections accounting for even more. And the Fed is already seeing slower growth and faster inflation along with having a waning appetite for further rate cuts. These tendencies will probably build next month. However, once growth becomes weak enough, and the price level pop proves to be “transitory”, the Fed’s tune should change. We still expect two 25 bp rate cuts in this year’s final trimester, with the easing continuing to the fed funds range midpoint of 3.125% before the end of next year.

Bank of Canada: On March 12, the Bank reduced the policy rate by 25 bps to 2.75%. This marked the seventh consecutive rate cut since the inaugural move last June, for a total of 225 bps. Like the previous action in January, this decision had much to do with risk management, as opposed to being a recalibration, given recent and prospective inflation performance. The announcement said: “While economic growth has come in stronger than expected, the pervasive uncertainty created by continuously changing US tariff threats is restraining consumers’ spending intentions and businesses’ plans to hire and invest.” (The underline is ours.) The restraining influence on spending, hiring and investing were the themes of the special surveys released at the same time.

However, the statement went on to say: “Monetary policy cannot offset the impacts of a trade war. What it can and must do is ensure that higher prices do not lead to ongoing inflation. Governing Council will be carefully assessing the timing and strength of both the downward pressures on inflation from a weaker economy and the upward pressures on inflation from higher costs.” Despite the escalating concern about the hit to GDP from tariffs, the inflation target remains front and centre for the Bank. In a speech on March 20, Governor Macklem said: “We need to make sure that a tariff problem doesn’t become an inflation problem.”

The BoC expects inflation to move up owing to the February 15 end of the tax holiday, to “about 2½%” by the March CPI. It was 1.9% y/y at the time of the March meeting (for January), but the February figure surprised with a 2.6% rise. The underlying monthly move was broad-based and suggests more than just the end of the holiday was at play. The tax-holiday-end impact could extend into the March number, but the April CPI is poised to benefit from the removal of the carbon tax effective April 1. Afterward, the one-two punch of retaliatory tariffs and currency depreciation start showing up more clearly. The Bank’s next meeting is April 16, two weeks after new U.S. tariffs will be announced, and with the March CPI in hand. There’s a chance the Bank could pause here given heightening inflation concern, but as the economy succumbs to an expected recession, we look for a 2% policy rate by the summer.

Bond yields: Ten-year Treasury yields averaged 4.45% last month and are on track to average close to 4.25% this month (based on the latest close). Both are down from January’s high-water mark of 4.63%, which was the highest since 2007 apart from October 2023’s 4.80%. Our forecast remains that 4.00% should hold as the low-water mark for the foreseeable future. Indeed, it’s held for 18 of the past 20 months, with the two months of sub-4% readings (August-September 2024) occurring amid escalating Fed easing expectations and the surprise 50-bp inaugural rate cut. For comparable market expectations and/or Fed action to be repeated, the economy would have to start emitting recession signals. While the odds of recession are still well below even, they are clearly on the rise in the wake of tariffs, radical government spending cuts and, of course, increasing policy and economic uncertainty.

Although yields can continue to trend down modestly as Fed rate cuts eventually resume and the economy slows but still grows, there are offsetting factors that should limit the downdrift. One is rising inflation risks owing to tariffs. While the related rise in the price level could be partially muted by movements in profit margins and the U.S. dollar, the risk is that the one-time increases linger as wage demands and pricing behaviours change.

Another factor is rising fiscal risks. The 2017 tax cuts expire at the end of this year, with tax rates returning to 2017 levels as of January 1, 2026. Presumably, the cuts will be extended to avoid a probable GDP contraction. The CBO estimates that full extension would increase the 10-year deficit by about $4.0 trillion, compared to the baseline based on current law. The House and Senate are now working at reconciling their respective budget resolutions, which should result in the total deficit increasing meaningfully compared to the baseline. Of course, there’s also the debt limit that must be lifted before ‘X-date’, which is expected by this summer.

Meanwhile, the outperformance of 10-year Government of Canada bond yields (vs. Treasuries) seems to have reached its limit. Canada-U.S. yield spreads are on track to average -127 bps this month (based on the latest close), after a record -139 bps last month. We had previously cited three fundamental factors driving record negative spreads, and one is now fading.

First was the Bank of Canada’s larger rate cut tally, at 225 bps compared to the Fed’s 100 bps, with further widening expected through mid-year. Second was Canada’s better fiscal performance. The federal budget deficit is running under 2% of GDP compared to the 6%-plus outcomes south of the border. We see both deficits deteriorating in the period ahead: Canada owing to recession and relief measures, the U.S. owing to the extension of expiring tax cuts. Third was Canada’s better inflation performance, which has since deteriorated. In February, Canadian CPI inflation was 2.6% y/y versus 2.8% in the U.S. Before the tax holiday pushed the Canadian figure more than 1 ppt below the U.S., it spent months running more than ½ ppt lower.

On balance, while Canada-U.S. 10-year spreads could continue moving less negative as the year unfolds, we look for the -100 bp line to hold for the time being.

U.S. dollar: The Fed’s broad trade-weighted dollar index averaged a record high in January but slipped 0.8% in February and is on track to slip a further 1.4% in March (based on the latest closes). It was last averaging lower in October, before the election. The FX market appears not as convinced as before that U.S. tariffs are poised to become as large and ubiquitous as advertised, thus causing the greenback to weaken [1].

However, we’re bracing for more tariff announcements on April 2, both a broad reciprocal tariff structure and more sectoral tariffs alongside those already on steel and aluminum. We reckon this will be a catalyst for a renewed strengthening trend for the greenback. We see this trend lasting until the resumption of Fed rate cuts (which we currently expect for September), before the U.S. dollar begins to depreciate again. In the interim, there remains the potential for the greenback to hit fresh record highs.

Canadian dollar: In January, after averaging its weakest level in over two decades (since April 2003) at C$1.439 (US$0.695), the loonie bounced back a bit last month to C$1.430 (US$0.699). However, it’s on track to re-weaken slightly this month to C$1.436 (US$0.696, based on the latest close). Against the backdrop of a strengthening greenback broadly, the loonie’s slight weakening mirrored the month’s on-again-partially-off-again U.S. tariffs on Canada and Mexico, along with steel and aluminum tariffs that hit Canada the hardest (it’s America’s largest foreign supplier). With new tariffs being announced on April 2 and beyond, most of which will impact Canada further and perhaps put it among the hardest hit for some (e.g., lumber, autos), we reckon the loonie will stay on this month’s path. And with the Bank of Canada likely to cut the policy rate another 75 bps by the summer amid an unfolding recession, we see the currency moving to C$1.49 (US$0.671) by September, in time for the Fed’s resumption of rate cuts. The event should mark a turnaround for the Canadian dollar.

[1] U.S. tariffs contribute to strength in the greenback by reducing the amount of U.S. dollars being converted into foreign currencies owing to consequent reduced U.S. demand for imports. Although retaliatory tariffs would cause the opposite—less buying of U.S. dollars—the reduced selling would still dominate the reduced buying given the size of the trade deficit. [^]

Overseas

Jennifer Lee, Senior Economist

Let's wait awhile....

Yes, I've quoted that Janet Jackson song probably once too often, but it is still quite fitting, especially these days for central bankers. Most (not all) are waiting to see what April 2nd brings, what "number" they will be handed by the U.S. (recall Treasury Secretary Bessent said "each country will receive a number that we believe represents their tariffs") and see what falls out from that.

That is what the BoE was likely thinking as it kept Bank Rate at 4.50% on March 20. But, it is also waiting to see what Chancellor Reeves' Spring Budget brings when it is tabled on March 26. For example, will she make changes to employment reforms that businesses have complained so bitterly about? Besides, data quality issues aside, the latest jobs report (payrolls and total employment up, wages still high) also supports a move to wait it out. Hence, the 8-to-1 vote to hold. The majority of the Committee felt that yes, there is progress on disinflation; but, there hasn't been a heck of a lot of new news since the last meeting, global uncertainties have intensified, and inflation/wage pressures persist. And we know that there are varying degrees of hawkishness/dovishness within the majority camp. Remember how the normally hawkish Catherine Mann shocked markets in February when she voted for a 50 bp cut? She qualified her decision later, explaining that she simply wanted to "cut through the noise" with a bolder act. Interesting that a couple of policymakers, Dave Ramsden and Alan Taylor, moved out of the "cut" camp for the first time since September, and voted to hold. So, for the first time since September, Swati Dhingra is back to being the lone uber-dove, who voted for a 25 bp cut. All in, this was not a dovish hold.

However, although there is upside risk to the GBP, it is limited. With so much uncertainty, and business surveys pointing to weaker growth ahead, the BoE will continue to move slowly in bringing rates out of restrictive territory. We continue to expect two more rate cuts (25 bps each) this year, but it depends on domestic and global issues.

The ECB will need to do some soul-searching at upcoming meetings. It has cut rates a combined 150 bps so far this cycle, with the most recent 25 bp drop on March 6 to 2.50% widely expected. The central bank still sees the disinflation process being “well on track” and that “monetary policy is becoming meaningfully less restrictive”. That line itself points to fewer rate cuts although there is a potential for more given the trade war has yet to truly ramp up. But now, the Governing Council can take a step back and see how these upcoming tariffs impact inflation and growth and be comforted in knowing that it is not dealing with this alone. There is support coming from Germany and its plan to unleash a 10-or 12-year €500 bln defense and infrastructure spending fund, outside of the constitutional debt brake. In the words of incoming Chancellor Friedrich Merz, he will do “whatever it takes” and this massive fund will have a multiplier effect of, by some estimates, 1-to-2x. That suggests the economy could grow about 1.5% on the back of this spending, which would be welcomed after Germany's economy contracted for two years in a row. So, this fund, along with the European Commission's €150 bln loan-for-weapons fund, will help the ECB do its job and push the EUR to $1.15 by year-end, if not higher. But there is much uncertainty ahead. As President Lagarde warned, growth risks are to the downside but Europe is more unified than it has been for a long, long time. Meantime, we will stick to our expectation for two more rate cuts (25 bps each) this year.

The BoJ stayed put at its March meeting, leaving its policy rate at 0.50%. This was widely expected by consensus but one (with the initials J.L.) could argue that the Bank could have hiked rates. Japan has been dealing with persistent inflation and wages have been rising, which should underpin stronger consumer spending. Plus, it was a good reason to support the JPY, showing the U.S. Administration that it was not purposely manipulating the currency. All of those factors would have built a strong case, and those reasons were outlined in the Statement on Monetary Policy. But it was the unknown that bothered the Board. It was pointed out that “there remain high uncertainties surrounding Japan's economic activity and prices, including the evolving situation regarding trade and other policies in each jurisdiction.” So, Governor Ueda is taking a wait-and-see stance. He acknowledged that the spring wage discussions were “somewhat strong”. But, “over the past month or so, there have been rapid changes in the extent and speed of U.S. tariffs ... however, there are elements that we may not know until April, so the level of uncertainty will remain high.” In other words, the pace of tightening will be data-dependent but rate hikes are not over yet (we look for two more hikes, 25 bps each), which suggests that the JPY has room to rally.

The RBA finally joined its peers and eased monetary policy in February. The central bank had been on the sidelines since December 2023 before it made the “carefully balanced decision” to lower the cash rate 25 bps to a 16-month low of 4.10%. But don't assume that we will be fed a steady diet of rate cuts from this point on. After all, it was not too long ago that both hikes and cuts were discussed. Besides, Governor Bullock warned that it was “too early to call victory on inflation”. According to the Statement, the improvement in inflation was “welcomed”, but policymakers “remain cautious on prospects for further easing”. In fact, the Statement also said that with its new forecasts, “if monetary policy is eased too much too soon, disinflation could stall.” It was, therefore, not a shock to see that the Minutes showed that members did not see the decision as committing them to more cuts. And, the latest CPI figures support the cautious stance. January's trimmed mean CPI rate perked up, rising from 2.7% to a 2-month high of 2.8%. For half a year, this core measure, which is what the RBA focusses on, has been stuck in the 2.5%-to-3% range. The next RBA announcement will be on April 1, the day before said tariffs will be announced by the U.S. And, the RBA will have one more inflation figure to mull over. Further stickiness in the February data may push policymakers back to the sidelines. But let's wait and see.

Foreign Exchange Forecasts

Interest Rate Forecasts