Forecast Summary

Canada-U.S. Rates

Michael Gregory, CFA, Deputy Chief Economist

December Divergence

The Federal Reserve and Bank of Canada both restarted rate cuts in September with follow-up moves in October. The actions occurred on the same days and, although their next policy decisions align on the same day in December (10^th), we expect the Fed to cut and the BoC to stand pat. For the most part, the theme of unrequited rate reductions should play well into next year. The dissimilar rate-cut cadences reflect the fact that the Fed’s current 3.75%-to-4.00% target range for fed funds is still above the FOMC’s 3.00% median projection for the longer-run or neutral level. Meanwhile, the Bank’s current 2.25% policy rate is already at the bottom of its 2.25%-to-3.25% neutral range. As Fed policy rate parings outpace in the period ahead, on net, we look for Canada-U.S. bond yield spreads to move less negative and the loonie to gain against the greenback.

Federal Reserve: The FOMC cut policy rates by 25 bps on October 29. In the press conference, Chair Powell went out of his way to emphasize that a third consecutive action in December “is not a foregone conclusion—far from it." The money market took heed. Heading into the confab, it had completely priced in a December drop. The odds are now around 50%.

Also prodding second thoughts was the dissenting vote in favour of no move. Kansas City President Schmid was concerned about cutting rates with the economy showing “continued momentum” (pumped particularly by accommodative financial conditions and AI-related capex) and inflation remaining “too high”. He argued: “I do not think a 25-basis point reduction in the policy rate will do much to address stresses in the labor market that more likely than not arise from structural changes in technology and demographics. However, a cut could have longer-lasting effects on inflation if the Fed’s commitment to its 2 percent inflation objective comes into question.” In the market’s mind, Schmid’s dissent more than countered Governor Miran’s renewed call for a 50 bp reduction.

And perhaps the market reminded itself that the FOMC’s conviction (as of September’s ‘dot plot’) about an October-December rate cut couplet was not that strong to begin with. There were 10 participants in the two-or-more moves camp and nine in the one-or-zero group.

We still look for a rate reduction next month. The latest statement reiterated the assessment that the “downside risks to employment rose in recent months” and what data are available point to the labour market remaining as weak or weakening further. As such, it is appropriate for policy rates to be in closer proximity to the neutral level (but not necessarily there now). Note that the top of the FOMC’s central tendency range for neutral is 3.50%, which we judge is a convenient location to consider slowing the rate cut cadence. We see a quarterly pattern unfolding next year on a path to 2.75%-to-3.00% (just a tad below neutral).

But, as Powell alerted, December is not a done deal (the slower easing clip could kick in next month). Although President Trump signed the bill ending the government shutdown on November 12, there is at least a 43-day backlog of official data to get through with the next FOMC decision in 28 days, along with the regularly scheduled reports. The Fed could still be flying a bit blind next confab, which could breed even more policy caution. At a minimum, we would not be surprised to see more dissenting votes in favour of standing pat.

Bank of Canada: The Bank also cut its policy rate by 25 bps on October 29. In the presser, Governor Macklem stated: “If the economy evolves roughly in line with the outlook in our MPR [Monetary Policy Report], 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.” In other words, the BoC could be finished easing with the target for the overnight rate at the bottom of the 2.25%-to-3.25% neutral range. There was a ‘we’ve done what we can for now’ feel to the policy pronouncements.

The summary of Governing Council deliberations (released November 12) stated that “members agreed that a cut to the policy interest rate would be needed” but they differed on timing. Some argued to wait for more data on the economy, labour market and inflation along with more developments on the U.S. trade and federal fiscal policy fronts. However, the arguments to act now won out, amid continued excess supply and labour market weakness (latest reading aside), and with weak real GDP projected for H2 alongside inflation staying close to target. But there was little talk about another rate cut afterwards.

In the press conference, Macklem also said: “… the weakness we’re seeing in the Canadian economy is more than a cyclical downturn. It is also a structural transition. The US trade conflict has diminished Canada’s economic prospects. The structural damage caused by tariffs is reducing our productive capacity and adding costs. This limits the ability of monetary policy to boost demand while maintaining low inflation.” With inflation expected to behave (thanks primarily to mounting economic slack) and U.S. trade policy still expected to pose heightened risks and uncertainties for the economy, we reckon the Bank could still ease another notch early next year. This ‘insurance move’ would lower the policy rate to 2.00%, just a bit below the neutral range.

Bond yields: Ten-year Treasury yields averaged 4.06% in October, which was a 13-month low, but, so far this month, they are averaging a slightly higher 4.12%. Although additional policy rate cuts should exert some downward pressure on yields, we judge a 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. Ahead of last month’s Fed meeting, the daily closes slipped just below 4.00% on four occasions for the first time in more than a year, but they jumped up in the wake of Powell's remarks. The above conditions were clearly not satisfied.

There is a mixture of factors causing this 4.00% ‘line in the sand’. First, the fiscal fundamentals are deteriorating. The additional deficits caused by the One Big Beautiful Bill Act could potentially be mostly covered by additional tariff revenue, but this revenue is now being called into question (we await the Supreme Court’s ruling on the legality of tariffs under the International Emergency Economic Powers Act (IEEPA)). This means deficits, debt, and interest payments—already on unsustainable paths—are poised for unimproved or worse trajectories. Second, there are lingering economic policy uncertainty and tariff risks to inflation. Third, there are lurking concerns about future Fed independence and U.S. dollar hegemony.

Meanwhile, Canada-U.S. 10-year yield spreads averaged -93 bps last month and, through November 12, are averaging 4 bps more negative. This is a long way from the record -139 bps back in February when BoC rate cuts were unmatched by the Fed. But it is also more negative than the -84 bps registered in August, which seems to have marked the end of the relative sell-off. We are chalking up the rebound as a stabilization pattern more than a trend reversal. We still expect that spreads will resume moving less negative as future Fed rate cuts outpace anything from the BoC.

And part of the pattern also reflects Canada’s own fiscal risks. The November 4 federal budget showed a $78.3 billion deficit for the fiscal year ended March 2026, roughly as we expected. This is double FY2025’s $36.3 billion shortfall, with deficits projected to remain well above $60 billion for at least the next couple of years. As a share of GDP, this takes the current 2.5% back to just under 2.0% (assuming modest economic growth), with federal debt grinding steadily higher from 42.4% to 43.3%. These ratios are manageable (and appear stellar compared to those south of the border) but they still bear watching, particularly with combined provincial finances deteriorating to a similar degree.

U.S. dollar: The Fed’s broad trade-weighted dollar index strengthened 0.6% in October and 1.1% against the advanced foreign economies (AFE). These moves more than reversed the 0.4% weakening for both in September amid the resumption of Fed rate reductions. So far this month, the AFE index has strengthened a further 1.0%.

As October unfolded, the mounting absences of most official data began casting more FX market doubt about Fed easing prospects, which are the dominant driver of the dollar depreciation narrative. The resulting reverse move was magnified as Chair Powell appeared to be more agnostic about a rate cut next month, and the money market pared the probability.

With the official data flow to resume shortly (but with a bulky backlog to unwind) and likely to accentuate the appropriateness of another risk-management-motivated rate cut on December 10 (which is still our call), we look for the greenback to start losing ground again. 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. For next month’s average, we see the Fed’s broad index down 6.5% from January’s record high and more than 8% against the AFE’s peak. We see further depreciation of under 2% and close to 3%, respectively, by the end of next year.

Canadian dollar: The loonie averaged almost C$1.400 last month (US$0.715), weakening 1.1% against the greenback, in line with the AFE pack. So far this month, the Canadian dollar has weakened further to above C$1.406, faring relatively better than the norm as BoC easing prospects faded more meaningfully than those for the Fed. While more aggressive Fed easing (100 bps versus 25 bps for the Bank into next year) should continue to lift the loonie, we reckon it is going to lag its advanced economy peers. The albatross around the Canadian dollar’s neck is U.S. trade policy.

Currently, U.S.-Canada trade negotiations are suspended with the Administration threatening another 10% tariff (but it’s not clear when and on what… goods not compliant with the USMCA currently face a 35% levy). The list of Section 232 ‘national security’ tariffs impacting Canadian goods continues to expand, despite the USMCA stating that they would not be applied to autos and parts and encouraging negotiation of things like tariff-rate quotas in other sectors. Even if current trade turmoil can be calmed, there’s next year's formal review of the USMCA looming. As Fed rate cuts and trade tensions tussle to drive the Canadian dollar, we look for the currency to average C$1.400 next month and appreciate to C$1.333 (US$0.752) by the end of next year, assuming the USMCA survives relatively intact.

Overseas

Jennifer Lee, Senior Economist

Central bankers are proving that they are not on autopilot. In fact, some are taking a step back to breathe and re-assess the landscape. Take the ECB. It stayed on the sidelines on October 30, which was widely expected. But, with increasing signs of more resilient economic growth, tight labour markets, and inflation close to the 2% target, it was unanimously agreed upon that there was no reason to cut during this meeting. During the press conference, President Lagarde was upbeat on growth prospects, noting how some of the downside risks had faded over the past few weeks. However, risks to inflation had not faded. The outlook was “more uncertain than usual”, given concerns about trade and that the risk of bottlenecks and supply issues “has not yet materialized”. In fact, Reuters’ sources (the ones that usually emerge from the darkness after the press conference is over) said that everything will depend on what the new staff CPI forecasts are for 2028. If they show inflation remaining well below target, then there is a possibility of a December rate cut. But others dismissed that, saying that undershooting the target by 20-to-30 bps is ok. Meantime, it is our view that this ECB rate-cut cycle is over.

The BoJ also stayed on the sidelines, keeping rates at around 0.5%, citing risks such as “high uncertainty on the impact of trade policies on overseas economic and price developments.” Two dissenters preferred a 25 bp hike, stating that “the price stability target had been more or less achieved.” But the majority is likely keeping its powder dry as the new government gears up to spend, led by PM Takaichi who has been openly critical of the Bank’s recent hikes. Nonetheless, with core inflation running above target since 2022, we continue to look for another rate hike. Going into 2026, though, the Bank will be watching wage talks and whether higher wages feed into consumption. The BoJ clearly has a lot of patience, but there was one notable line from the latest Statement of Opinions: "It is likely that conditions for taking a further step toward the normalization of the policy interest rate have almost been met." A December 19 rate hike is still possible.

As expected, the RBA kept the cash rate steady at 3.60% in November. It wasn’t exactly shocking given the latest Australian inflation readings showed headline CPI rising beyond the 3% target for the first time in over a year. Indeed, the first heading of the Media Release was “Inflation has recently picked up”. The Policy Board also described the latest inflation reading as “materially higher”; though some of the reasons were probably “temporary”, there is concern that “some inflationary pressure may remain”. If anything, Governor Bullock played it right down the middle: “…the board will have to wait and see. It is possible there are no more rate cuts, possible there are more”. Given the strong October jobs report (42,200 new jobs, all full-time, and the unemployment rate slipping to 4.2%), it is likely that the hawkish-leaning central bank is finished easing.

Where things could get a little more interesting is in the U.K. The BoE stayed the course in November, as was generally expected. However, it was, once again, an intriguing result. The vote was super tight: 5 voted to keep Bank Rate at 4.00%, while the other 4 wanted to lower rates by 25 bps. Governor Bailey was the swing vote, and was clearly dovish. He said that upside risks to inflation are “less pressing” now, and that “I see further policy easing to come if disinflation becomes more clearly established”. With comments like that, one would assume he was in the rate cut camp. But he was not. He felt there was value in waiting for more evidence. And judging by the latest employment report, and GDP, he has that evidence. Payrolls fell 32k, broader employment was down 22k, and the jobless rate ticked up 0.2 ppts to a 4½-year high of 5.0%. More to the point, wage growth cooled: private sector earnings excluding bonuses climbed 4.2% y/y, the most modest increase in nearly five years. And, economic growth not only slowed in Q3, but it contracted in September. That should be enough to push him out of the "hold" corner, where he was in the company of those who were far more hawkish, and join the four doves, who believe that the time is now to cut rates. And that time could come as soon as December... unless something unexpected arises from the Autumn Budget.

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