Stock markets closed out a strong 2024 on a muted note as investors began to recalibrate their expectations for future interest rate cuts by the U.S. Federal Reserve. This shift in expectations led to a rise in government bond yields that has continued in recent weeks. Below, we provide updates on recent developments in Canada and the United States.
The Federal Reserve cut interest rates at its mid-December meeting, as widely expected, despite inflation showing signs of being sticky. Fed Chair Jerome Powell struck a different tone on future rate cuts, stating that it will likely be appropriate “to slow the pace of further adjustments,” while acknowledging that the risks of economic weakness and inflation are relatively balanced. Policymakers’ projections revealed that they now expect to cut rates by only 0.5% in 2025—half of what was previously anticipated—and raised their inflation forecast for the year. Given the labour market strength exhibited in recent U.S. data, cuts in 2025 may be less than 0.5%.
Closer to home, the Bank of Canada (BoC) also signalled the potential for a more restrained approach to interest rate cuts going forward. Markets currently expect 0.50% to 0.75% of rate reductions this year. It would not be surprising if the BoC feels compelled to go further to avoid the risk of undershooting its 2% inflation target. The Canadian economy has been lacklustre, with expectations that slow growth may continue near-term. This expectation has contributed to significantly lower bond yields in Canada compared to the U.S. The Canadian dollar has suffered as a result because global funds tend to flow toward higher-yielding currencies, thereby strengthening their value relative to lower-yielding ones.
Canadian Prime Minister Justin Trudeau recently announced his resignation following months of poor polling, recent exits of key officials within the Cabinet, and mounting calls for his departure. His exit introduces significant political uncertainty at a time when Canada is dealing with the threat of tariffs from the incoming Trump administration. Prime Minister Trudeau will remain in office until his successor is selected, with Parliament suspended until late March. Although the Canadian government retains the power to impose counter-tariffs on the U.S. without legislative approval, the leadership void could complicate negotiations. This uncertainty is a further negative for the Canadian dollar.
Recent developments in Canada may not inspire confidence among investors. It is worth noting, however, that the Canadian equity market may not depend as much on political and economic developments at home as it once did. Canadian equities rose nearly 20% last year despite the fractures that already existed domestically. Instead, other factors, such as falling interest rates and declining inflation, have arguably been more important. In addition, U.S. growth has benefited many of the Canadian businesses that have become increasingly tied to activity south of the border over the years. In our view, it is important to not be overly swayed by developments domestically.
Overall, we expect continuing pessimism regarding Canada’s near-term economic prospects, including the negative impact of potential U.S. tariffs. Interest rates may continue to move lower, driving anticipation of better economic and earnings growth later in 2025. In the U.S., the consensus expectation is for continued economic expansion, the emergence of regulatory and tax tailwinds, and for limited additional interest rate cuts. These expectations, which are positive for the U.S. and less so for Canada, are already reflected in current market valuations. It is the potential for a change in the outlook, for better or worse, that will likely drive market movements.
If you have any questions, please do not hesitate to contact us.
Drew M. Pallett, LL.B.
Senior Portfolio Manager & Investment Advisor
Email: drew.pallett@rbc.com