Following recent signs of weakening labour market conditions in Canada and the U.S., central banks in both countries decided to reduce their benchmark interest rates, resuming monetary easing cycles that had been on hold amid uncertainty in the broader economic and trade policy backdrop. We discuss the decisions, the market reaction, and the potential economic implications in more detail below.

Rate Cuts

The U.S. Federal Reserve (the “Fed”) lowered its benchmark rate by 0.25% at its meeting this week, a move widely expected by markets. It was the first cut since December 2024. A series of softer-than-expected labour market data over the summer had heightened concerns over a potential growth slowdown, while recent inflation readings had reflected less tariff pass-through than previously anticipated. These factors gave the Fed room to act to cushion against the downside risks in the economy.

The Bank of Canada (the “BoC”) matched the Fed’s decision, reducing rates by a quarter-point this week. A high degree of USMCA compliance in trade flows and the removal of retaliatory tariffs on the U.S. has helped to keep inflation in check, opening the window for the BoC to cut rates to support some trade-impacted sectors and a labour market that is facing rising unemployment. The BoC offered little guidance on the future path for monetary easing, with officials stressing that they would be “proceeding carefully” in an uncertain policy and economic environment.

Bond yields

Bond markets had largely priced in the latest rate cuts, with government bond yields having already moved lower in Canada and the U.S. over recent weeks. Short-term government bond yields, which are more sensitive to central bank rate decisions, have fallen steadily since mid-July. Longer-term yields, which tend to be shaped more by broader growth and inflation expectations, also declined as markets weighed the prospect of weaker economic momentum ahead.

After this week’s rate cut decisions, short- and long-term yields have diverged slightly, with short-term rates generally holding on to their recent declines and long-term rates edging modestly higher. This pattern suggests that markets believe that the proactive rate cuts could help prolong the economic expansion and maintain stable growth and inflation expectations over the medium term, thereby propping up longer-term yields.

Economic implications

Broadly speaking, rate sensitive areas of the economy should be poised to benefit from easier financial conditions, with housing likely to be a primary beneficiary. In Canada, housing market activity has increased somewhat recently with existing home sales reaching a 2025 high this month amid lower prices and improved inventory dynamics. The housing sector continues to face some challenges, including affordability constraints, slowing population growth and broader economic uncertainty. Lower financing costs could provide a boost to demand in the Canadian housing market. Similar dynamics apply in the U.S., where lower mortgage rates could provide relief in a market that has been constrained by affordability challenges and muted builder activity.

Cyclical segments of financial markets will benefit from the tailwind of lower borrowing costs, including smaller-sized companies, more economically sensitive sectors and lower-quality corporate borrowers. Nevertheless, a risk worth monitoring is inflation. An overly aggressive approach to interest rate cuts could lead to renewed concerns around inflationary pressures, a potential source of market volatility.

Takeaways

The evolving balance of risk between inflation and the labour market has led central banks to place a greater emphasis on keeping the labour market on a steady footing. The resumption of rate cuts is aimed at countering downside risks, as slowing job creation has become more evident. While easier financial conditions should provide broad support for the economy and the prices of stocks and bonds, there remains significant uncertainty over how far and how fast interest rates will fall. Central banks remain committed to maintaining inflation stability in a range that is aligned with their long-term targets.

We will be watching the future path of monetary policy closely alongside government bond yields as central banks navigate the complex tradeoffs between the labour market, inflation and the broader economy.

If you have any questions, please do not hesitate to contact us.

 

Drew M. Pallett LL.B. 

Senior Portfolio Manager and Investment Advisor 

RBC Dominion Securities Inc.

Email: drew.pallett@rbc.com