ECONOMIC & FIXED INCOME COMMENT- “The Global Reset”

The global economy has transitioned from a phase of steady growth and easing inflation to one marked by significant challenges and uncertainty. Escalating trade tensions, persistent geopolitical conflicts, and declining consumer and business sentiment are influencing the prospects for global growth. As a result, global GDP is projected to decrease from 3.3% in 2024 to 2.9% in 2025.

The potential for a significant shift in the global economic landscape has introduced new complexities and challenges for central banks and governments across the globe. Monetary policy is moving into a phase marked by divergence. During the first half of 2025, inflation across most developed markets remained within the target range of 1%–3%. However, it is expected to increase unevenly in the latter half of the year due to differing reciprocal tariff rates. Several trading partners are currently in negotiations with the U.S., with proposed tariff rates of 20% for the European Union, 26% for India, and 24% for Japan. Countries that have not yet engaged in trade discussions with the Trump administration will receive a letter on July 9^th outlining the tariff rates that will apply for their imports starting August 1^st. Consequently, the timing and extent of interest rate cuts are expected to differ markedly among central banks.

Additionally, fiscal policy is entering a more precarious phase, as countries across the globe face mounting pressure to stimulate demand while maintaining financial stability (see chart).

In the first quarter, the Canadian economy displayed notable resilience, characterized by strong growth, stable employment, and inflation approaching the central bank's 2% target. However, a marked slowdown is expected in the second and third quarters as trade uncertainty impacts business investment, employment levels, and consumer spending. The Canadian labour market has weakened significantly since the beginning of the year with the unemployment rate hitting 7% in May. The slowdown has been considerable, primarily affecting sectors and regions that are most vulnerable to international trade challenges. As a result, the unemployment rate is expected to rise to 7.3% by year-end, as businesses reconsider their hiring plans amid ongoing trade uncertainties. In response to the challenging economic environment, the new Liberal government has implemented short-term fiscal measures designed to mitigate the effects of tariffs. These measures include tax deferrals, loan programs, and expanded eligibility for employment insurance. In the medium term, the recently announced increase in defense spending to meet NATO's 2% target, along with the passage of the “One Canadian Economy Act,” could serve as catalysts for growth in 2026.

The U.S. administration's focus on implementing tariffs to address trade deficits is having a detrimental effect on consumer spending and overall sentiment. In the first quarter, U.S. GDP contracted by 0.5%, primarily due to reduced consumer spending. As we look ahead, the U.S. economy is expected to face challenges in the coming quarters, with weaker exports and trade uncertainty exerting pressure on growth. However, the resilience of the labor market and the recent passage of the Big Beautiful Bill could provide support. The legislation combines tax reductions with increased funding for defense and border security, while reducing funding to Medicaid and social programs. It is anticipated to add $3.4 trillion to the federal deficit and increase GDP by 0.8% over the next decade.

On June 4^th the Bank of Canada (BoC) maintained the overnight bank rate at 2.75%, marking a second consecutive pause in the rate-cutting cycle. The BoC noted that while there is some softness in the Canadian economy, it is not experiencing significant weakness, and core inflation has shown firmness in recent months (see chart). As a result, the BoC plans to maintain a cautious approach to monetary policy, seeking to balance the challenges posed by slowing economic activity with inflation pressures. Economists expect domestic economic indicators will be the primary driver for the BoC’s policy decisions going forward. Consequently, a growing number of economists have revised their forecasts for rate cuts, now anticipating two additional reductions in 2025, bringing the overnight rate to 2.25%. Moreover, BoC officials noted that while monetary policy serves as a general tool to shape overall economic demand, fiscal measures are often more effective in delivering targeted support to workers and businesses affected by the trade war. As a result, we do not expect the BoC to lower policy rates below 2%.

The Federal Reserve (Fed) has kept the Fed Funds Rate at 4.5%, highlighting the strength of the economy and the labor market. The Fed will continue to monitor incoming economic data as it evaluates potential changes to monetary policy. Currently, markets are pricing in two rate cuts by year end.

During the second quarter, fixed income markets experienced notable volatility driven by geopolitical tensions, uncertainties surrounding tariffs, and increasing oil prices. The Canadian yield curve continued to steepen, reflecting a more pronounced rise in yields for longer-term bonds, influenced by expectations of future economic growth and inflation. Specifically, since April, the yields on 5-year and 10-year bonds have increased, while the overnight rate has remained stable (refer to the chart below).

In the near-term, Canadian long-term yields are likely to experience a gradual increase in line with rising U.S. yields. This is influenced by a higher term premium associated with growing inflation expectations and concerns over fiscal debt. The observed trend reflects the strong correlation between Canadian and U.S. yields, suggesting that the Canadian bond market is closely tied to movements in the U.S. (figure below).

We expect 10-year bond yields to remain within a volatile but defined range of 2.75% to 3.50%. The prevailing economic uncertainty is likely to present opportunities as market participants re-evaluate their expectations regarding central bank policies. We favour Canadian bonds, particularly in the short and intermediate segments of the yield curve as they provide appealing yields and the potential for capital appreciation should economic growth fall short of expectations.