ECONOMIC & FIXED INCOME COMMENT- “The Great Divide”

In the first half of 2025, global growth has proven to be more resilient than expected, leading the Organization for Economic Cooperation and Development (OECD) to adjust its growth forecast for the year upward, from 2.9% to 3.2%. Key factors influencing this adjustment include China's fiscal stimulus measures, increased industrial production in response to expected tariff hikes, and significant investments in Artificial Intelligence in the United States. As we approach 2026, the comprehensive effects of tariffs and persistent policy uncertainties remain unclear. As a result, global growth is projected to decelerate to a growth rate of 2.9%.  Monetary and fiscal policies will play a crucial role in influencing the future global economic landscape.

Governments worldwide are facing growing budgetary challenges and rising debt levels, influenced by factors such as economic instability, aging population, climate change and geopolitical conflicts. Ongoing deficits could lead to higher interest rates, as investors seek compensation for elevated risk premiums in government bond yields. Therefore, maintaining fiscal discipline is essential for ensuring long-term debt sustainability and preserving the ability to respond to future economic shocks (see chart).

In the second quarter, Canada’s GDP experienced a notable decline, contracting at an annualized rate of 1.6%, a sharp contrast to the robust 2% growth recorded in the first quarter.  Going forward, the trajectory of the Canadian economy will be heavily influenced by changes in U.S. trade policy. Overall, the economy is expected to grow 1% for 2025.

The U.S. economy expanded 3.8% in Q2, an upward revision from the previous estimate of 3.3%. This adjustment was primarily due to a significant boost in consumer spending along with rising investments in Artificial Intelligence.  According to the Bureau of Economic Analysis, private fixed investment in information processing equipment and software—a proxy for AI spending—rose by 4.6% on an annualized basis in Q2. For 2025, the U.S. economy is projected to expand 1.7%.  Nonetheless, the U.S. government shutdown could impact economic growth. Past studies of government shutdowns indicate a modest drag on overall GDP growth. However, if the shutdown continues for an extended period or if government workers face permanent layoffs, the economic repercussions could become more significant.

On September 17^th, the Bank of Canada (BoC) lowered the overnight bank rate 25 basis points to 2.5%. This decision was largely anticipated, driven by sluggish economic growth, disappointing job data, and easing inflationary pressures. Moving forward, the BoC will focus on monitoring export growth and its effects on business investment, employment, and consumer spending. We expect the BoC to lower its policy rate by an additional 25 basis points to 2.25% by year-end.

After keeping the federal funds rate steady for nearly a year, the U.S. Federal Reserve (Fed) lowered the Fed funds rate 25 basis points to 4.25% on September 17^th. This move was highly anticipated by the market and received strong backing from the Federal Open Market Committee (FOMC). In his statements, Fed Chair Jerome Powell emphasized the rising risks to the labor market, pointing out a slowdown in hiring and a rise in layoffs. While the vote in favor was unanimous, views on the future direction of monetary policy remain diverse. The Fed's dot plot, which reflects members' projections for the federal funds rate over the coming years, revealed a wide range of forecasts between 2.5% and 4%.  Markets are currently anticipating an additional 25 basis point rate cut at the upcoming meetings in October and December. However, the ongoing government shutdown poses challenges for the Fed, as the lack of new data complicates decisions on whether to maintain or reduce interest rates. We believe that the Fed’s focus on “risk management,” combined with the limited insights from September's metrics, raises the likelihood of the Fed continuing its easing cycle in October.

North American labor market conditions have shown signs of deterioration, potentially indicating a slowdown in economic momentum. In Canada, job growth has significantly decreased as companies postpone hiring due to trade uncertainties. In August, the economy lost 66,000 jobs, causing the unemployment rate to rise to 7.1%, a figure not seen since May 2016, apart from the exceptional years of 2020 and 2021 during the COVID-19 pandemic. Meanwhile, in the U.S., the labor market is also decelerating, with August data revealing an addition of only 22,000 jobs and an increase in the unemployment rate to 4.3%, marking the highest level since 2021. The softness in the labor market might lead the Fed and BoC to adopt more accommodative monetary policy measures.

Historically, comparable macroeconomic conditions have created a favorable environment for interest rates, supporting the extension of duration.  Specifically, fixed income returns are typically stronger during periods of economic weakness, as declining bond yields drive prices higher (see chart below).

We expect 10-year Canada 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.  Moreover, any shifts in the yield curve are more likely to come from bull steepening via front-end rallies, rather than bear steepening from long-end selloffs.