Gauging the impact of trade tensions on the Canadian fixed-income market

What happened?

Tariffs are in effect, with the exception of United States-Mexico-Canada Agreement (USMCA)-compliant Canadian goods headed to the United States. This list includes automakers, which were among the first to be exempted due to concerns over ensuing supply chain disruptions. Despite this slight reprieve, tariffs will still be imposed on more than 60% of Canadian goods. Some energy products are still subject to 10% levies while many other goods still face 25% duties. This dispute has now come into clearer focus, but the fallout is anything but. Although market participants clearly see the escalation in tensions as being negative for risk assets, the price action has so far been relatively contained in the fixed-income market, with global investors and businesses having had a month to plan for this event.

Canada has responded with 25% tariffs on CAD$30 billion worth of U.S. goods immediately, with 25% on an additional CAD$125 billion of products expected to go into effect in April. Separately, China imposed new tariffs on a host of U.S. agricultural products. In what appears to be an attempt to come to another last-minute deal, Mexico has yet to announce its plans for retaliation.

How has the market responded so far?

The Canadian dollar has marginally weakened since the tariffs were first announced. Although market participants see the escalation in tensions as negative for risk assets, the price action has so far been contained, with global investors and businesses having had another month to prepare. Canadian bonds have rallied in response to weaker growth prospects and expectations of additional or more aggressive Bank of Canada (BoC) rate cuts. Meanwhile, U.S. bonds at the front-end also rallied on the back of weaker growth while the longer-end rose in reaction to expectations of higher future inflation. 

What policy actions can we expect in Canada?

Tariffs are likely to be a significant headwind to Canadian growth, with the BoC's latest analysis citing an impact of 2.9% by 2027.  In our view, tariffs could reduce GDP by 0.5-1% in 2025. If the tariffs remain in place until 2026, we anticipate a larger downgrade to GDP growth next year as the economy slides further into oversupply.

On the Canadian fiscal front, automatic stabilizers will provide the first line of defense until Parliament is expected to return from prorogation, and a spring election would likely delay any fiscal response until late Q2. In our view, a fiscal package in the range of 1.5-2% of nominal GDP (CAD 25B–CAD 40B) may be implemented over the 2025-2027 period, subject to (or depending on) policy decisions and economic conditions.

We anticipate the central bank to assess incoming data and maintain a methodical approach to further rate cuts, with a dovish tilt to future policy actions. We also anticipate the BoC to announce a 25-basis point rate cut at each of the next three meetings (between March and July), bringing overnight rates to 2% by the summer, with the option to cut more aggressively if data and circumstances warrant. We believe that a Canadian fiscal package could be introduced after the election, and we anticipate the new government to introduce elevated borrowing programs to finance such an initiative, which would likely weigh on the performance of the longer end of the curve.

How do we expect Canadian bonds and the CAD to behave in the coming weeks?

Canadian bonds are likely to react based on three factors: how the BoC responds, the impact of tariffs on growth and inflation, and fiscal policy measures. We anticipate a continued rally in Canadian bonds due to weaker growth prospects and believe the yield curve to steepen as the front end is likely to benefit most from potential BoC rate cuts. The Canadian fixed-income team believes Canadian bonds to outperform U.S. bonds in the coming days if the tariffs that recently took effect remain in place. In our view, the playbook from here is bullish for Canadian bonds, particularly for front-end and intermediate bonds. We anticipate yields to grind lower if tariffs remain in place and the tangible negative effect begins to filter through.

We anticipate USD/CAD to remain in the 1.43 to 1.52 range in the near term. We believe the exchange rate will ultimately depend on the duration of the tariffs.

Within the Canadian corporate bond market, we believe some sectors will be more affected than others. Regulated utilities, pipelines, telecoms, and insurance should be insulated, in our view. Canadian banks will most likely be negatively affected over time if the tariffs ultimately dent economic growth. In terms of real estate investment trusts, we believe the tariffs’ impact to vary by subsector, depending on how economically sensitive each subsector is. Consumer staples will likely be somewhat insulated while consumer discretionary will likely underperform. Infrastructure names, on the other hand, are likely to experience slower-than-expected growth in traffic, which will weigh on the sector. The auto sector will most likely feel the most materially negative impact.

Where are the opportunities now in fixed income?

The Canadian fixed-income team believes the front end and the belly of the Canadian yield curve are attractive as they should benefit from further BoC rate cuts. We also feel five-year U.S. inflation-protected securities may bode well in this potentially inflationary environment.

We’re cautious on provincial credit as provinces may have to take on more debt to weather the economic fallout from the tariff measures and we continue to like Canadian corporates in the front end and belly of the yield curve. We prefer Canadian corporates over U.S. credit and are cautious on the long end of the corporate curve.

While trade tensions pose ongoing challenges for Canadian fixed-income markets, selective opportunities remain. A methodical approach focused on high-quality corporates and the front end of the yield curve could offer attractive risk-adjusted returns in the months ahead.