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Just like everything else in the markets these days, the outlook for the Canadian bond market is complicated. This was seen in the Bank of Canada’s decision on Wednesday to hold interest rates steady in the face of “pervasive uncertainty” about the economic outlook as a result of US President Donald Trump’s tariffs. That came after a spike in Canadian bond yields following Trump’s pause in tariffs against other countries, which eroded some of the outperformance Canadian bonds recently enjoyed.
Market observers say the central bank isn’t done easing. With the Canadian economy expected to take a hit from tariffs, the Bank of Canada is expected to cut rates, which would take short-term yields lower. Bond prices and yields move in opposite directions, so that would be good news for bond holders. The central bank reduced its policy rate from 5.00% to 2.75% over seven consecutive cuts since last summer, with markets pricing in at least three more cuts before year-end 2025.
However, it’s a different story for longer-term bonds. Unlike short-term bond yields, which tend to respond immediately to interest rate cuts, long-term yields are guided by expectations for future economic growth and inflation. Tariffs are inflationary, raising the costs of goods. “Given the eventual stimulative effects of the Bank of Canada’s easing cycle, the yield curve still has room to steepen somewhat further as 2025 progresses, particularly if the Bank decides to cut rates more,” says David Stonehouse, senior vice president and head of North American and specialty investments at AGF Investments. A yield curve is a graphic representation of interest rates of bonds over various periods.
Stonehouse’s only caveat is a potential recession. In that case, “the yield curve could flatten again in anticipation of that outcome before eventually steepening as the market looks past the recession to the recovery.” A yield curve steepening occurs when the gap between short-term and long-term bond interest rates widens.
Bond Market Selloff Bucks the Trend
Bond markets have whipsawed in recent weeks amid escalating trade rhetoric and a worsening economic backdrop. A bond market selloff last week led to an uptick in both short-term and long-term yields, as investors grew anxious over rising inflation and uncertainty surrounding Canada’s economic stability. These concerns were further fueled by fears of a US recession and its potential spillover effects.
The 10-year Government of Canada bond yields fell from its January peak of 3.60% to 3.01% in March before climbing back to 3.5% in the second week of April, as Trump’s trade war roiled global markets. Yields for two-year bonds slid from 3.15% in January to a low of 2.37% in the first week of April, then soaring back to 2.53% in mid-April.
Once the dust of the tariff war settles, bond experts forecast that short-term yields will fall faster than long-term yields over the remainder of the year, reflecting higher odds of continued monetary easing. The result could be further steepening of the yield curve, a pattern often associated with the central bank intervening amid economic stress. For that reason, Carl Gomez, chief economist and head of market analytics at CoStar Group Canada, forecasts yields will steadily decline unless a meaningful jump in inflation causes them to rise again. “I see yields continuing to come down across the curve in 2025, taking their lead from a few more ‘emergency’ Bank of Canada cuts,” he says.
However, with the bond market facing varying crosscurrents, including the shift in US trade policy, Gomez says, “the short end is expected to be anchored by a few more Bank of Canada cuts, [while] long bonds could drift a bit higher, being pulled [even] higher by rising US yields due to a higher term premium caused by rising inflation expectations and fiscal concerns.” Term premium refers to the extra yield investors demand for holding long-term bonds.
More specifically, Gomez projects that the Bank of Canada could cut to a terminal rate of 2.00%-2.25% by year-end, while the 10-year Government of Canada bond yields could rise to about 3.7% from their current 3.00%.
Canadian Bond Market Remains Attractive
The Canadian bond market continues to attract investors seeking refuge amid trade and economic uncertainty. Analysts say the trend is likely to persist throughout the year, even though the market may not repeat the outperformance of 2024.
After handily outpacing its US counterpart in 2024, Canada’s bond market has continued to tick higher for much of this year, albeit at a slower pace. The slowdown can be attributed to contrarian forces exerted by the central bank’s continued monetary easing and the threat of higher inflation stoked by sweeping US tariffs.
Their attractiveness is further borne out by the fact that in January, foreign investors increased their exposure to Canadian bonds by C$33.5 billion—the highest investment since April 2020—according to the Statistics Canada’s most recent data. Notably, the Canadian dollar fell by 0.7% against the US dollar in January, further boosting Canadian bonds’ allure to global investors.
Stonehouse points out that as of March 31, the year-to-date return of 2% had exceeded returns on cash proxies like GICs and T-bills, further illustrating bonds’ appeal. “Bonds have benefited from uncertainty around tariffs, with the adverse potential impact on economic growth outweighing concerns about the potential inflationary effects,” he says.
Investor concerns have also been stoked by significant declines in business and consumer confidence. “With elevated risk, bonds have rallied to some extent over the first quarter, while the Bank of Canada has indicated it will continue to cut its policy rate to support an economy facing increased risk,” says Gomez.
Market Outlook as Tariffs Materialize
Dustin Reid, chief fixed income strategist at Mackenzie Investments, says Canada’s bond market has performed broadly well, with 10-year yields moving moderately lower throughout most of the quarter. His outlook has largely remained unchanged from last year, despite select US tariffs coming into force. “The largest trade for us is for Canadian and US yields to narrow in the 10-year and 30-year space, which they have, but we believe still have room to go,” he says.
As a result of the swift and sweeping implementation of US tariffs, Stonehouse says he’s been “cautious about the near-term outlook and consequently positioned for somewhat better bond returns in the Canadian and US markets than we initially perceived.” Domestically, he expects the new Canadian government to continue to administer fiscal stimulus, regardless of which political party wins the election. These efforts are “likely to result in quickening economic growth by the latter part of the year and into 2026, which may prove more challenging for Canadian bonds.” By the end of 2025, Stonehouse assures that the Canadian bond market can still achieve mid-single-digit returns.
The Bond Market’s Reaction to 2025 Rate Cuts
This year, the Bank of Canada has delivered 50 basis points in interest rate cuts, which has helped two-year bonds outperform. “As rate cuts have continued, the short-to-medium-term parts of the curve have declined in yield, providing a boost to returns over and above the initial yields,” Stonehouse notes. That is because short-term government bond yields react more promptly to the central bank’s policy maneuvers.
Bond prices and yields are inversely correlated. When yields fall, because of lower interest rates, bond prices usually rise, and vice versa. On the other hand, Stonehouse says long-term bonds yields haven’t dropped that much, because “the market anticipates that the stimulus will eventually result in higher economic growth.” He points out that long-term yields are only slightly lower now than at year-end 2024.
Additionally, the bond market’s reaction to the recent cuts has been more muted than in previous cutting cycles, according to Gomez. “A big part of that is a growing term premium, given rising inflation expectations becoming entrenched in the market,” he explains.
The Road Ahead: What’s in Store for Bonds?
It’s widely believed that whichever Trump tariffs remain in force, along with the spillover effect of a slowdown in the US economy, could weigh on Canada’s economic growth in the near term. This supports the case for continued policy easing, which will drive down short-term bond yields.
However, the impact of tariffs on long-term bonds could be minimal. Stonehouse argues that since 225 basis points of cuts have already materialized, and the policy rate now stands in the middle of the central bank’s target range of 2.25%-3.25%, “longer bond yields have been more rangebound than declining as they reflect an eventual return to better growth prospects.”
Gomez says the differing impact of rate cuts on short-term and long-terms bond yields could widen the gap between them, “resulting in some curve steepening through 2025.” While additional cuts amounting to 50 or 75 basis points may be in the cards, the Bank will likely not cut below 2%, “largely due to potential inflation risks, which will ultimately put a floor on the handle of the yield curve.”
What Should Investors Do?
In the face of continued uncertainty and market volatility, it’s important to stay nimble as the environment evolves, advises Rachel Siu, managing director and head of Canadian fixed income strategy at BlackRock. For investors seeking risk mitigation, she recommends Canadian bonds, while global diversified income portfolios can also offer potential cushion.
Thematically, Siu sees opportunities in several areas of global fixed income in the current economic environment. “We believe there is an attractive opportunity for investors to build an allocation to fundamentally sound, income-generating assets with compelling all-in yields while owning some duration in the belly of the curve,” she says. She prefers to hold shorter-terms bonds and focus on markets outside the United States.
Reid says the current market volatility and economic backdrop makes it prudent to add exposure to income-generating assets. “With equities exhibiting more volatility on the tariffs discussion, which is unlikely to dissipate [soon], there are numerous fixed-income opportunities that can provide a more stable return in a properly balanced outlook,” he contends.
Stonehouse points to Canadian bonds’ robust outperformance over the years, notwithstanding the recent decline in bond yields. “Canadian bonds have provided some of the highest yields in the last 20 years, and investors can obtain even higher yields from other categories such as investment grade bonds,” he stresses.
He adds that these yields can provide several compelling advantages. First, they have now become more attractive than cash equivalents like GICs, which wasn’t the case a couple of years ago. Second, they help investors achieve income and return objectives with relatively lower risk than equities. Additionally, yields are high enough to provide a cushion if the Canadian economy falls into recession. “This backdrop is among the most attractive bond investors have seen in the last couple of decades,” contends Stonehouse. He adds that bonds are a key portfolio component, tailored to investors’ return objectives and risk tolerance.
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.
