The Bank of Canada has reduced interest rates by a quarter-point, from 2.75%. This was anticipated by most economists, following a rate cut in March. The rate-cutting began last June.
Global economic growth is showing signs of slowing down. Core inflation measures have hovered around 3% in recent months, but the earlier momentum has lessened. Underlying inflation stands at about 2.5%. The removal of most retaliatory tariffs on US goods is expected to reduce price pressures.
Governing Councils Careful Considerations
The Governing Council is moving cautiously, considering risks and uncertainties. Shifts in trade are likely to continue imposing costs, despite weighing on economic activity. The Council aims to support economic growth whilst controlling inflation.
The Governing Council is evaluating the evolution of exports amid US tariffs and trade relationship changes. They are also monitoring potential spillovers into business investment, employment, and household spending. Trade disruptions and supply chain changes may affect consumer prices and inflation expectations.
Before the announcement, USD/CAD was at 1.3761, a rise of 23 pips. Markets had largely expected the cut, with projections for further easing by June, including today’s 25 basis point reduction.
With the Bank of Canada now in an easing cycle while the US Federal Reserve remains on hold, the policy divergence between the two countries is widening. Recent US data from August 2025 showed core inflation holding firm at 3.2%, suggesting the Fed is unlikely to cut rates soon. This environment favors strategies that are long the US dollar against the Canadian dollar, likely pushing the USD/CAD pair towards the 1.4000 level last seen in early 2024.
Canadian Yield Curve Outlook
The rate cut should also cause the Canadian yield curve to steepen, a classic pattern observed in the early stages of past easing cycles. This means we expect short-term bond yields to fall more rapidly than long-term yields. Derivative traders should look at setting up steepener trades, which can be done by buying two-year Government of Canada bond futures (BAX) and simultaneously selling ten-year bond futures (CGB).
The Bank’s cautious tone signals that future rate cuts are highly dependent on incoming data, especially with underlying inflation still around 2.5%. The market is pricing a 52% probability of another cut in October, making the next employment and CPI inflation reports critical triggers for market volatility. We believe buying options straddles on the Canadian dollar, which profit from a large price move in either direction, is a sensible way to trade this event risk.
Looking further out, the market is pricing in just over one more 25-basis-point cut by June 2026. This seems low given that Canadian business capital expenditures have already contracted for two consecutive quarters in 2025, a historical indicator of a deepening economic slowdown. We see value in positioning for a more aggressive cutting cycle than is currently priced by the market, perhaps through interest rate swaps that pay a floating rate and receive a fixed rate.
