Where are interest rates headed in 2025?

The Bank of Canada (BoC) delivered another 50 basis point (bps) interest rate reduction in December 2024, its second like this in less than two months. Amongst major global central banks, the BoC has the most aggressive policy easing Opens a new window.. We expect it to remain one of the most dovish in coming months. 

This view reflects the near-term economic outlook where the downside risks to growth currently appear to outweigh the risks of a renewed rise in inflation. Although several key inflation indicators have fallen below the BoC’s 2% policy target, inflation — excluding mortgage interest cost — averaged just 1.2% over the past 3 months. The output gap remains negative, applying downward pressure on inflation. And labour markets also softened, with the unemployment rate in November two percentage points higher than its 2022 low.

The level of interest rates has also become an increasing impediment for key segments of the housing market. Recent BoC rate cuts are expected to result in only a modest decline in mortgage rates. This further strengthens the case for additional rate cuts to help lower mortgage rates and support Canadian housing activity.

We anticipate an additional 75 bps of cuts in 2025, which would lower the BoC’s policy rate to 2.5% and account for 250 bps in total interest rate cuts since June 2024. BoC policy easing through rate cuts is expected to become an increasingly important tailwind for economic activity and we expect gross domestic product (GDP) growth will likely gain momentum in the second half of 2025. 

Consumer spending is expected to be an important driver of this recovery reflecting strong income growth, excess savings, a modest easing in fiscal policy, and a recovery in labour demand. The threat of U.S. tariffs is a risk to this constructive view Opens a new window.. But we currently see this primarily as a negotiating tool. Any increase in spending — for instance, on border protection — triggered by tariff negotiations would actually reinforce our positive growth outlook.

An expected recovery in GDP growth will likely be supportive of higher corporate earnings. This is constructive for Canadian equities, particularly in the context of benign longer-term valuations. Our tactical asset allocation positioning remains overweight in Canada and underweight in international equity, where the economic outlook is less constructive and where the threat of tariffs may be more significant. Concurrently, with the BoC likely to ease by more than the U.S. Federal Reserve and with the threat of U.S. tariffs likely to linger well into 2025, we see the risk of a further weakening in the value of the Canadian dollar against the U.S. dollar. 

Against a backdrop of declining interest rates and an outlook of accelerating growth, Canadian bonds present an attractive income-generating opportunity with relatively small downside risk — an appealing characteristic in a period of considerable uncertainty.