Navigating bond markets in the Trump era

The trouble with bond yields

Since even before his inauguration in January, President Trump has made no secret of his desire for lower interest rates. This sort of political pressure on central banks often concerns investors—except, in this case, Chairman Jerome Powell is nearing the end of his tenure as head of the U.S. Federal Reserve (Fed).

When Powell’s term ends, the belief is that President Trump will likely move on, which in turn means that the Fed chair is currently free to act based on data alone. He has all the independence a central banker can possibly dream of. Now his only job is to manage a graceful exit.

This may prove difficult, however, as we find ourselves in a strange environment where interest rate cuts do not always result in cheaper borrowing costs. For example: when the Fed recently reduced the benchmark rate by 100 basis-points, we actually saw yields on 10-year Treasury notes increase by nearly 100bps.

What we’re seeing there is a simple normalization of the yield curve. The curve was inverted for so long that rates were bound to become upward sloping at some point, and the tipping point appears to be President Trump’s policy agenda. Whether it’s tariffs or tax cuts, markets clearly view the proposals as inflationary and have therefore been driving up longer-term yields, which in turn makes the curve look “normal” by historical standards.

Of course, the underlying assumption here is that most or all of President Trump’s proposals will pass Congress. The market is very reactionary at the moment, and the pendulum could swing back if some of his ideas don’t make it into reality. At present, the base expectation is for the Fed needing to maintain higher interest rates over the long run to fight a resurgence of inflation—which means borrowing costs are unlikely to drop meaningfully in the foreseeable future.

Volatility in the Trump era

Entering the new Trump era, our gameplan was to brace for anything in the first 100 days. That strategy has generally panned out well. The back and forth on tariffs has kept markets on edge, and the potential for a permanent trade war will likely drive higher volatility. Of course, what is impossible to know is if any tariffs will stick—Trump can continue to either waive or delay the tariffs, as he has done previously.

In the past, we have seen the market adopt a Teflon-like attitude to the president’s comments. Investors built an immunity to the noise during Trump’s first term in office, but this term may be different and short-term volatility will almost certainly continue. From retaliatory tariffs to an expansion of the trade war to Europe, we should expect further surprises.

Impact on the Canadian economy

Unfortunately, the Canadian economy is likely to suffer setbacks on account of the confusion. Business investment, which was starting to mend on account of the Bank of Canada’s rate cuts, will now be interrupted by other considerations, such as whether or not to relocate part of their production down south. The uncertainty itself is crippling. Not knowing Trump’s endgame will make it challenging for CEOs to make strategic decisions in this environment, which puts in jeopardy hiring, spending, and the fragile recovery that was beginning to take root.

Case in point: job growth slowed significantly in February, keeping the unemployment rate at 6.6% for a second straight month.¹

The tariff blow only widens the gulf between the U.S. and Canadian economies. We were already facing the problem of slower gross domestic product (GDP) and high population growth (via immigration), which has not been easy to manage from a policy standpoint. On a per capita basis, our economy has contracted for nearly two years—a clear hallmark of recession. By contrast to the past decade where the U.S. was acted as the safe harbour during storms, Trump’s policy uncertainty around trade, and the wake-up call it has triggered, notably in Europe, has challenged the established superiority of U.S. assets in 2025. Unfortunately for Canada, its dependence to U.S. trade leaves it in a more precarious situation.

Outlook: Terminal rates

Naturally, we saw movements in the bond market as a result of the tariff talks. Investors sold credit as that uncertainty came into the market and the yield curve began to normalize, particularly with respect to U.S. bonds. On the Canadian side, the expectation for further Bank of Canada rate cuts remains priced in at the moment, whereas market expectations for the Fed remain in flux. We could see a pause in June at the earliest, but only if inflation is well and truly tamed by then.

Right now, most market participants seem to have two potential outcome scenarios in mind: with tariffs and without. The base case is the latter: investors expect the Bank of Canada to cut rates one more time to reach a terminal rate of 2.5% if trade tensions cease between the U.S. and Canada. Our prediction is slightly lower at 2.25%. Should the tariffs become permanent, we believe rates could go even further and settle somewhere between 1.25% and 1.5%.

South of the border, a no-tariff scenario for the Fed will likely culminate at a benchmark interest rate of 3.25 to 3.5%. However, as mentioned above, a prolonged trade war would likely create inflationary pressure in the U.S., meaning the U.S. central bank would be vastly more constrained than its Canadian counterpart and could have to hold rates at 4%.

The difference in outlooks sets a positive environment for broad Canadian fixed income strategies. We have seen positive flows in the underlying ETFs for the BMO Aggregate Bond ETF Fund and the BMO Corporate Bond ETF Fund, both of which offer full term exposure that helps manage the risks of yield curve normalization. Investors are beginning to move out on the curve, so yes, the short-end may come down, but long-term yields are likely to increase and there’s a way to balance that exposure.

The good news for the U.S. is that Powell at helm, unencumbered by distractions, bodes well for markets. His views on policy have been far more pragmatic that they were in his early days as a rookie central banker. In 2018, for example, he insisted on dogmatically following academic models which told him to raise interest rates four times in the span of a year. It led to weaker economic growth and fueled a wave of recession wave which led to sharp losses for equities in the fourth quarter of that year.

The Powell of today has a more nuanced application of central banking. He seems to understand that monetary policy is less about getting the theory perfectly right and more about avoiding major mistakes. It is an iterative process. You can always cut rates to put a lid on anxiety, and then, regardless of political pressure, pause if the data changes.

Please contact your BMO Global Asset Management wholesaler for any additional support and guidance.

Sources

¹ Canada’s Job Market Stalls After Months of Strong Gains, Bloomberg, March 7, 2025.