Canada – Walking the Tightrope
The Bank of Canada took center stage this week, holding its policy rate at 2.25%. It reinforced a message that has become increasingly clear: Canada’s economic growth is soft at the same time that risks to inflation remain elevated. The tone of the announcement struck a careful balance. Policymakers acknowledged that growth disappointed in Q1 and that excess supply persists, but flagged that higher oil prices are complicating the inflation outlook, despite core inflation measures having recently eased toward target.
This leaves the BoC in a narrow channel for future policy decisions. Importantly, Governing Council preserved optionality in both directions, noting it could respond if growth deteriorates more sharply or if inflation pressures filter through to core inflation. Markets interpreted the message as modestly dovish, with pricing for a 25 basis points (bps) hike by year-end edging lower following the decision. Recall, at the onset of the war, markets expected up to three quarter-point hikes by December as inflation concerns dominated. In that sense, market expectations are converging to our view that the policy rate will stay on hold through the rest of the year (Chart 1). Elsewhere in financial markets, upward inflation and rate hike expectations in the U.S. pushed the CAD to a fresh 7-month low (0.7140/USD), while Canadian government bond yields dipped by roughly 10 bps across the curve.
Away from monetary policy, this week’s data offered some constructive signals. Canada’s April merchandise trade surplus widened for a second consecutive month to the largest surplus since early 2025. While higher oil prices played a role, the details were encouraging: export volumes rose further and recent gains are reasonably broad-based (Chart 2). In other words underlying export momentum has improved after a weak start to the year. The upshot is that net trade now looks poised to contribute positively to Q2 growth, reversing its drag in Q1.
That improvement comes just as thse July 1 CUSMA review approaches. At this stage a timely renewal looks unlikely as negotiations have yet to gain steam. However, missing the deadline does not imply a collapse of the agreement. Instead, CUSMA would remain in force and would shift to rolling annual reviews, raising the spectre of prolonged negotiations and ongoing trade uncertainty. For the Canadian economy, that means that the backdrop remains unsettled, weighing on business confidence and investment decisions in the near-term.
Friday’s Q1 national balance sheet release added another piece to the puzzle. Household net worth rose 1.3% q/q, while the debt service ratio edged up to 14.8%, underscoring that while households continue to provide some support to activity, high debt burdens are a constraint for many. Taken together, this week’s developments point to an economy regaining its footing, but not yet strong enough – or stable enough – to declare the soft patch is over.
U.S. – Price Pressures Now on the Front Foot
Middle East tensions spiked and then eased again this week, with President Trump threatening new strikes on Iran and then calling them off as he noted progress toward a deal. WTI oil prices, which had been holding near $90/barrel, fell sharply toward $85/barrel. The 10-year Treasury yield also dipped initially, reflecting hopes that a resolution to the conflict would limit the energy shock’s spillover into broader inflation expectations, but recovered some lost ground later in the week as investors digested another firm inflation report.
The May CPI report was the clearest evidence that inflation pressures continue to build. Headline inflation accelerated to the fastest pace in three years – 4.2% year-on-year (Chart 1). Higher energy costs accounted for the bulk of that increase. The gain in core inflation was more contained, but the annual rate still moved further above target (2.9% y/y), adding support to a “higher for longer” policy stance. Sifting through the details, shelter cooled after April’s outsized gain and core goods prices slipped, but non-housing services remained firm.
Inflation pressure was also evident in the NFIB small business survey, where a growing share of firms reported that they had raised average selling prices and that they planned further increases in the months ahead. This supports the view that higher energy and input costs are starting to ripple beyond the pump.
Housing offered a modest reprieve from the sour inflation news. Existing home sales rose a solid 3.2% in May to the highest level since December. Still, little has changed in the broader picture, with activity hovering near the 4-million mark for the third consecutive year and home price growth remaining in the slow lane.
Labor market signals, meanwhile, were mixed. Initial jobless claims ticked higher for the third week in a row but remained broadly range-bound, while continuing claims are still low by historical standards. Signals out of the small business survey, however, were less reassuring on this front. Small businesses are pointing to slower job creation ahead, with job openings and hiring plans softening recently amid an increase in inflation concerns (Chart 2).
All told, the effects of the Middle East conflict continue to show up in the data, and this is becoming harder for the Fed to ignore. Our view is that core inflation will likely remain elevated through year-end, supporting the case for an extended Fed pause. Next week marks Kevin Warsh’s first FOMC meeting as Chair. Markets will be watching not only for a clear rate signal, but also for clues on how he intends to communicate. Warsh has indicated a preference for a shift in communication strategy, like potentially not holding a press conference after every Fed meeting. We expect the committee to telegraph a “higher for longer” policy stance in its updated Summary of Economic Projections, which had reflected 25 bps of easing this year and next. It is also likely to drop its easing bias in the statement. This expected shift would move the Fed closer to market pricing, which now reflects a toss-up between “no action” and a 25-bps hike by year-end.
