On the Radar: Impact Of December 2025 Rate Decisions On The Canadian Bond Yield Outlook

Three Takeaways

• The Bank of Canada held its benchmark overnight rate at 2.25 percent on Wednesday, reinforcing a near-term floor for Canadian short-term yields.
• A divided U.S. Federal Reserve cut its policy rate to a 3.50–3.75 percent range, signaling a tentative pause and highlighting unusual internal disagreement.
• The probability of a 25 bps cut in January is 21% in both Canada and the U.S.

The Bank of Canada holds at 2.25 percent and anchors the short end

On Wednesday, the Bank of Canada kept its policy rate at 2.25 percent, the level reached after four cuts earlier in 2025. The governing council described this rate as about the right level to keep inflation close to the 2 percent target while supporting the economy during a period of structural adjustment. With that message, the bank effectively told markets that the easing phase is over for now and that any change, in either direction, will be data-driven rather than pre-scheduled.

The decision reflects a balanced risk assessment. Headline inflation has been running close to 2 percent, with the bank estimating underlying (core) inflation at around 2.5 percent. Growth has surprised on the upside, with third-quarter real GDP reported at an annualized 2.6 percent, up from the 0.5 percent the bank had projected, helped by a stronger trade balance after a weak second quarter. At the same time, the labour market remains soft but improving, with the unemployment rate moving down from a recent peak of about 7.1 percent to 6.5 percent in November and roughly 180,000 jobs added over three months.

Given that backdrop, the bank is signaling that it wants to avoid stimulating the economy but also does not want to risk over-tightening into a still fragile adjustment to higher tariffs and trade uncertainty. Officials stress that uncertainty around the outlook is greater than normal and that they are prepared to move in either direction if there is a material change in the data. For markets, that language points to a relatively firm anchor at the very short end of the curve. The overnight rate and related instruments, such as three-month Treasury bills, are likely to trade in a narrow band around 2.25 percent as long as inflation and growth remain consistent with current forecasts.

The derivative markets  pricing puts the probability of a cut at the next Bank of Canada meeting on January 28 at only about 21 percent, based on overnight index swaps and futures pricing. That market-based probability is low enough to reinforce the idea that the base case is “on hold” rather than further easing. Short-dated yields tend to converge to what markets believe is the prevailing policy rate plus a small term premium, so this pricing suggests stability at the short end unless new data persuade investors that a cut or a hike is back on the table.

U.S. Federal Reserve cut and rare division in the FOMC

Later on Wednesday, the U.S. Federal Reserve cut its target range for the federal funds rate by 25 basis points to 3.50–3.75 percent. On the surface, that looks like a straightforward continuation of the easing cycle that began in 2024, but the details of the vote and the projections matter more for Canada’s bond market than the single move itself.

Three policymakers dissented. Two regional Fed presidents argued that rates should have been left unchanged, while one governor argued for a larger half-point cut. This three-way split, with hawkish and dovish dissents on the same decision, is rare. It is the first time since 2019 that there have been three dissents on a Fed rate decision.

The Fed’s new projections show a median expectation of just one more quarter point cut in 2026, the same profile officials sketched in September. Inflation is forecast to ease to roughly 2.4 percent by the end of next year, while real GDP growth is projected at about 2.3 percent, with the unemployment rate near 4.4 percent. Chair Jerome Powell emphasized that, after a cumulative 75 basis points of cuts since September and 175 basis points since the previous year, the fed funds rate is now within a broad range of estimates of its neutral value. In other words, the Fed believes policy is no longer clearly restrictive and is now at a point where it can wait to see how the economy reacts.

The key tension inside the Fed mirrors the dual mandate. Inflation remains slightly above the 2 percent target and has been drifting higher again, partly due to tariff-related cost pressures. At the same time, job gains have slowed, and the unemployment rate has risen to around 4.4 percent from earlier lows, raising concern that the labour market is cooling more than headline growth suggests.

When the Fed faced similar trade-offs in the past, such as during the early stages of the 1970s stagflation or in some late-cycle phases in the 1990s, internal division often increased as different groups of policymakers prioritized inflation or employment risks differently.

Near term outlook for Canadian overnight and short term yields

With the Bank of Canada signalling comfort at 2.25 percent and the Fed hinting at a pause, the near-term outlook for Canadian overnight and very short-term yields is one of cautious stability. ions for one or two years of stable policy, rather than large swings based on hopes of rapid cuts.

Short-term yields could still move within that band as new data arrive. A string of weaker data on Canadian employment or output, or a faster-than-expected decline in core inflation, would likely cause markets to raise the perceived probability of a cut at upcoming meetings, pulling two year yields lower. Conversely, if growth and employment surprise on the upside and inflation measures drift higher, markets would begin to price in a small chance of hikes in late 2026, pushing two year yields up even if the bank insists that its base case is to stay put. The point is that the overnight rate has found a near term home, and the burden of proof has shifted to the data.

Medium term path for 5 year and 10 year Canadian yields

The medium term story is more complex, because 5-year and 10-year Government of Canada yields embed expectations about the entire future path of short rates plus inflation risk and term premiums. These maturities are also the reference points for most fixed rate mortgage pricing, so movements here have a large impact on mortgage pricing.

If the BoC and the Fed are broadly right about the economy, a reasonable baseline is a gradual steepening of the Canadian yield curve. In that scenario, the overnight rate stays around 2.25 percent for an extended period, but 5-year and 10-year yields drift somewhat higher as investors internalize a world where growth remains positive and inflation is close to target. The revisions to Canadian GDP, which showed stronger growth in 2022 through 2024 than previously thought, suggest the economy has greater underlying momentum and capacity than earlier estimates implied.

Even in a benign baseline, investors will demand some compensation for the risk that inflation or term premiums could move higher over five to ten years. Tariff related price pressures, global supply disruptions, and fiscal policies all create the possibility that inflation could run somewhat above 2 percent for stretches of time. The Fed has already noted that tariffs have contributed to a steady upward drift in inflation from 2.3 percent to 2.8 percent in recent months. If similar forces show up in Canada, bondholders may ask for higher yields at longer maturities even if the Bank of Canada keeps its overnight rate unchanged. That would tend to push 5 year and 10 year yields higher relative to the overnight rate and gradually steepen the curve.

For now, the weight of evidence suggests that Canadian 5-year and 10-year yields are entering a phase where they are less driven by one-way expectations of cuts and more by a dynamic balance between growth, inflation, and central bank credibility.

The unusual degree of division at the Fed is an important part of that story, because it reminds investors that the policy path is not preordained and that the internal debate inside central banks can move markets almost as much as the official decisions.