Introduction to Canada’s Economic Outlook
Canada has officially entered a recession due to the escalating trade dispute with the United States. According to a new forecast from Oxford Economics, the economic drag may be softened over time thanks to a sharp increase in federal defence spending. This spending is expected to push bond yields higher, affecting mortgage rates and the overall economy.
Impact of Defence Spending
Oxford Economics has revised its GDP forecast slightly higher for 2025 to 0.9%, up from 0.8%, to reflect Ottawa’s recent pledge to raise military spending to 2% of GDP by the end of this fiscal year. The government also plans to steadily ramp up funding to meet NATO’s new 5% target by 2035. This additional spending will support growth in later years but is expected to be deficit-financed, raising the federal debt burden and long-term borrowing costs.
Effect on Bond Yields
The forecast puts the 10-year Government of Canada bond yield at 4.0% by 2027, up from 3.84% in last month’s estimate. This increase in bond yields is likely to impact mortgage rates, making borrowing more expensive for consumers and businesses.
Pressure on Mortgage Rates
The updated forecast from Oxford Economics arrives amid elevated bond yields, which have already been impacting fixed mortgage rate pricing. Lenders across the country have been steadily increasing rates across various terms in recent weeks, reflecting higher funding costs and economic uncertainty. As for variable-rate pricing, Oxford expects the Bank of Canada to hold its policy rate at 2.75% for now, weighing the opposing forces of slowing growth and persistent inflation risks.
Inflation and Interest Rates
While Oxford doesn’t rule out another one or two quarter-point rate cuts, it says the policy rate is unlikely to fall below 2.25% unless inflation continues to ease and the economy needs additional support. The forecast suggests that inflation pressures are building, with headline inflation expected to rebound to 3% by mid-2026 as temporary Canadian tariff relief expires and supply chain disruptions feed into prices.
The Impact of Tariffs
The forecast was shaped by significant uncertainty around Canada-U.S. trade relations. Without a new economic and security agreement, and if U.S. President Donald Trump follows through on his threat to impose tariffs on non-USMCA Canadian goods, the recession could deepen and drag on. U.S. tariffs will lead to fewer Canadian goods exports, while uncertainty and a weaker job market will hurt domestic demand.
Economic Projections
Oxford projects a 0.8% peak-to-trough GDP contraction from Q2 to Q4 2025 and anticipates the unemployment rate could rise to 7.6% (from 6.9% currently) as job losses spread beyond trade-exposed sectors. The outlook snapshot provides a detailed summary of the economic projections for the next few years.
Outlook Snapshot
| Category | 2024 | 2025 | 2026 | 2027 |
|---|---|---|---|---|
| GDP growth | 1.6% | 0.9% | 0.4% | 3.0% |
| CPI inflation (y/y) | 2.4% | 2.3% | 2.6% | 1.9% |
| Unemployment rate | 6.4% | 7.2% | 6.7% | 6.2% |
| 10yr bond yield (end of period) | 3.23% | 3.65% | 3.91% | 4.00% |
| Policy rate | 3.25% | 2.75% | 2.75% | 2.75% |
Conclusion
In conclusion, Canada’s economy is facing significant challenges due to the trade dispute with the United States. The increase in defence spending may provide some support to the economy, but it also raises concerns about the federal debt burden and long-term borrowing costs. The pressure on mortgage rates and the potential impact on inflation and interest rates are key factors to consider in the coming months. As the economic outlook continues to evolve, it is essential to monitor the developments in Canada-U.S. trade relations and their effects on the economy.
