Are tariffs pushing up bond yields?

Escalation of the U.S. trade war casts a cloud over Canada’s economic prospects. The Bank of Canada will provide whatever support it can through accommodative monetary policy, although the latter’s effectiveness is likely to be dented by persistently elevated bond yields. In this Economic and Financial Market Update, we zoom in on why bond yields are rising and provide clues on whether or not that concerning trend will continue.

Trade war escalation cements near 1% GDP growth for Canada

The dreaded "In the middle" CUSMA scenario which we highlighted last June has materialized. With the U.S. declining to renew the trade agreement, there will now be mandatory annual reviews of CUSMA until its expiry, which is currently scheduled for 2036. In the meantime, American tariffs are still being imposed on various goods exported by Canada, with the list of impacted products getting a bit longer after the U.S. escalated its trade war in August. All in all, about one fifth of our exports are now subject to American tariffs which range from 10% to as high as 50% on some goods.

Exporters of non-energy goods, who have still not fully recovered from last year’s tariffs, now have to contend with this escalation of the trade war. That casts a cloud over the economic outlook in the second half of the year, as well as 2027. So, despite the uptick in economic activity observed in the second quarter, the Canadian economy remains on track to register its worst annual performance in six years, with 2026 GDP growth slated to come in near 1% (see forecast table at the end of this report). This below-potential growth print suggests the output gap, or excess supply, will remain wide open, and put downward pressure on inflation.

As such, look for inflation, which climbed to 3% in July amid rising energy prices, to come back down in the second half of the year. It’s true that Canada’s retaliatory tariffs, if they go ahead as planned later this month, may pressure prices a bit. But a Bank of Canada study on the 2025 retaliatory tariffs (which were larger than the ones planned for this month), found limited impacts on consumer price inflation i.e., just three tenths of a percentage point. More importantly, perhaps, is the fact that core inflation, which excludes volatile items, and is therefore a better gauge of underlying price pressures, remain mild in Canada, near 2%. In other words, the central bank won’t be in a rush to tighten monetary policy. We continue to see the overnight rate remaining unchanged at 2.25% for the next several months.

What’s pushing up bond yields?

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