The Growing Interest Rate Gap and Its Impact on North American Markets
Policy alignment between neighbors is fraying
By
Franco Faraudo
– Editor, Propmodo
Bank of Canada’s decision to hold its policy interest rate at 2.25 percent in January underscored a widening gap between Canadian and U.S. monetary policy that has rarely been so clear in recent memory. Governor Tiff Macklem acknowledged elevated uncertainty about growth, trade, and inflation while keeping rates unchanged, leaving the door open to cuts or hikes depending on how economic conditions evolve. The BoC’s cautious stance reflects slower GDP growth in Canada, trade disruptions from tariffs and a softening labour market that have prompted economists to forecast a steady rate through 2026.
The Bank’s guidance contrasts sharply with how markets have been pricing U.S. Federal Reserve policy. Due to President Trump’s insistence on lowering rates and his attacks on Fed board members, traders have increasingly bet that the Fed will begin trimming rates earlier than previously expected. That pricing behavior has shown up in futures markets and in the relative trajectory of Treasury yields, where the implied probability of Fed rate cuts has climbed even as the BoC signals restraint. The result is a growing interest-rate differential between Canada and the U.S. that has animated currency markets, with the Canadian dollar gaining ground against the U.S. dollar as investors price in slower relative tightening in Canada.
Part of what’s shaping this divergence is how each central bank views its economic backdrop. The BoC’s inflation outlook remains near its 2 percent target, and recent surveys of economists suggest most do not expect a rate change in 2026 unless trade policy shocks intensify or growth weakens materially. Some models even show the next BoC move could be a hike in late 2026 or early 2027, a scenario driven by inflation and output conditions rather than U.S. financial cycles. Canadian policymakers are also more attentive to external risks, including renegotiations of the Canada-U.S.-Mexico Agreement, which they flag as a key downside risk to exports and business investment.
By contrast, the Federal Reserve’s rate path is being shaped by a different set of pressures, including persistent slack in some sectors and stronger signs of easing in inflation measures. Markets have priced multiple potential rate cuts for the U.S. in 2026 as underlying economic data and softening labour market indicators have shifted sentiment on how long high policy rates will be needed. That has introduced the possibility that U.S. interest rates could fall well below Canada’s—a scenario that would be historically noteworthy. Academic and central bank research shows that monetary policy divergences between Canada and the U.S. are common, but they typically emerge during tightening cycles and do not persist for long. If the U.S. moves into a cutting phase while Canada stays on hold or tightens slightly, this divergence could become one of the longest of its kind in recent decades.
If U.S. rates did drop significantly below Canadian rates, the implications would ripple through real estate and financial markets north and south of the border. Canadian borrowers would face relatively higher financing costs, potentially slowing household and business borrowing and amplifying the drag on sectors like housing and commercial property. A persistent rate gap could also strengthen the Canadian dollar further, making exports less competitive and complicating inflation dynamics. On the U.S. side, lower rates could ease mortgage costs and support investment in property markets that remain sensitive to financing conditions. Capital flows might tilt back toward U.S. assets if yield spreads compress, but those moves would also depend on relative growth prospects and currency expectations.
What’s shaping up is a monetary policy dance in which both central banks are responding to domestic signs of inflation and growth rather than simply following the other’s lead. Canada’s slower pace, anchored by its own neutral rate estimates and trade-driven uncertainty, could keep its policy curve flatter for longer. The U.S., with markets betting on rate cuts, could see a steeper downward shift. That divergence, once merely a technical point of economics research, is now becoming a live policy experiment with real implications for cross-border capital allocation, exchange rates, and financing conditions across property markets on both sides of the border.
