BMO's Outlook on the Bank of Canada's Neutral Rate Range: Implications for Canadian Fixed Income and Equity Markets

The Bank of Canada's September 2025 rate cut, reducing the overnight rate to 2.5%, marks a pivotal moment in its monetary policy trajectory. This adjustment places the central bank at the midpoint of its estimated neutral rate range of 2.25% to 3.25%, a range that has remained unchanged since 2024 Assessing the US and Canadian neutral rates: 2025 update^[1]. BMO Capital Markets has underscored the significance of this development, emphasizing that the BoC's cautious approach—keeping the “door fully open” to further rate cuts—reflects a delicate balance between economic fragility and inflation moderation 2025 Capital Markets Outlook: Bunches and Punches^[3]. For Canadian fixed income and equity markets, this evolving policy environment presents both opportunities and risks, as outlined in BMO's latest analysis.

Neutral Rate Range and Economic Context

The Bank of Canada's neutral rate range of 2.25% to 3.25% is informed by a complex interplay of demographic, productivity, and trade policy factors. According to a 2025 update by Bank of Canada staff, slower population growth—partly due to reduced immigration—is a drag on potential output, while higher productivity growth, driven by AI adoption, partially offsets this trend Assessing the US and Canadian neutral rates: 2025 update^[1]. Additionally, trade policy uncertainty, particularly U.S. tariffs on Canadian exports, remains a critical risk. BMO notes that even in a prolonged trade war scenario, the neutral rate range remains stable, as the negative impact of tariffs on growth is counterbalanced by productivity gains BMO Global Asset Management 2025 market outlook^[2].

The recent 25-basis-point rate cut to 2.5% was a direct response to a weak labor market (7.1% unemployment in August 2025) and a 1.6% GDP contraction in Q2 2025, driven by U.S. tariffs Bank of Canada lowers policy rate to 2½%^[4]. BMO's Douglas Porter highlights that the BoC is “nimble” and prepared to act on new data, with further cuts expected in 2025 and 2026 2025 Capital Markets Outlook: Bunches and Punches^[3].

Fixed Income Market Implications

BMO anticipates a significant easing cycle in 2025, projecting the Bank of Canada's overnight rate to fall to 2.5% by June 2025 and remain there thereafter 2025 Capital Markets Outlook: Bunches and Punches^[3]. This aggressive easing is expected to reshape the fixed income landscape. For instance, BMO forecasts Canadian 2-year bond yields to decline to 2.75% and 10-year yields to 3.00% by year-end 2025, creating a steeper yield curve 2025 Capital Markets Outlook: Bunches and Punches^[3]. Such a shift would enhance returns for long-duration bonds and incentivize allocations to corporate credit assets, including investment-grade and high-yield bonds, which offer attractive yields amid a low-interest-rate environment Bank of Canada lowers policy rate to 2½%^[4].

The terminal rate in Canada is projected to settle at 2.75%, significantly lower than the U.S. Federal Reserve's expected 4.00% terminal rate Bank of Canada lowers policy rate to 2½%^[4]. This divergence could strengthen the Canadian dollar relative to the U.S. dollar and support domestic fixed income markets. BMO estimates that Canadian fixed income portfolios could deliver total returns in the 4% range in 2025, driven by falling yields and a resilient credit market 2025 Capital Markets Outlook: Bunches and Punches^[3].

Equity Market Outlook

BMO's bullish stance on Canadian and U.S. equities is rooted in the anticipated benefits of lower interest rates and a resilient U.S. economy. While Canada faces headwinds such as rising unemployment and high consumer debt, the strong U.S. economy—bolstered by its own rate-cutting cycle—creates a favorable backdrop for cross-border trade and corporate earnings BMO Global Asset Management 2025 market outlook^[2]. BMO Global Asset Management notes that Canadian equities, particularly in sectors like energy and technology, could benefit from a rebound in investor sentiment as rate cuts ease borrowing costs and stimulate economic activity BMO Global Asset Management 2025 market outlook^[2].

However, risks persist. A prolonged trade war or aggressive U.S. tariff hikes could force the BoC to accelerate rate cuts, potentially undermining corporate profits and equity valuations. BMO advises investors to maintain a balanced portfolio, hedging against trade policy risks while capitalizing on the current low-rate environment Rates Scenario for February 13, 2025 - economics.bmo.com^[5].

Conclusion

BMO's analysis underscores the Bank of Canada's pivotal role in shaping Canada's financial markets. With the neutral rate range anchoring policy expectations and further rate cuts on the horizon, fixed income markets stand to gain from falling yields and a steepening curve, while equities could benefit from a more accommodative monetary environment. However, investors must remain vigilant to trade policy uncertainties, which could disrupt these positive trends. As the BoC navigates a fragile economic landscape, BMO's outlook provides a roadmap for capitalizing on opportunities in both fixed income and equity markets.