Canadian Dollar Weakness and Rising Yields in 2025: Navigating Currency Risk and Yield Curve Dynamics

The Canadian dollar (CAD) has entered a period of sustained weakness in 2025, driven by a confluence of monetary policy divergence, economic stagnation, and geopolitical tensions. For investors, this environment presents both risks and opportunities, particularly in currency risk management and yield curve positioning. By dissecting the forces at play, we can identify actionable strategies to navigate this complex landscape.

Factors Behind CAD Weakness

The Bank of Canada's dovish pivot has been a primary driver of CAD depreciation. In September 2025, the central bank cut its key interest rate to 2.5%, the first reduction in six months, to address a deteriorating labor market and subpar inflation Bank of Canada cuts rates to 2.5%, says ready to cut again if risks rise^[3]. This move, coupled with a readiness to ease further if risks materialize, has widened the yield gap with the U.S. Federal Reserve, which has maintained a hawkish stance. As of September 17, the U.S. 10-year Treasury yield stood at 4.08%, while Canada's 10-year bond yield hovered near 3.47% Canada 10-Year Government Bond Yield - Quote - Chart - Historical^[4], creating a -61 basis point (bps) spread—a stark contrast to the -125 bps gap seen in early 2025 Canada 10-Year Government Bond Yield - Quote - Chart - Historical^[4].

Domestically, Canada's economic fundamentals have worsened. Two consecutive months of job losses pushed unemployment to a nine-year high, while Q2 GDP contracted, eroding investor confidence Bank of Canada cuts rates to 2.5%, says ready to cut again if risks rise^[3]. Meanwhile, the commodity-dependent economy faces headwinds from volatile oil prices, as global oversupply and slowing demand have curtailed export revenues Canada 10-Year Government Bond Yield - Quote - Chart - Historical^[4]. Exacerbating these challenges, U.S. tariffs on Canadian steel and dairy products have introduced trade uncertainty, further dampening demand for CAD assets Canada 10-Year Government Bond Yield - Quote - Chart - Historical^[4].

Yield Curve Dynamics: Divergence and Steepening Opportunities

The U.S. yield curve has shown signs of steepening in 2025, reflecting divergent expectations about monetary policy. As of September 12, the 10-year minus 2-year Treasury spread stood at 0.50% (10-year yield at 4.06%, 2-year at 3.56%) Treasury Yields Snapshot: September 12, 2025 - dshort^[2], a positive slope that suggests market confidence in sustained economic growth. This contrasts with Canada's flatter curve, where the 10-year minus 2-year spread narrowed to 0.74% as of July 23, below its long-term average of 0.82% 10-2 Year Canada Bond Yield Spread (Market Daily) - Historical^[1]. The Canadian curve's compression reflects expectations of prolonged accommodative policy, with the Bank of Canada's August 25 rate cut (2.72% for 2-year bonds, 3.47% for 10-year) signaling a structural shift 10-2 Year Canada Bond Yield Spread (Market Daily) - Historical^[1].

For investors, these divergences highlight asymmetric opportunities. In the U.S., a steepening curve may favor long-duration bonds, as investors anticipate slower rate cuts in Q4 2025. Conversely, Canadian investors might prioritize shorter-duration instruments to mitigate risks from potential rate volatility. The narrowing U.S.-Canada 10-year yield spread—from -153 bps in February to -75 bps by year-end projections—also suggests a convergence in economic outlooks, driven by shared trade war pressures Canada 10-Year Government Bond Yield - Quote - Chart - Historical^[4].

Positioning for Currency Risk and Yield Curve Moves

Given CAD's vulnerability, hedging strategies are critical. Investors holding CAD-denominated assets should consider forward contracts or options to mitigate exposure to further depreciation. For those seeking yield, the U.S. dollar's relative strength makes it an attractive carry trade asset, though risks from trade tensions and Fed easing could limit gains.

In the bond market, the U.S. yield curve's steepness offers opportunities for curve steepeners—positions that benefit from rising short-term rates relative to long-term. Conversely, Canadian investors may find value in 2-year bonds, which have outperformed 10-year issues as policy easing expectations dominate.

Conclusion

The Canadian dollar's 2025 weakness underscores the interplay of monetary policy, economic fragility, and geopolitical risks. While the U.S. yield curve's steepening offers tactical advantages, Canadian investors must remain cautious about domestic headwinds. By aligning currency hedging with yield curve positioning, market participants can navigate this volatile environment with greater precision.