The Escalating Case for Rate Cuts in Canada: Implications for Equity and Fixed Income Markets

The Canadian labor market has entered a critical phase, with unemployment surging to 7.1% in August 2025—the highest level since May 2016, excluding pandemic-era disruptions [1]. This deterioration, driven by a loss of 66,000 jobs in August alone and a 0.2 percentage point rise in unemployment from July, has intensified pressure on the Bank of Canada to implement further rate cuts. With inflation easing to 1.7% in July and GDP contracting by 1.6% annualized in Q2 2025 [3], the central bank faces a delicate balancing act: addressing labor market weakness while navigating trade-related uncertainties.

Labor Market Deterioration and Policy Implications

The August jobs report revealed a broad-based slowdown, with job losses concentrated in part-time roles (-60,000) and key sectors such as professional services (-26,000), transportation (-23,000), and manufacturing (-19,000) [1]. Youth unemployment remains stubbornly high at 14.5%, while core-aged men and women saw employment declines of 58,000 and 35,000 jobs, respectively [1]. These trends underscore a labor market struggling to absorb shocks from U.S. tariffs and global supply chain shifts [5].

The Bank of Canada, which has maintained its benchmark rate at 2.75% since July 2025, now faces mounting expectations for a 25-basis-point cut in September. Market pricing suggests a 90% probability of such a move, with analysts from BMO and Scotiabank forecasting additional cuts in October [2]. Governor Tiff Macklem has signaled openness to further easing if downward inflationary pressures from a weaker labor market outweigh upward pressures from trade tensions [4]. This aligns with the Bank’s updated projections, which anticipate inflation remaining near its 2% target despite the labor market slowdown [3].

Equity Market Responses to Rate Cut Expectations

Historical patterns suggest that equity markets often react positively to anticipated rate cuts, particularly in sectors sensitive to borrowing costs. In August 2025, the S&P/TSX Composite Index hit a record high as investors positioned for policy easing, with materials and healthcare sectors outperforming [1]. However, financials and energy stocks faced headwinds amid concerns over trade-related volatility and debt serviceability [6].

The current environment mirrors past cycles, such as the March 2025 labor market slump, when a 33,000-job loss triggered renewed rate cut speculation and a surge in equity valuations [4]. While rate cuts typically lower borrowing costs and stimulate economic activity, their effectiveness remains constrained by external factors like U.S. tariffs, which have contributed to a year-long recession in some Bank of Canada scenarios [3].

Fixed Income Markets and Yield Dynamics

Fixed income markets have already priced in aggressive rate cuts, with Canada’s five-year bond yield falling to its lowest level since early June 2025 [1]. The 10-year bond yield followed suit, declining as investors anticipated further monetary easing. This trend reflects historical patterns where labor market downturns have driven bond yields lower, as seen during the August 2025 jobs slump [6].

The Bank of Canada’s Financial Stability Report highlights that rate cuts help alleviate debt serviceability pressures for households and businesses, reducing systemic risks [3]. However, trade uncertainties have introduced volatility, with bond yields expected to remain range-bound between 2.75% and 3.25% in 2025 [5]. Institutional investors, including foreign buyers and Canadian pension funds, have also influenced bond price movements, amplifying the impact of policy expectations [3].

Conclusion: A Policy Dilemma and Market Outlook

The Bank of Canada’s September 17 decision will be pivotal in shaping the trajectory of Canada’s labor market and financial conditions. While rate cuts are likely to provide short-term relief to households and businesses, their long-term efficacy depends on resolving trade tensions and stabilizing employment. For investors, the equity market’s sectoral divergences and fixed income yields’ sensitivity to policy signals underscore the need for a balanced approach. As the central bank navigates this complex landscape, markets will remain closely attuned to labor data, inflation trends, and geopolitical developments.

Source:
[1] The Daily — Labour Force Survey, August 2025 [https://www150.statcan.gc.ca/n1/daily-quotidien/250905/dq250905a-eng.htm]
[2] 'Exceptionally weak' jobs report prompts markets to price in 90% chance of BoC rate cut this month [https://www.theglobeandmail.com/investing/markets/inside-the-market/article-market-based-odds-of-boc-rate-cut-this-month-zoom-to-90-after-weak/]
[3] Financial Stability Report—2025 [https://www.bankofcanada.ca/2025/05/financial-stability-report-2025/]
[4] Posthaste: The odds of a Bank of Canada rate cut just rose ... [https://ca.finance.yahoo.com/news/posthaste-odds-bank-canada-rate-120006721.html]
[5] Canada: Real GDP Takes a Tariff-Induced Dive in Q2 [https://www.desjardins.com/en/savings-investment/economic-studies/canada-quarterly-gdp-august-2025.html]
[6] Canada's Labor Market Stumbles, Putting Bank of Canada Interest Rate Cuts Back on the Table [https://global.morningstar.com/en-ca/economy/canadas-labor-market-stumbles-putting-bank-canada-interest-rate-cuts-back-play]