USD/CAD and the Impact of Soft US Inflation on Carry Trade Strategies: Rebalancing Forex Exposure in a Lower-Yield Environment

The USD/CAD carry trade, once a cornerstone of forex strategies in a high-yield environment, is now navigating a landscape reshaped by soft U.S. inflation and divergent central bank policies. With U.S. inflation easing to 2.7% in November 2025-a decline from 3% in September and the lowest core rate (2.6%) since 2021-investors must reassess how to position their forex exposure in a world where yield differentials are narrowing according to recent data. Meanwhile, the Bank of Canada's decision to hold its overnight rate at 2.25% while U.S. rates hover at 3.50–3.75% creates a fragile but still viable window for carry trade strategies as reported by the Bank of Canada. However, the path forward demands caution, as structural adjustments in both economies and lingering inflationary risks complicate the calculus.

The U.S. Inflation Slowdown: A Double-Edged Sword

The U.S. Federal Reserve's December 2025 rate cut, the third in three months, reflects a growing consensus that inflation is decelerating but remains stubbornly above the 2% target. According to a report by the Bureau of Labor Statistics, November's headline inflation of 2.7% was driven by slower housing and food price increases, though core inflation edged down to 2.6%. This softening has emboldened the Fed to reduce rates, but its own projections-citing inflation above 2% until 2028-underscore that the lower-yield environment may persist longer than investors hope as projected by U.S. Bank.

For USD/CAD carry traders, this means the traditional allure of the U.S. dollar as a high-yield asset is dimming. While the Fed's 3.50–3.75% rate range still outpaces Canada's 2.25%, the spread has narrowed significantly from historical averages. As stated in its December 2025 statement, the rate cuts were justified by "a data-dependent approach to ensure inflation remains on a sustainable path to 2%". This signals a prolonged period of cautious monetary policy, which could erode the returns of carry trades reliant on aggressive rate differentials.

Canada's Stable but Uninspiring Policy Stance

On the Canadian side, the Bank of Canada's decision to maintain its overnight rate at 2.25% in November 2025 reflects confidence in its inflation control framework. Data from Statistics Canada shows that annual inflation held steady at 2.2%, with food prices driving the headline number. Core inflation measures, such as CPI-median and CPI-trim, fell to 2.8%, the first time since March 2025 they've dipped below 3% according to The Globe and Mail. This has allowed the central bank to avoid further tightening, preserving liquidity for Canadian borrowers while keeping the CAD from depreciating too aggressively against the dollar.

However, the lack of rate hikes means the yield advantage for USD/CAD carry trades is not as pronounced as in previous cycles. For instance, the 1.25% spread between U.S. and Canadian rates (3.75% vs. 2.5% deposit rate) is modest compared to the 2–3% spreads seen in 2023. As noted in its opening statement, policymakers emphasized that the current rate is "at about the right level to support the economy during structural adjustment". This suggests that Canadian rates may remain anchored, limiting the potential for carry trade expansion.

Rebalancing Forex Exposure: Strategies for a Lower-Yield World

Given these dynamics, investors must rebalance their forex exposure to mitigate risks while capitalizing on the modest yield differential. Here are three key considerations:

1. Hedging Against Inflation Volatility: While U.S. inflation has softened, the Fed's own projections highlight that it will remain above target for years as reported by CNBC. Carry traders should hedge against unexpected inflation spikes by incorporating inflation-linked derivatives or short-term Treasury securities into their portfolios.

2. Diversifying Carry Trade Portfolios: With the USD/CAD spread narrowing, investors should diversify into other currency pairs with more attractive yield differentials, such as USD/JPY or USD/CHF, where central banks like the Bank of Japan or the SNB may offer more aggressive rate cuts.

3. Monitoring Structural Adjustments: Both the U.S. and Canada are undergoing structural shifts-such as supply chain realignments and energy transitions-that could disrupt inflation trajectories. For example, the U.S. government shutdown delayed October CPI data, creating uncertainty around November's figures. Carry traders must remain agile, adjusting positions as new data emerges.

Conclusion: A Delicate Balance

The USD/CAD carry trade is at a crossroads. Soft U.S. inflation and the Fed's rate cuts have created a lower-yield environment, while Canada's stable but unexciting policy stance limits the potential for outsized returns. For investors, the key lies in rebalancing forex exposure through hedging, diversification, and close monitoring of structural risks. As the Fed and Bank of Canada navigate their respective inflation targets, the carry trade will require a more nuanced approach-one that prioritizes resilience over aggressive yield capture.