Could there be a Second Wave of Inflation?

Inflation may return next year, depending on the geography.

After experiencing nearly a 9% inflation surge in both the U.S. and Canada throughout 2022, the last two years have brought much-needed relief. Both countries saw a similar pattern of inflationary spikes and subsequent declines. However, we expect to see a divergence in 2025.

Looking ahead, the fiscal policies proposed by U.S. President-elect Trump could reignite inflationary pressures, if enacted. Mass deportations will cost money, tax cuts will spur higher spending, and tariffs will surely provoke retaliatory actions from any affected countries, all leading to price hikes across the board.

For these reasons, we anticipate that inflation in the U.S. could accelerate in 2025.

The bond and currency markets both appear to share our outlook. Long-term interest rates typically rise when inflation is expected. After all, any bond investor would demand higher interest payments as their purchasing power erodes because of rising prices. In September, the 10-year U.S. Treasury yield stood at about 3.6%. Since then, it has climbed to 4.4%. Meanwhile, the U.S. dollar has appreciated 7% against a basket of foreign currencies.

Despite the Federal Reserve’s decision to cut its benchmark rate by 25 basis points yesterday, U.S. inflation stood above the Fed’s target at 2.7% in November, year-over-year. We expect the Fed to pause its rate cuts moving forward and change its language from dovish to moderately hawkish.

Canada, however, faces entirely different circumstances.

Our year-over-year inflation rate was 1.9% in November, slightly below the Bank of Canada’s median target. Additionally, neither the bond nor currency market is forecasting any significant inflation in the near future. In mid-September, the 5-year Canada yield was 2.7%; today, it has only risen slightly to 2.9%. The Canadian dollar fell below $0.70 USD earlier this week—the lowest point since the pandemic. This signals that the currency market, much like the bond market, doesn’t anticipate inflationary pressures returning to Canada anytime soon. Currency speculators chase geographies with higher interest rates; without inflation, there’s no need for the Bank of Canada to change their dovish direction.

While tariffs on Canadian goods could create some inflationary pressure, we expect Trump’s threat against Canada to be resolved early on in his administration. Additionally, Ottawa has reduced its immigration target by 20% over the next three years, which is likely to dampen housing demand.

Should inflation in the U.S. reignite, the Federal Reserve will likely shift its stance on rate cuts, leading to increased volatility in U.S. equities. However, we don’t foresee similar inflationary pressures in Canada. As a result, we expect the Canadian market to fare better in comparison and predict that the TSX will outperform the S&P 500 next year.

-written by Jeff Pollock