The financial system began 2025 with increased resilience
From the time of the 2024 Report until the beginning of 2025, major central banks eased monetary policy as inflation fell worldwide. Lower policy interest rates helped reduce vulnerabilities in the financial system related to debt serviceability.
Despite brief periods of volatility in global markets, Canadian fixed-income and other core funding markets functioned well, and debt issuance conditions remained solid. Banks maintained elevated levels of capital and liquid assets. Non-financial businesses also kept healthy balance sheets. As interest rates declined, the pressure on businesses and households with variable-rate debt and those facing mortgage renewals also eased.
At the same time, some risks increased. Financial asset prices rose, and valuations in some markets appeared elevated. Global debt levels also increased. Leverage of some non-bank financial intermediaries (NBFIs) continued to grow alongside a rise in their participation in core funding markets.
The trade war and pervasive uncertainty have rattled markets
Since January, the unpredictability of US trade policy has caused a sharp increase in uncertainty and market volatility. The new tariffs announced by the United States in early April were significantly larger than market participants had anticipated. This led to sharp repricing in equity, bond and currency markets as investors revised their economic outlooks. Benchmark equity indexes fell sharply before recovering almost entirely, while stock market volatility rose to its highest level since the COVID-19 crisis. Sovereign bond yields in Canada and the United States saw large swings. Many investors appeared to diversify away from US assets. The US dollar and US Treasuries weakened in tandem with stocks instead of playing their traditional safe-haven roles amid uncertainty. Part of that weakening may reflect an unwinding of leveraged positions by hedge funds and other market participants.
Even as volatility spiked and liquidity at times diminished in some asset classes, markets continued to function relatively well both globally and in Canada. But market participants in Canada have been cautious. Some have pre-emptively adjusted their portfolios or investment strategies, reduced the amount of risk they take on or sought additional protection against losses. Many are also reviewing whether their hedging strategies need to be adjusted to reflect recent market conditions.
The trade war and ensuing uncertainty have reshaped the global backdrop, lowering the prospects for global growth and raising inflation expectations.
Vulnerable households and businesses may struggle with debt, causing credit losses
In Canada, uncertainty about the scope and duration of the trade war has weighed on consumer and business sentiment and decisions.
To assess how a trade war could affect the Canadian economic outlook, the Bank’s April 2025 Monetary Policy Report (MPR) presented two illustrative scenarios spanning a wide range of paths for US trade policy. In Scenario 1, most new tariffs get negotiated away and their impact is limited, although uncertainty remains. In Scenario 2, a long-lasting global trade war with large and permanent tariffs brings severe economic consequences for Canada, including a year-long recession. These are two of many possible outcomes and, importantly, they are not forecasts.
At the same time, the MPR acknowledged the presence of further downside risks to these scenarios from potential worsening of financial stress. Permanent tariffs could cause high unemployment and business insolvencies that result in defaults on household and business debt. This would lead to credit losses for banks and would test the financial system’s resilience.
Canadian banks have maintained healthy balance sheets, putting them in a good position to absorb higher credit losses (Box 1). Nevertheless, credit losses could lead banks to reduce lending. This could exacerbate an economic downturn.
The trade war increases the risk of disorderly market sell-offs
Continued US trade policy uncertainty could spur further market volatility and an abrupt repricing of assets, which in turn could lead to acute and persistent liquidity pressures that test the financial system’s resilience.
A further correction in asset prices could be amplified if leveraged investors were to quickly unwind their trading positions. Asset managers might hoard cash and sell fixed-income assets to meet fund redemptions or margin calls. Liquidity in core funding markets could deteriorate if volatility caused hedge funds to step away from these markets or to quickly reduce leverage. This risk is exacerbated by the increasingly large presence of hedge funds in sovereign bond markets, including in the Government of Canada securities and repurchase (repo) markets.
Banks could also cut back on their intermediation services to protect their balance sheets—further disrupting the supply of liquidity when market participants need it most.
For a detailed assessment of the potential impacts of a trade war, see In focus—How a severe and long-lasting global trade war could affect financial stability.
