Bank of Canada warns Trump’s tariffs could trigger ‘market dysfunction’

Bank of Canada governor Tiff Macklem. The central bank released its assessment of potential risks to the stability of Canada's financial system Thursday. Photo by Justin Tang/The Canadian Press

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The Bank of Canada warns recent market volatility as a result of United States tariffs could lead a sharp repricing in assets, and in extreme circumstances, result in “market dysfunction.”

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“Now, the Canadian economy and financial system face a new threat,” said Bank of Canada governor Tiff Macklem, during prepared remarks in Ottawa. “Tariffs and uncertainty have sharply reduced prospects for global economic growth. And financial markets have been rocked by chaotic policy announcements and reversals.”

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The central bank highlighted key risks to the Canada’s financial system on Thursday in its Financial Stability Report (FSR). U.S. President Donald Trump’s protectionist trade policies roiled global markets last month and tariffs remain a source of uncertainty for the Canadian economy.

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While market volatility is a short-term risk, a global trade war could lead to severe economic consequences in the medium to long term, including slower growth and higher unemployment. This would result in some households and businesses being unable to keep up with their debt payments.

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“This could, in turn, have important ramifications for our financial system,” said Macklem. “If loan losses occur on a large enough scale, banks could cut back on lending in response. This would exacerbate the economic downturn and put more pressure on businesses and households.”

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The central bank presented two scenarios in its monetary policy report last month, opting not to publish forecasts given the uncertain trade environment with the U.S. In the first scenario, a deal occurs and tariffs are lifted, but growth stalls in the second quarter of 2025 and then averages 1.6 per cent through the end of 2027. In the second scenario, which assumes a protracted trade war occurs, GDP contracts for four quarters averaging about -1.2 per cent.

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Thursday’s financial stability report said Canadian banks remain well positioned to absorb higher credit losses.

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“Banks have increased their capital buffers in recent years and, more recently, they’ve increased provisions for credit losses, bolstering their resilience,” said Macklem.

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The report warns that the growing presence of hedge funds in the Government of Canada bond market “raises some concern” because they have taken out increasingly large amounts of leverage to purchase these bonds.

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“This makes them more likely to pull back from these crucial markets in periods of stress, introducing added volatility,” said Macklem.

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Macklem pointed to the recent “gyrations” in the U.S. Treasury market as an example of this risk. If the trade war causes a larger spike in volatility than we’ve seen so far, hedge funds “need to make sure that they are prepared to respond to sudden liquidity needs without disrupting market functioning,” he said.

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The report highlights improvements to risks that were concerns in last year’s FSR, including mortgage renewals and the ratio of household debt to disposable income which has now declined from 179 per cent to 173 per cent.