Key Takeaways
- Slowing labor markets and cooling inflation are dragging bond yields down, but longer-term bond yields stay elevated.
- Canadian investment-grade bonds are set to outperform cash.
- The AAA rating keeps Canadian bonds attractive, sustaining foreign demand.
Canadian bond yields have been trending downward since mid-July 2025 across maturities, suggesting markets are increasingly pricing in further interest rate cuts by the Bank of Canada.
Fund managers say that, against a backdrop of weakening domestic economic data, trade tension, and a slowing US economy, the trend could persist for the foreseeable future.
Government of Canada two-year bond yields, which stood at 2.83% on July 15, fell to 2.54% by Sept. 5. The yield on five-year bonds similarly fell from 3.13% to 2.82%, while 10-year bond yields, which stood at 3.60% in July, dropped to 3.27% by Sept. 5. For the year to date, only 10-year yields have risen above their levels at the start of the year. The yield trajectory suggests that the market is increasingly pricing in another Bank of Canada interest rate cut.
“The recent decline in bond yields reflects a combination of weakening economic conditions and growing structural risks,” says Sam Acton, portfolio manager and co-head fixed income at Picton Investments. “Employment data in both Canada and the US has softened over the past six months, with unemployment rates trending higher and payrolls rolling over.”
Weak Economic Data Driving Short-Term Yields Lower
Analysts say the usual suspects—inflation, labor market conditions, and economic activity—have paved the way for falling bond yields. And some of these variables are showing weakness on both sides of the border.
While inflation remains hotter in the US than in Canada, the latest Canadian labor market report shows an unexpected loss of 66,000 jobs in August, marking two months of back-to-back declines. The unemployment rate also ticked higher in August to 7.1%, worse than estimated. Similarly, the Canadian economy contracted 0.1% in June, its third consecutive monthly decline.
In a similar vein, recent reports showing a broad-based slowdown in hiring south of the border paint a bleak picture of the US labor market.
“Canada is following the US, where softer data, especially the sizable downward revisions to job growth, has revived expectations for Fed cuts,” says Konstantin Boehmer, head of fixed income and portfolio manager at Mackenzie Investments.
The move has been especially pronounced in short-term bonds, which are more reactive to economic data and rate moves, edging lower during periods of economic weakness and falling interest rates.
And yields could continue to fall “if growth weakens further or inflation cools,” prompting the central bank to restart easing, Boehmer says. Although “strong upside surprises in jobs or inflation would challenge it,” he adds.
Sticky Long-Term Bond Yields
Longer-term bonds, though, are a different story.
Government of Canada 10-year bond yields increased by about 70 basis points between early April and July, before declining by 20 basis points since then. And it is global forces, such as large US budget deficits and trade war uncertainty, that are keeping longer-term Canadian government-bond yields elevated, according to Tiago Figueiredo, a macro strategist at Desjardins Capital Markets.
A key driver of this is the rising term premium, or compensation, for holding longer maturity bonds. This market dynamic “reflects the extra return investors demand for holding longer-term bonds above and beyond the overnight rate,” Figueiredo says.
Dagmara Fijalkowski, managing director, senior portfolio manager, and head of global fixed income and currencies at RBC Global Asset Management, says: “The expectations for the Bank of Canada have been fairly stable since the last meeting on July 30, [but] we have to remember that since the economy has not fallen into recession as a result of the early Trump tariff salvo directed to the north, the market actually reduced expectations for the number of Bank of Canada rate cuts by year-end.”
The Bank of Canada has left its policy rate unchanged at 2.75% at its past three meetings in April, June, and July after cutting seven consecutive times, including twice this year.
Even the three consecutive gross domestic product declines have only slightly nudged the needle on the odds of another rate cut.
Credit Quality and the Loonie Support Bond Outlook
The current local and global economic challenges notwithstanding, Canada stands out in this environment because of its strong fiscal position, supporting the view that Canadian bonds remain safe and attractive, which bolsters demand, Figueiredo says.
Canada boasts “the lowest general government deficit-to-GDP ratio in the G7,” he adds. “Our research shows Canada’s AAA credit rating [the highest possible sovereign credit rating] is secure for now.”
The current softening of the US dollar has further boosted the attractiveness of Canadian-dollar-denominated bonds to investors.
Figueiredo observes that “the Canadian dollar’s growing role as a reserve currency is boosting foreign demand for Canadian bonds.”
Meanwhile, concerns about US institutional stability may be prompting “a gradual shift away from US assets, potentially benefiting Canada,” he adds.
Outlook for Canadian Bond Yields
RBC’s Fijalkowski says bonds provide attractive incentives for investors to move off the sidelines. “Without heroic assumptions on long end yields dropping, and with healthy respect for term premium required by bond vigilantes, the scenario analysis suggests nice odds of coupon-type returns or better, with low odds of flat by year-end,” she says.
Bonds are quite likely to outperform cash over the next year, Fijalkowski says. By investing in Canadian investment-grade credit bonds, investors can earn, on average, an additional 100 basis points annually. “Real yields, net of inflation compensation, on an investment-grade bond portfolio (government and corporate risk) are 1.5% to 2.0%,” she adds.
Mackenzie’s Boehmer sees modestly lower yields by year-end. “A weakening domestic economy plus a [US] Fed, willing to cut, should support bonds,” he says.
The underlying assumption is that when the US central bank cuts, US yields fall, prompting investors to look elsewhere for higher yields. In this scenario, Canadian bonds offering higher yields become more attractive. However, when the capital flows into Canadian bonds, their prices soar and yields fall, owing to the inverse relationship between the two.
“The path won’t be linear, but the bias is toward lower yields as growth cools,” Boehmer says.
Echoing that sentiment, Picton’s Acton says to expect continued easing in yields.
“The short end of the curve is likely to drift lower as markets continue to price in central bank rate cuts, in response to slowing growth and rising unemployment,” he contends.
Conversely, the yield curve for the long-term bonds faces upward pressure, with inflation proving sticky and fiscal deficits expanding.
“The combination should result in a steeper yield curve by year-end,” he says.
Historically, a yield curve with a spread of 150–200 basis points between short-term and long-term maturities is not unusual, Acton says. The yield curve is a graphical representation of government-bond yields across different maturities.
Currently, the differential between two-year and 10-year yields stands at around 73 basis points. “The move we have already seen may still be in its early stages and could continue rising to the [historical] 150-200 basis-point range,” he says.
Acton’s message for bond investors is clear: “Be prepared for a Canadian curve that is meaningfully steeper, with short rates easing but long-term yields holding firm or even rising.”
RBC’s Fijalkowski prefers to analyze the performance of bond funds across a range of forward-looking scenarios—known as scenario analysis—rather than relying on a single forecast or expectation.
“Currently, the scenario analysis flags inherent asymmetric risk in corporate bonds, warranting a selective approach in that segment,” she says, highlighting that she has been “reducing exposure to corporate credit in aggregate and upgrading the quality of holdings.”
Fijalkowski insists that government bonds, while out of investors’ favor these days, offer better potential risk/reward.
