Key Takeaways
- Canadian bond yields have surged back toward recent highs.
- A sharp runup in US bond yields is the primary driver of Canadian yields, analysts say.
- A stronger Canadian economy and a shift in the Bank of Canada’s outlook have also contributed to rising yields.
Canadian bond yields have marched higher since the beginning of July, clawing back toward their highest levels since mid-May. Analysts say a selloff in US Treasuries has been the main catalyst, while stronger-than-expected Canadian economic data and a shift in the outlook for the Bank of Canada away from interest rate cuts toward a possible hike have added to the pressure.
In the US market, bond investors are concerned about diverse forces that have sent yields on US government bonds soaring to multidecade highs. They include Federal Reserve policy uncertainty, a hefty government deficit, ballooning corporate borrowing fueled by the artificial intelligence buildout, and inflationary pressures from higher energy prices linked to the Iran war. Similar moves in other developed markets—including the United Kingdom, France, and Japan—have intensified the bond rout and added to broader unease in global markets, including Canada.
This cross-border dynamic has affected Canadian bonds of all maturities. The yield on 10-year Government of Canada bonds has risen to 3.69% from 3.45% at the start of July. Meanwhile, the yield on the two-year government bond has climbed to 2.98% from 2.76%. The upswing has pushed the two-year yield close to its May 15 high, and the 10-year yield past its high.
“The most important driver of Canadian long-term yields has been the US Treasury market,” says Kelvin Kingsley, VP, portfolio manager, fixed income strategies at Global X. “Canadian bonds don’t trade in isolation, and our market is heavily influenced by what happens south of the border.”
US Treasury Yields Set the Tone in Canada’s Bond Market
Yields on US Treasuries exert a strong influence on the Canadian bond market. US Treasury yields have hit multidecade highs, as investors concerned about the threat of inflation, interest rate uncertainty, and large fiscal debt demand greater compensation (the so-called term premium) to hold government debt—particularly longer-term bonds, the epicenter of the ongoing bond rout.
“US Treasuries are the anchor for global fixed income, so Canada will always see higher US yields or broader global term premium pressures reflected in Canadian interest rates to some extent,” says Vikram Rai, senior economist at TD Economics. That is because investors have the option of selling Canadian bonds and buying US Treasuries instead. This pushes Canadian yields higher to compensate when yields on US Treasuries rise, he explains.
Canadian bond yields have risen faster than those of their US counterparts. Dustin Reid, chief fixed-income strategist at Mackenzie Investments, notes that since June 30, Canadian 10-year yields have climbed by about 0.30%, while US 10-year yields have risen 0.25%.
The US 10-year Treasury yield sits at approximately 4.74%, while the equivalent 10-year Government of Canada bond yield is around 3.75%. That’s a spread of roughly 0.99% in favor of US debt as of Aug. 20. Meanwhile, the yield on the 30-year US Treasury bond rose to 5.31%, its highest level in nearly two decades, from below 5.00%. The yield on 30-year Government of Canada bonds jumped to 4.09% from 3.77%.
Stronger Canadian Growth Adds Pressure
On the domestic front, Canada’s bond market underperformance is attributable to “a shift in the outlook for the economy and a stronger growth profile, while the latest set of US data is showing some signs of weakness,” Mackenzie’s Reid adds.
The Canadian economy bounced back in the second quarter after dipping into a technical recession in the first. At the same time, the job market rebounded with surprise gains even as Iran-war-linked energy inflation remained well-behaved.
The improving economic data has flipped market expectations for the Bank of Canada’s policy path from a potential interest rate cut to a possible year-end hike. Few economists are convinced such a hike is coming. Still, “Canadian yields have increased as markets have marked down the odds of Bank of Canada rate cuts,” says TD’s Rai. “This is a rates-repricing story, with some added term premium as global investors demand more compensation for uncertainty.”
The Bank of Canada has remained on hold since December last year, leaving the interest rate at 2.25%.
Short-Term Yields Remain Relatively Stable
Longer-term yields have risen more sharply than those of two-year bonds, which tend to track central bank interest rate decisions more directly. “Short-term yields have remained relatively anchored [as] the Bank of Canada continues to balance the downside risks created by ongoing trade tensions with the United States against renewed inflation risks related to geopolitical developments and higher energy prices,” says Global X’s Kingsley.
While policymakers can influence those factors, “their ability to directly control long-term yields is limited.” Instead, he says long-term yields are more influenced by investor expectations of economic factors such as growth, inflation, fiscal stability, and capital supply and demand.
What Bond Investors Are Watching
In Canada, bond analysts and investors are focused on “whether Canadian core inflation stays contained and whether growth continues to look resilient,” says TD Economics’ Rai.
Other key factors include “US trade negotiations, the health of the consumer, and real estate markets,” says Sam Acton, portfolio manager and co-head of fixed income at Picton Investments. And for greater clarity, “the tone from central bank meetings will also be critical, especially the Bank of Canada.” Bank policymakers are set to meet on Sept. 2.
Energy prices are another moving part of the bond market math. “A resolution of the conflict affecting the Strait of Hormuz [a key global energy choke point], followed by a decline in oil prices, would ease some of the market’s inflation concerns and could help restore confidence in longer-duration bonds,” says Global X’s Kingsley.
In the United States, economic growth and developments in the Treasury market are leading indicators for Canada’s bond market. “If US growth slows in a sustained way and the data show that inflation pressures are continuing to ease, that would likely provide some support for longer-term bonds and help bring yields lower,” says Kingsley. Trends in the US market “will in turn influence Canadian yields.”
