Key Takeaways
- The bond market faces rising yields and volatility if the Iran war’s energy shock persists, analysts say.
- Sustained energy inflation may force the Bank of Canada to raise rates, driving up short-term yields.
- Long-term Canadian bond yields tend to track US Treasuries, which are tied to expectations for US Fed policy.
The jump in oil prices driven by the Iran war sparked a sharp rise in Canadian bond yields, reversing a broad-based decline across maturities since the beginning of the year. Analysts forecast more pain in the bond market, as geopolitical uncertainty could keep energy inflation elevated until the war abates.
Bond yields, which move in the opposite direction to bond prices, have turned sharply higher. The yield on the Government of Canada’s two-year note—which tends to be hypersensitive to geopolitical uncertainty, and even a leading indicator of monetary policy moves—has jumped to 2.95% from 2.39% since the war started on Feb. 28. Similarly, the yield on five-year bonds shot up to 3.18% from 2.67%, while 10-year bonds soared to 3.58% from 3.13%.
The jump was triggered by the war’s disruption of global oil flow, which has stoked energy inflation. Markets are now pricing in multiple interest rate hikes from the Bank of Canada by year-end.
The spike defies the course that yields tend to follow during such bouts of uncertainty, according to analysts. “Usually, geopolitical turbulence would lead to lower bond yields, as investors turn to stable investments in times of uncertainty,” says Penelope Graham, mortgage expert at Ratehub.ca. “However, today’s bond investor is concerned that spiking energy costs will lead to entrenched higher inflation, as well as reduce the likelihood that North American central banks will lower interest rates.”
So why are bond yields surging? Analysts point to four key reasons.
Rising Oil Prices
Mounting investor unease over energy inflation is the key factor impacting bond yields, explains Dustin Reid, chief fixed-income strategist at Mackenzie Investments: “The main drivers have been higher energy prices and a renewed inflation premium built into nominal bond yields since the end of February. That combination has pushed yields higher across the curve.”
He adds that energy prices will remain central in the near term. “Structurally higher oil prices raise the risk that yields remain elevated, as investors demand more compensation to hold nominal fixed income in a higher inflation-risk environment,” he says.
The Trickle-Down Effect of US Treasuries
The rise in longer-term yields is largely a function of US Treasuries, says Sandy Liang, head of fixed income at Purpose Investments. “Even before the Middle East conflict emerged, there was growing unease with the US inflation picture,” he says. “The expectation now is that 10-year [US] yields hold above 4% and 30-year yields hover near 5%.”
The Canadian bond market typically tracks moves in US Treasuries, due to global capital flows and shared monetary policy expectations. This impacts Canadian bond yields “regardless of what’s happening in Ottawa,” Liang says.
A Potential Stagflation Squeeze
Normally, if the economy is stagnant, the Bank of Canada cuts rates to stimulate it. This makes bond prices go up. But when inflation is high, the Bank raises rates to cool it, which lowers bond prices. However, higher near-term inflation while growth decelerates (a dynamic known as stagflation) is a “scenario central banks are least-equipped to handle cleanly,” explains Liang.
He says the mixed picture muddies the Bank of Canada’s rate path, and the uncertainty makes bonds volatile. Higher inflation and softening economic growth “does the most damage to conventional bond portfolios,” says Liang.
Bank of Canada Outlook
Since short-term yields are almost entirely driven by interest rates, the monetary policy impact is felt most clearly among these bonds, says Mackenzie Investments’ Reid. “The Bank of Canada still has scope to ease more than current market pricing implies, [which] creates room for Canadian [short-term] front-end yields to adjust.”
Another factor is the difference in policy rates between central banks on either side of the US-Canada border. Typically, Canadian bonds benefit when the US Federal Reserve’s policy rate is higher than the Bank of Canada’s. Due to the inverse correlation between bond prices and yields, higher interest rates tend to dent the prices of US bonds, making Canadian bonds more attractive.
But the policy divergence has become considerably more complicated, says Purpose Investments’ Liang. “The spread, which was expected to widen in Canada’s favor, may compress instead,” he says. “For bond investors, that means less of a tailwind from policy than the beginning-of-year consensus assumed, and more reason to focus on income over price return.”
