Charles St-Arnaud: Canada has escaped higher bond yields, but higher borrowing costs are still on the way
Tomas Kauer 
United States bond yields have risen meaningfully since the beginning of the year, with the yield on the 10-year U.S. Treasury up about 100 basis points, roughly half of that increase occurring in September alone.
The move has spilled into global markets, although not evenly. Highly rated sovereigns have generally experienced smaller increases, while countries such as France and Japan have seen somewhat larger moves.
What is driving U.S. bond yields higher? U.S. growth expectations have remained robust, with a lot of excitement around AI and the growth boost it will bring, but they have not improved enough to justify the scale of the selloff in government bonds.
The more convincing explanation is a combination of mounting fiscal concerns, renewed inflationary risks and greater uncertainty about the conduct of monetary policy .
The U.S. fiscal outlook remains bleak. The Congressional Budget Office expects the federal deficit to reach 5.8 per cent of gross domestic product (GDP) in 2026 and to remain exceptionally large over the coming decade, and there isn’t any real appetite to reduce it.
Debt held by the public is already above 100 per cent of GDP and is projected to keep rising. Net interest costs are now about 3.3 per cent of GDP, consuming a growing share of federal revenues and leaving the government increasingly exposed to higher refinancing costs. These problems are not new, but they are becoming harder for bond investors to ignore.
Inflation risk has also returned to the foreground. The war in Iran and disruptions to global flows of crude oil and refined petroleum products have pushed fuel prices sharply higher. Large fiscal deficits are adding stimulus to an economy that already has limited spare capacity. These pressures are emerging while inflation remains above the U.S. Federal Reserve’s target.
At the same time, uncertainty about U.S. monetary policy has increased, leading investors to question the Fed’s resolve to control inflation.
President Donald Trump’s repeated calls for lower interest rates and attacks on the Fed’s independence have raised questions about whether the central bank will be allowed to respond forcefully if inflation persists. The opaque communication style of the new Fed chair only adds to the uncertainty. Investors are therefore demanding a larger premium to hold long-term U.S. government debt in compensation.
Canada is not an island. It is an open economy with free capital flows and a floating exchange rate. Hence, global financial developments inevitably reach our shores.
Canadian 10-year yields have risen by about 45 basis points this year, compared with roughly 100 basis points in the U.S. The widening interest-rate differential between the two countries has also contributed to a sharp depreciation of the Canadian dollar in recent weeks.
The smaller rise in Canadian yields reflects the country’s strong credit rating and comparatively better fiscal position. It also reflects weaker growth expectations as the trade conflict with the United States intensifies. But smaller does not mean immune. Canadian yields are unlikely to decouple if U.S. yields continue to climb. At best, they will rise less.
That matters because government bond yields determine fixed-rate borrowing costs across the economy. For example, five-year fixed-mortgage rates move closely with five-year Government of Canada yields. Fixed-mortgage rates have so far risen less than bond yields, but some catch-up is likely as lenders adjust their pricing and funding costs.
Higher borrowing costs will weigh on housing activity and business investment. The size of that drag depends partly on how quickly changes in market yields pass through to borrowers. An economy with a larger share of fixed-rate borrowing experiences more immediate tightening from higher bond yields, potentially reducing the need for the central bank to raise its policy rate.
In Canada, however, variable-rate mortgages account for roughly 40 per cent of new mortgages, well above their historical share of about 25 per cent. That could make the tightening in monetary conditions from higher long-term yields less powerful than in past episodes.
The Bank of Canada has been clear that higher bond yields are not automatically a substitute for monetary policy. In October 2023, when Canadian bond yields were near today’s levels, governor Tiff Macklem said they were “not a substitute for doing what needs to be done to get inflation to come back to our target.” Inflation, however, was also considerably above the target at the time.
More recently, Macklem said the Bank of Canada does not want to raise its policy rate and restrain growth when inflationary pressures are contained, likely reflecting the expectation that the intensification of the trade war will reduce growth in the coming month.
Taken together, those statements point to patience. The central bank will not want to add unnecessary restraint while market-driven borrowing costs are already tightening financial conditions. In other words, unless higher fuel prices begin to spread more broadly into the prices of other goods and services, the increase in bond yields could delay the next policy-rate hike.
But delay should not be confused with relief. If U.S. yields keep rising, Canadian borrowing costs will continue to follow. If higher fuel prices lead to broader inflation, the Bank of Canada will eventually have to respond.
Either way, borrowing costs are going to be higher in the coming months, unless inflation risks from high fuel prices decrease. Canadian households and businesses should prepare for this new reality.
Charles St-Arnaud is chief economist at Servus Credit Union.
