Bond markets rallied after news of a potential peace deal in the Middle East, causing yields to drop worldwide on hopes that inflation remains contained and central banks maintain their current policies. However, long-term yields did not fall significantly, and analysts suggest they are unlikely to stay down due to larger underlying forces.
"Even if a permanent de-escalation were to come to fruition, the risk that the long-end remains high is very real," said National Bank of Canada strategists Kyle Dahms and Taylor Schleich. They estimate that the average 10- and 30-year borrowing cost in the G7 ended April at a 17-year high and remains within a few basis points of those levels.
The lack of fiscal discipline combined with high geopolitical risk will continue to put upward pressure on term premiums going forward, according to the strategists. Term premiums are the extra compensation investors demand for holding long-term government bonds. A key reason they remain high is investor concern about rising debt levels.
The pandemic raised public debt, but it has continued to climb due to shocks such as Donald Trump's trade war and the Middle East conflict. Higher military and defence spending have also contributed. "As a result, governments across advanced economies are issuing large volumes of long-term bonds at a time when the supply of these bonds is already elevated," said a Bank of Canada study.
The bank noted that market intelligence suggests growing unease about whether the market can absorb such large volumes of government debt. During the pandemic, central banks bought a significant share of new issuance, keeping yields lower. Now, those programs have wound down, and some central banks are selling bonds on the secondary market. Private investors have stepped in but are demanding higher compensation.
Canada's inflation and fiscal balance sheet may be in better shape than many G7 peers, but it is not immune to these pressures. As a small open economy, Canada's long-term government bond yields are heavily influenced by global forces and closely track U.S. Treasury yields. Over the past 20 years, the term premium for 10-year government bonds has moved in tandem with other advanced nations. Since 2023, that premium has increased to levels not seen in over a decade.
Why does this matter? "Yields on long-term government bonds play a crucial role in the economy by directly influencing the interest rates charged on mortgages and business loans," said the Bank of Canada. Therefore, the more investors demand to hold Canadian debt, the more Canadians pay on credit cards and mortgages, dragging on the economy.
