Are tariffs pushing up bond yields?

Escalation of the U.S. trade war casts a cloud over Canada’s economic prospects. The Bank of Canada will provide whatever support it can through accommodative monetary policy, although the latter’s effectiveness is likely to be dented by persistently elevated bond yields. In this Economic and Financial Market Update, we zoom in on why bond yields are rising and provide clues on whether or not that concerning trend will continue.

Trade war escalation cements near 1% GDP growth for Canada

The dreaded "In the middle" CUSMA scenario which we highlighted last June has materialized. With the U.S. declining to renew the trade agreement, there will now be mandatory annual reviews of CUSMA until its expiry, which is currently scheduled for 2036. In the meantime, American tariffs are still being imposed on various goods exported by Canada, with the list of impacted products getting a bit longer after the U.S. escalated its trade war in August. All in all, about one fifth of our exports are now subject to American tariffs which range from 10% to as high as 50% on some goods.

Exporters of non-energy goods, who have still not fully recovered from last year’s tariffs, now have to contend with this escalation of the trade war. That casts a cloud over the economic outlook in the second half of the year, as well as 2027. So, despite the uptick in economic activity observed in the second quarter, the Canadian economy remains on track to register its worst annual performance in six years, with 2026 GDP growth slated to come in near 1% (see forecast table at the end of this report). This below-potential growth print suggests the output gap, or excess supply, will remain wide open, and put downward pressure on inflation.

As such, look for inflation, which climbed to 3% in July amid rising energy prices, to come back down in the second half of the year. It’s true that Canada’s retaliatory tariffs, if they go ahead as planned later this month, may pressure prices a bit. But a Bank of Canada study on the 2025 retaliatory tariffs (which were larger than the ones planned for this month), found limited impacts on consumer price inflation i.e., just three tenths of a percentage point. More importantly, perhaps, is the fact that core inflation, which excludes volatile items, and is therefore a better gauge of underlying price pressures, remain mild in Canada, near 2%. In other words, the central bank won’t be in a rush to tighten monetary policy. We continue to see the overnight rate remaining unchanged at 2.25% for the next several months.

What’s pushing up bond yields?

The stability of short-term interest rates, however, does not mean bond yields will also flatline. In fact, Government of Canada bonds yields have climbed quite a bit since last November despite an unchanged overnight rate (Figure 1). And that’s largely because of what’s happening in the U.S. bond market. Indeed, Canadian bonds, like most other non-U.S. bonds, take their cues from U.S. Treasuries. And the latter is affected by U.S. economic data, some of which are flashing red.

Figure 1: Canadian bond yield on the rise despite Bank of Canada pause

Sources: Bank of Canada, FCC Economics

For instance, U.S. inflation is showing persistence, prompting the Federal Reserve to signal that it may have to raise its policy rate soon despite weakening economic activity stateside. Part of the problem seems to be tariffs which, according to The Budget Lab at Yale University, have raised the U.S. inflation rate by about 0.7 percentage points. That’s bad news for bond investors because inflation erodes the real return on Treasuries.

U.S. public finances under greater scrutiny

Another point of concern for bond investors is the challenging U.S. fiscal situation, which raises doubts about the ability of the American government to repay its creditors. Not only did U.S. government debt cross the symbolic $40 trillion mark for the first time, but there doesn’t seem to be a credible plan to get debt under control. The U.S. budget deficit continues to widen and is on track to hit $2 trillion in fiscal year 2025-26 i.e., around 6% of GDP, which is the worst among G7 countries.

Here too, tariffs could be playing a role. Recall that the U.S. government had positioned tariffs as a mechanism to offset the lost revenue from large tax cuts it delivered last year. Turns out that tariff revenues have largely underperformed the White House’s expectations, leaving the U.S. with massive budget deficits and a ballooning debt load (Figure 2).

Figure 2: U.S. government debt has surpassed $40 trillion

Sources: U.S. Department of the Treasury, FCC Economics

As such, bond investors are now asking for extra compensation for enhanced risks associated with Treasuries. This extra compensation, also called the “term premium”, is now at a 12-year high, whether you’re looking at 5-year or 10-year U.S. Treasuries (Figure 3). Given the enhanced economic and geopolitical uncertainties, and unsustainability of U.S. public finances, nobody should be surprised if the term premium, and therefore overall bond yields, remain elevated for some time.

Figure 3: Term premia on U.S. bonds highest in 12 years

Sources: Federal Reserve Bank of New York, FCC Economics

Surge in the supply of corporate bonds

The increase in corporate issuance has also changed the dynamic in the U.S. bond market. Last year corporate bond issuance amounted to more than $2 trillion i.e., roughly 19% of all new bond issuances in the U.S. (Figure 4). That share is expected to rise even further this year as private sector debt issuance moves up another gear. Much of this, of course, is being driven by the five largest tech companies, the so-called “hyperscalers”, which are tapping bond markets at an unprecedented pace to finance massive investments in artificial intelligence (AI) and related infrastructure. Those companies, by themselves, now account for about 10% of investment-grade bond issuance in the U.S.

Figure 4: Corporate bond issuance is rising faster than issuance of other bonds

Sources: SIFMA, FCC Economics

This additional supply of investment-grade bonds has led to more competition for capital, resulting in issuers (including government) having to offer higher yields to entice investors. This seems to be a structural change in the bond market, as opposed to just a cyclical phenomenon, with important implications. Indeed, AI-related expenditures, and therefore issuances, are expected to grow further over the coming years, meaning that upward pressures on bond yields won’t fade anytime soon.

Will the U.S. Treasury’s intervention work?

The surge in bond yields presents problems not just for households and businesses (e.g. holders of fixed-rate loans like mortgages), but also for governments. As mentioned above, the U.S. debt load is massive, which means debt servicing would increase by billions of dollars for every basis point increase in Treasury yields, further eroding America’s public finances.

That is why the U.S. Treasury is doing its best to calm bond markets. In August, it announced more aggressive bond buybacks, which are designed to temporarily reduce the supply of government bonds. But it’s unclear if that strategy will sustainably bring down bond yields, considering the small size of those planned buybacks in comparison to the massive $30+ trillion Treasury market. And as mentioned above, there are powerful forces such as elevated U.S. inflation, poor American public finances, and increased bond issuance/supply from the U.S. private sector, which are all working in tandem to push up U.S. bond yields.

Bottom line

Inflationary policies enacted by the U.S. government (such as tariffs and expansionary fiscal policy), deteriorating American public finances, and the private sector’s AI investment boom, are all contributing to the rise in U.S. bond yields. And given the interconnectedness of global bond markets, bonds of other countries, including Canada, are being impacted.

For Canadian households and businesses, this means fixed mortgage rates and long-term financing costs will remain much higher than levels prevailing during the 2010s. And for the Canadian government, the end of cheap financing could translate to tighter budget constraints.

Simply put, higher long rates will continue to limit economic growth even next year. That means the Bank of Canada’s overnight rate will have to remain low to provide support to a fragile economy.

Summary of forecasts of key economic variables

Sources: Bloomberg, FCC Economics

Krishen Rangasamy

Manager, Economics, Principal Economist

Krishen is the Manager, Economics and Principal Economist at FCC. His insights and leadership help guide research on topics related to macroeconomics and agriculture, which FCC and external clients use to support strategy and monitor risk.

Prior to joining FCC in 2023, Krishen spent over fifteen years as a macroeconomic specialist on Bay Street, including at two major Canadian banks, where he advised trading desks and helped lead economic research and forecasting. He also regularly appeared on leading business TV channels and written media with his insightful commentaries on financial markets. Before going into investment banking, Krishen worked as an analyst in the energy industry in Western Canada. Krishen received his master of arts degree in economics from Simon Fraser University.