Borrowing costs could remain elevated and even rise sooner than expected for businesses and consumers, including in Canada, after experts say a sharp rise in U.S. bond yields this week was a major warning sign about inflation, interest rates and economic uncertainty.
The 30-year U.S. Treasury yield climbed above five per cent this week to about 5.25 per cent as of publication, the highest level since 2007.
The sharp increase came after the U.S. Federal Reserve held interest rates steady on Wednesday, with investors focusing on signals that rates could remain higher for longer, or even be raised again.
“There is a basic premise that when the 30-year U.S. government bond is greater than five per cent, that is an attractive option for many people,” says Colin White, president and CEO of Verecan Capital Management and the Verecan Group of Companies.
“That makes it easier for people who are looking for guarantees to allocate capital and not worry about things. It’s considered the risk-free rate of return.”
What are bonds?
Bonds are essentially loans that governments and companies take from investors, and in return for borrowing people’s money, the bond issuer pays interest on those loans as measured by yields.
Those yields, or the return investors receive relative to what they pay, fluctuate regularly based mostly on supply and demand, and expectations for the economy.
While higher yields can offer attractive returns with minimal risk for individual investors, they can also signal warning signs for the broader economy.
A sudden sharp rise in bond yields can signal that markets are concerned about inflation, government debt or economic uncertainty. Higher yields can also drive up interest rates on mortgages, corporate loans, consumer credit and other products.
Bonds are typically considered low-risk investment products, and when the yields rise significantly, bonds can become more attractive compared with riskier investments. This can weigh on demand for stocks, real estate and business investment.
“When we get to a point where people are not expecting the same growth rates on earnings and the overall economy, then this will become a drag because that’s where the money will all flow,” White says.
“It’ll flow out of investing and capital markets, and it’ll flow into the bond market, which is basically a saving instrument to hold on and wait for things to look better.”
Stock markets on Bay and Wall streets, including the Dow Jones Industrial Average, the S&P 500, the Nasdaq and the Toronto Stock Exchange, were each down by roughly half a per cent on the week ahead of Friday’s trading session.
After the Fed announced it was keeping interest rates unchanged, investors focused on the fact that three out of 12 voting members dissented, or voted to raise rates. The split may have contributed to concerns that inflation remains a challenge and that the Fed may not cut rates as quickly as some had expected.
“That suggests that the U.S. is having a bit of a problem with inflation, keeping their costs under control, and so this is spooking markets,” economics professor Moshe Lander of Concordia University says.
“Beyond just the bond market, financial markets around the world reacted, as did foreign exchange markets, because it’s all connected.”
With inflation concerns mounting, especially in the U.S. amid tariffs and higher oil prices linked to the Iran war, investors are watching central banks like the U.S. Fed and the Bank of Canada closely for any signals that they may need to keep interest rates at current levels for longer than originally planned, or raise rates to prevent inflation from spiking.
Another concern investors are watching is government borrowing.
What could happen next?
The cost of the Iran war was highlighted last week after U.S. Defense Secretary Pete Hegseth said about US$38 billion had been spent by the government so far, and as the total public outstanding U.S. debt climbs to more than $39 trillion.
If investors lose confidence that a government can pay back its loans, including through bonds, then those investors may demand higher returns in exchange for the higher perceived risk.
The same principle applies to consumers, where someone viewed by lenders as a higher-risk borrower may have to pay higher interest rates to take out a loan.
While the Bank of Canada makes its interest rate decisions independently and does not follow the U.S. Federal Reserve, Canada’s economy is still closely tied to its largest trading partner through trade and financial markets.
“At some point, it could actually spill over onto this side of the border, then, where the Bank of Canada either does it right off the top to address it straight away, or in the medium to long term, they’re going to have to increase interest rates just to avoid importing American inflation,” Lander says.
“We too then could become victims, in a sense, of importing American inflation because of their inability to get this under control.”
Based on reporting by Global News.