In its July Monetary Policy Report, the Bank of Canada cited global tightening financial conditions as a key downside risk to the inflation outlook: “the rapid expansion of government debt issuance around the world” would raise long-term government yields, in turn dampening domestic demand. The Bank had also highlighted tightening global financial conditions as a key downward risk in January.
For now, market participants don’t anticipate a sharp rise in government bond yields based on results of a Market Participants Survey conducted by the Bank of Canada from June 25 through July 3. The survey shows the median expectation for Canada’s 10-year bond yield at 3.23 per cent at the end of 2025 and 3.25 percent at the end of 2026. The largest increase is expected in the 5-year yield, seen ending 2025 at 2.78 per cent and 2026 at 2.90 per cent.
Still, given today’s new trade policy realities, how governments react, along with households and businesses, was “the focus of considerable discussion” at the July 30 policy meeting. The minutes of that meeting revealed that monetary policy decision makers debated “the extent to which spending by all levels of government could partially offset the weakness in sectors affected by tariffs.”
In an August 14 report, the Parliamentary Budget Officer projected federal capital amortization expenses to be $7.1 billion higher over a five-year period than initially expected, which doesn’t even reflect Ottawa’s pledge to meet NATO’s 5 per cent of GDP defence-spending target. The PBO expects higher deficits than estimated in the March 2025 Economic and Fiscal Outlook as a result.
Canada is no exception. Rising defence spending is one of the reasons Fitch Ratings revised its global sovereigns outlook to “deteriorating” from “neutral” just last month. Interest costs, demographic trends, weak growth and social pressures are all expected to keep public finances in developed countries under pressure this year.
Almost certainly, this will translate into higher government bond issuance, including in Canada, potentially creating challenges for government debt management.
One key challenge is the extent to which markets can absorb growing debt supply, a question the Bank of Canada will ask securities distributors and institutional investors in an upcoming consultation on Canada’s domestic debt program: “In an environment where the outstanding stock of Canadian-dollar debt has been growing (e.g., GoC securities, provincial securities, Canada Mortgage Bonds, and Canadian pension fund securities), how are dealers and clients absorbing the increased supply of GoC securities?”
Another challenge raised in a previous Bank of Canada research paper stems from the involvement of hedge funds. Over the past 15 years, international hedge funds have become increasingly important players in Canada’s government bond auctions, now accounting for up to 40 per cent of certain newly issued bonds for certain tenors. There is a positive side to this trend: the rise of hedge funds in government bond auctions has helped keep borrowing costs low through competitive bidding, improving market liquidity.
The downside is the added vulnerability related to the fact that most hedge funds are international players susceptible to exit quickly when conditions change: “without organic commitment to the Canadian market, they could be more likely to pull back during a Canada-specific stress event,” Bank of Canada research staff noted.
The stakes go beyond public finances. Higher government bond yields typically feed directly into private-sector borrowing costs, affecting households and businesses alike.
