ECONOMIC & FIXED INCOME COMMENT - Onward and Upwards

Global growth moderated in the first half of 2026, but remained resilient in many countries despite the adverse effects from the conflict in the Middle East. Sizeable oil inventories, additional supply from outside the Gulf economies and discretionary government support measures all helped to cushion the impact on the global economy. Looking ahead, global growth is projected to expand 2.9% in 2026 before edging higher to 3.0% for 2027. Near-term momentum is expected to face headwinds from persistent price pressures, softening real income growth, and the lagged effects of higher interest rates across many economies. However, robust AI-driven activity and an anticipated easing of energy prices — consistent with current futures market pricing — are expected to provide a meaningful offset, supporting a gradual strengthening of activity through 2027.

Against this backdrop, central banks face a delicate and increasingly complex balancing act. The combination of a renewed energy price shock and persistently above-target inflation reinforces the need for policymakers to remain vigilant in upholding the credibility of their inflation frameworks and ensuring that long-term expectations remain firmly anchored. Importantly, the path of monetary policy is unlikely to be uniform across economies — divergence between central banks is expected to grow, reflecting the uneven nature of the forces driving global growth and inflation. Where price pressures show signs of broadening, or where growth deteriorates materially, further policy adjustments will likely be warranted.

Global Yields: What's Really Driving the Rise

The recent surge in global bond yields is being driven primarily by higher short-term rate expectations and a rising term premium, rather than a repricing of inflation; a distinction with significant implications for markets and monetary policy. A useful framework for understanding the rise in 10-year yields is to break it down into three key components: expected short-term interest rates, reflecting where markets anticipate policy rates will be over the life of the bond; expected inflation, capturing the compensation investors require for the anticipated erosion of purchasing power; and the term premium — the additional return demanded for committing capital to longer-dated debt rather than rolling over a series of shorter-term instruments. Together, these three components provide a comprehensive lens through which the current repricing of long-term yields can be understood.

Since late February, the most significant driver of higher 10-year yields has been the sharp repricing of expected short-term interest rates. At the start of the year, markets were broadly anticipating a cycle of rate cuts over the near term; those expectations have since reversed dramatically, with markets now pricing in a meaningful path of rate hikes.

The term premium has emerged as the second critical driver of rising yields and is arguably the more structurally significant of the two. Unlike short-rate expectations, which can shift rapidly in response to central bank signals, the term premium is shaped by deeper and slower-moving forces — most notably the growing imbalance between bond supply and demand. Across several sovereign nations, elevated fiscal deficits and rising government borrowing requirements have dramatically increased the volume of debt being brought to market, while the pool of willing buyers has struggled to keep pace. This persistent supply and demand mismatch has placed sustained upward pressure on longer-dated yields. Compounding this, the rapid expansion of AI-related corporate borrowing has intensified competition for capital across fixed income markets, further widening the gap between available supply and investor demand, and contributing to a broader and more durable repricing of the term premium.

Canadian yields have not been immune to the gravitational pull of rising global yields, though they have largely remained more contained (see chart below).

For example, since the end of August, U.S. 10-year Treasury yields have risen 61 basis points, compared with a more modest 45 basis point increase in equivalent Government of Canada yields. Canada's softer growth backdrop — shaped in part by ongoing trade tensions — alongside relatively subdued inflation and a less strained fiscal position, have all served to dampen the move higher. Furthermore, the Canadian yield curve continued to steepen (10-year yield now sitting 63 basis points above the 2-year yield). This widening spread reflects a market increasingly driven by global term premium dynamics and longer-term growth and inflation risks, rather than near-term BoC policy expectations alone.

On September 16^th, the Federal Reserve (Fed) raised its benchmark interest rate by 25 basis points to 4.00% — its first rate hike in more than three years — with the Federal Open Market Committee voting unanimously in favour of the decision. Fed Chair Kevin Warsh underscored that the move was underpinned by signs of accelerating economic growth, following the central bank's decision to hold rates steady at its July meeting.

Notwithstanding this hawkish action, a combination of encouraging August PCE data, softer-than-expected U.S employment figures, and dovish commentary from several Fed officials has since tempered market expectations for a follow-up hike at the October meeting. While these developments afford policymakers greater flexibility over the timing of future rate adjustments, lingering geopolitical risks and above-target inflation suggest that the current tightening cycle is not yet complete. Our base case anticipates two additional rate increases, which we view as a measured, midcycle adjustment rather than the beginning of a more aggressive or prolonged tightening campaign.

As widely anticipated, the BoC held its overnight rate at 2.25% on September 2^nd, marking a seventh consecutive meeting without a rate change. The Governing Council reiterated that its primary concern remains the broader inflationary implications of elevated energy prices. Before the October rate decision, policymakers will have access to additional economic data, including September's inflation and labour report, as well as the Q3 Business Outlook Survey — a key gauge of firms' forward-looking inflation expectations.

Market attention has since turned to whether the BoC will follow the Fed’s lead and raise interest rates at its October meeting. In a recent speech, Governor Tiff Macklem was clear that the Governing Council will continue to calibrate monetary policy based on domestic conditions — namely, the outlook for growth, inflation, and the labour market — rather than in response to actions taken by the Fed. Nonetheless, economists remain divided on whether a rate hike in 2026 is warranted.

On balance, we believe it would not be unreasonable for the BoC to raise the overnight bank rate to 2.75% through a pair of 25 basis point increases beginning early next year. Such a move would bring the policy rate to the midpoint of the Bank's estimated neutral range (2.25%-3.25%) the level at which borrowing costs are neither stimulating nor restraining economic activity. The cumulative 50 basis points of tightening we potential anticipate falls well short of the approximately 125 basis points of hikes currently priced in by markets by yearend 2027. In our view, near-term market pricing has become increasingly disconnected from Canadian domestic fundamentals. With the BoC’s preferred core inflation measures (trimmed-mean and median core rates) holding at just 1.9% and 2.0% respectively in August, and headline inflation remaining overwhelmingly an energy story driven by 22.8% gasoline price inflation, there is little in the current data to support the aggressive tightening cycle now priced into markets.