The Best Laid Fiscal Plans of Mice and Men Often Go Awry

One of the more interesting aspects of spending two weeks of every summer in the Canadian wilderness is seeing what’s changed and what hasn’t when you return to civilization. Erratic trade policy External link., questionable Federal Reserve appointments and federal government firings External link. continued to erode the economic credibility of the US administration. US External link. and Canadian External link. central banks kept rates unchanged, as expected. And equity markets seemingly took it all in stride, rallying to new heights.

Where the US administration’s misguided economic policies and attacks on monetary policy and statistical independence have instead been reflected is in the bond market. Longer-term US government bond yields remain elevated, boosted by planned larger deficits and higher debt along with still-lofty inflation expectations south of the border (graph 1). Meanwhile, shorter-term bond yields have fallen on the expectation of future rate cuts. We expect the Federal Reserve to cut interest rates in September, with markets pricing in more than two full cuts by year-end. The resulting steepening of the US yield curve means newly issued longer-term debt will become more costly to service than shorter-term debt, possibly incentivizing the US administration to favour Treasury bills over bonds. But while this may benefit the administration in the near term, it could be more costly in the long run in the unlikely event that the Fed is forced to ultimately hike rates to combat tariff- and deficit-induced inflation. This is already a concern, as US government debt has a shorter average term to maturity than the government debt of most other OECD countries, including Canada.

While notable in the United States for all the wrong reasons, a steepening yield curve isn’t just a US problem. Yield curves have steepened in other major advanced economies as well, Canada among them. The spread between 10‑year and 2‑year Government of Canada (GoC) bond yields is now the largest it’s been since the Bank of Canada’s policy rate lifted off rock-bottom levels in early 2022. The same is true for the spread between 5‑year and 2‑year bond yields. Meanwhile, 30‑year bond yields recently hit their highest level in 15 years—a particularly acute risk for provincial governments who are the primary issuers at this longer-term maturity. Our Macro Strategy team External link. has determined that much of the recent run-up in long-term GoC bond yields reflects global factors, with the higher term premium imported largely from the United States. And they expect this trend toward a steeper yield curve in Canada, the US and further afield to persist going forward (graph 2).

What does this mean for the Government of Canada’s fiscal position? Considering the federal government has been actively cutting taxes (excluding tariffs) and announcing massive new spending measures, particularly on defence External link., deficits were expected to be large even if interest rates remain relatively contained. And that assumes recently announced spending cuts are achieved. If the Government of Canada’s yield curve steepens further, the federal government could find itself in a position where public debt charges start eating up an ever-increasing share of revenues (graph 3). While not expected to be anything close to the vicious spiral that characterized federal finances in the 1980s when interest rates hit double digits, a steepening yield curve poses a risk to fiscal sustainability that is largely beyond the control of the federal government. But the same is true for other countries, including advanced economies similarly ramping up defence spending but from a worse fiscal starting point. As such, unless long-term borrowing costs rise especially aggressively or are accompanied by a sharp slowing in the Canadian economy, our research External link. suggests a steeper yield curve may not be enough on its own to cause a downgrade of Government of Canada debt.

Although not an imminent risk to federal fiscal sustainability, rising long-term interest rates risk raising borrowing costs for the Government of Canada. Ultimately, the GoC could be left with no choice but to raise taxes and/or forego planned spending to ensure federal debt obligations can be met. Indeed, to borrow from an old proverb, “the best laid fiscal plans of mice and men often go awry.”