Global equity markets continue to grind higher on the back of the trade war de-escalation. Moreover, a U.S. federal court recently ruled that President Trump had overstepped his authority in using an emergency law to impose tariffs, leaving investors and businesses questioning the implications. The U.S. administration had indicated it would appeal the court’s ruling and late last week, it was announced that a federal appeals court has paused Wednesday’s ruling from the Court of International trade that had blocked these tariffs. This pause adds further confusion and uncertainty around the impact of tariffs, and it remains too early to draw any real conclusions.
In this week's economic update, we focusing on U.S. government bonds and the implications of the recent increases in longer-term bond yields. We are also touching upon the latest changes in the U.S. tariff situation, and perhaps some of the new developments you might have missed.
Economic Update
U.S. stocks are close to where they began the year, whereas other stock markets are nearing or sitting at all-time highs. As trade tensions ease somewhat (with caveats), markets have increased their attention to movements in government bond yields. We discuss this more on this topic below.
A brief primer on government bond yields
A government bond is a form of debt issued by sovereign countries to fund spending and cover financial obligations. For major developed nations, these bonds are often considered lower-risk investments since they are backed by countries with reliable revenues, political stability, and liquid capital markets. The yield on these bonds (the interest payment divided by the market price of the bond) can effectively be considered a proxy for the cost of government financing and the return demanded by investors to lend to that government. The higher the yield, the greater return investors seek to lend to a government, and vice versa.
These instruments can vary in maturity with differing factors driving yield changes. The yields on short-term government bonds (ie. five years and less), are generally subject to a mix of market factors and central bank policy (ie. interest rates), whereas long-term yields are driven more by broader market dynamics and fiscal stability. In a "normal" environment, markets tend to pay close attention to interest rate decisions by central banks (influencing short-term yields more) but in recent weeks and months, the focus of investors has been on the rise in longer-term government bond yields.
Long-term yields moving higher in many places
During periods marked by elevated uncertainty and investor concern, government bonds typically see their prices rise (and yields fall) as investors seek the stability and safety that can be offered by government bonds. But as mentioned before in previous economic updates, that relationship has been put to the test this year.
For example, at the beginning of April when the U.S. government unveiled its reciprocal tariffs on a range of countries, longer-term U.S. government bond yields rose abruptly (and U.S. government bond prices fell). And after a brief recovery, long-term U.S. government bond yields continued to climb higher, suggesting investors may be reassessing some of their views around the U.S. and its government.
It is tempting to think this is a U.S. issue, but it appears to be part of a global phenomenon. Despite the moves noted above, the U.S. 10-year Treasury yield has fallen modestly year-to-date, compared to sovereign yields in other major developed countries (Canada, Germany, Japan, Australia, and the U.K.) that have risen. Meanwhile, the rise in the 30-year U.S Treasury yield has been much more notable, but broadly in-line with the aforementioned countries. In fact, longer-term (ie. 30-year) government bond yields across a range of developed countries sit near or above levels that haven’t been seen in well over a decade. This suggests that investors are demanding more return than they have in the past for locking up their money in longer-dated loans to governments.
Investors increasingly focusing on the sustainability of government finances
There may be a variety of factors that are responsible for the recent move higher in longer-term bond yields. However, concerns over the trajectory of government finances appear to be playing some part.
Debt levels across regions have been trending higher in recent decades. That had not been a big concern when interest rates were falling and were relatively low, but the interest rate regime changed a few years ago and the cost of servicing debt has meaningfully increased as a result. In addition, budget deficits are aggravating the issue as some governments continue to plan to spend more than they are earning, which will require them to raise even more debt in the future. The most recent example is in the U.S., where the government is trying to pass a bill that includes higher spending and lower taxes (ie. lower revenue) and will require another increase in the government’s so-called debt limit. Other regions are dealing with similar issues to varying degrees.
Summary
The unsustainable nature of governments’ fiscal trajectories is not new. It has been a concern on the minds of some investors for as long as we can remember. Yet that has not presented too much of a hurdle for governments (except the U.K. in 2022) and investors. Nevertheless, at some point, investors may demand a return that is high enough that governments may be forced to take more decisive action to address their fiscal issues. We are not sure that time is near but remain mindful of that eventuality.
Unpacking the latest tariff news and developments
While it’s difficult to keep up with the constantly shifting and evolving tariff situation coming out of the U.S. Administration, it is worth analyzing the latest developments and what we should continue to look out for.
Last week, a significant portion of U.S. tariffs were blocked by a ruling from the Court of International Trade – and almost immediately that decision was temporarily halted on appeal. While this narrative continues to generate uncertainty around the U.S. strategic trade policy, other developments are underway and worth exploring. You can read the full analysis by clicking here.
As always, we are available to connect with you personally. Please don’t hesitate to contact us at 519-822-2024 or elineskyschuett@rbc.com.