Markets are betting the Federal Reserve will cut interest rates again this week. Bond markets, however, haven’t got the message. Longer-term yields remain stubbornly high, and there’s no single explanation for the growing disconnect between what investors expect from the Fed and how bonds are actually trading.
Since September 2024, the Fed has lowered its policy rate by 1.5 percentage points. The markets anticipate another 25-basis-point cut Wednesday and are pricing in two or more cuts next year. While the Fed can impact the short end of the yield curve, it has less influence over the longer end.
Several theories have emerged to explain the divergence between falling policy rates and persistently high long-term yields. The most optimistic is the U.S. economy has averted a recession, reducing the need for deeper cuts. A more neutral view is that markets are simply normalizing after years of near-zero overnight rates. The more cautious view is that increasing concerns over ballooning national debt levels are putting upward pressure on long-term yields, as investors demand a higher risk premium.
Another factor that could steepen the Treasury curve is concern over Fed independence. The central bank’s autonomy has been tested in the past. In 1941, during World War II, the Fed intervened to keep the Treasury bill rate at 0.375 per cent and long-term government bonds yields at between 2 and 2.5 per cent to help finance the war effort. By early 1951, with inflation above 20 per cent following the end of price controls and the Korean War, the Fed sought to reassert its independence. The resulting 1951 Treasury-Fed agreement ended the era of “fiscal dominance” and laid the foundation for modern U.S. monetary policy. Later, in the lead-up to the 1972 election, President Nixon pressured Fed Chairman Arthur Burns to adopt a more accommodative monetary stance — a move often cited as contributing to the inflationary excesses of the 1970s.
The Trump administration is pushing for the Fed to cut rates more quickly, and pressure on the central bank is likely to intensify in the run-up to mid-term elections. Any erosion of the Fed’s credibility would likely steepen the U.S. yield curve by 50 to 100 basis points: short-term yields would fall, reflecting stronger expectations of rate cuts, while long-term yields would rise due to a higher term premium, signalling growing doubts about the Fed’s ability to keep inflation under control.
Here at home, the Bank of Canada is expected to hold rates steady. Since its October decision, the central bank has leaned in this direction, supported by positive employment data and a recent upward revision to GDP. Some economists are even calling for a rate hike some time down the road.
While I agree that the Bank of Canada will likely hold this month, I expect a cautious approach given upcoming discussions on CUSMA in 2026. The bond market has moved higher amid this revised view of the Bank, alongside a broad-based back-up in global bond yields. The 5-year bond yield jumped almost 30 basis points to 3.02 per cent – a level not seen since August.
For borrowers the message is clear: don’t expect any mortgage rate relief in 2026.
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