Long term yields in several major bond markets, including Canada, moved sharply higher in early December. In part, the rise in yields reflected investors’ reduced expectations for additional monetary easing. While some central banks might lower their interest rates further, many, such as the Bank of Canada, may have reached the lowest rates of this cycle. A surprising drop in Canadian unemployment reinforced that view. In other countries, such as Japan and Australia, investors began anticipating interest rate increases in the next three months, leading to sharp rises in bond yields. Fiscal and inflation worries also played a role in the jump higher in yields. As well, the rise in long term yields put upward pressure on short and mid term yields. It also spurred demand for corporate bonds as investors sought to secure attractive all-in yields. Despite record new issue supply, corporate spreads tightened in response to strong demand. The FTSE Canada Universe Bond index declined 1.28% in December.

The most noteworthy economic data in Canada came early in December when the unemployment rate unexpectedly dropped to 6.5% from 6.9%. A third consecutive month of robust job creation plus a decline in the participation rate were responsible for the improved labour situation. The news caused the yield on 2-year Canada bonds to jump 18 basis points higher on the day as investors realized there was little possibility of the Bank of Canada lowering interest rates in the near future. Other positive economic news included the first monthly trade surplus since January as exports increased while imports fell. Interestingly,  the share of Canadian exports bound for U.S. declined from 76% in 2024 to 71% in September, driven by a decline in exports to the U.S. and gradually increasing exports to other countries.In addition, inflation held steady at 2.2%, with the core measures of inflation declining to 2.8% from 3.0%. Less positively, Canada’s GDP shrank by 0.3% in October and the annual pace of growth slowed to 0.4% from 1.0%. While the Alberta teachers strike was a factor in the monthly data, weak business investment and  the trade war offset reasonably healthy domestic demand. The Bank of Canada did the expected and left its interest rates unchanged. In doing so, the Bank said that it expected fourth quarter economic activity would be weak and underlying inflation was roughly 2.5%.

In the U.S., the federal government shutdown from October 1 to November 12 caused a backlog in economic data that was only gradually unwound during December. Of particular concern was the state of the labour market. Despite no increase in unemployment claims and a jump in the number of job openings in  September and October, the U.S. Federal Reserve decided to lower its interest rates by 25 basis points on December 10th, its third consecutive easing move. In its announcement, the Fed indicated that it would likely slow the pace of additional rate cuts, but the range of opinions within the committee was unusually wide, making projections more risky than normal. After the Fed’s decision, labour market data showed that job creation had apparently stalled and the unemployment rate rose to 4.6% in November from 4.4% in September (no rate was calculated for October due to the shutdown). However, the impact of the government shutdown on both job creation and unemployment was uncertain and the labour data for December (to be received in January) will hopefully provide a clearer picture. Late in December, U.S. GDP was estimated to have grown in the third quarter at the robust pace of 4.3%, which reduced pressure on the Fed for further rate cuts.

Internationally, as December was starting, Japanese investors realized that the Bank of Japan might raise its interest rates as early as December 19th, prompting volatility in the Japanese stock market and higher yields on Japanese Government Bonds (JGBs). The Bank of Japan did make a 25 basis point increase on the 19th, leading JGB yields to hit their highest levels this century. In Australia, inflation jumped to 3.8%, far higher than expected, and the Australian bond market began pricing in expectations for the Reserve Bank of Australia to increase interest rates as soon as the first quarter of the new year. Among other major central banks, only the Bank of England followed the Fed’s lead and lowered rates in December. Other central banks appeared to be closer to their lowest rates of the cycle.

The Canadian yield curve moved markedly higher and steepened in December. The yield of 2-year Canada bonds rose 16 basis points while the yields of 5, 10, and 30-year Canada bonds jumped between 25 and 28 basis points higher. The higher yields, of course, meant bond prices fell. The U.S yield curve also steepened in the month, but the Fed interest rate reduction led to smaller yield movements. The yield of 2-year Treasuries declined 5 basis points, while the yield of 30-year Treasuries rose only 18 basis points.

The federal sector, which had a duration a year shorter than the overall index, returned -1.15% in the rising yields of December. In contrast, the provincial sector’s average duration was more than two years longer than the Universe, leading to a decline of 1.97% in the month. Investment grade corporate bonds fared better than government issues, declining only 0.59%. Even though December’s corporate new issue supply of $13.2 billion was a record for the month, corporate yield spreads tightened by 6 basis points on robust investor demand. A tender by Telus that retired just under $1.1 billion of its long term bonds also contributed to the demand as investors sought to reinvest their proceeds. Non-investment grade corporate bonds earned +0.23% as their high yields offset small price declines. Real Return Bonds’ average return of -2.51% was in line with that of nominal bonds of similar durations. Preferred shares closed out 2025 with another strong performance, rising 1.55% in December to finish with an annual gain of 16.03%.

We believe the Bank of Canada is likely on hold for the next quarter or two, unless the economic environment changes significantly. As a result, we believe bonds are likely to remain in a trading range. Also, we believe the current “normal” shape of the yield curve is appropriate and significant further steepening is unlikely. We remain cautious about the corporate sector as the current yield spreads are not properly pricing the level of economic and financial risk.

In the United States, the Fed’s next rate decision will be announced on January 28th, a few days before Jerome Powell’s term as Chair finishes. His replacement is likely to be announced ahead of the Fed meeting but is unlikely to participate in the decision. We believe the Fed will leave rates unchanged but the range of disagreement at the December 10th meeting (one vote for a 50 basis point cut and two votes for leaving rates unchanged) makes the outcome more of a toss-up.

As we noted recently, we see several potential sources of volatility in the next few months. Clearly trade negotiations remain a source of risk, with Trump potentially using a threat of cancelling the USMCA as a negotiating tactic. Elevated equity valuations are another risk, as price/earnings ratios are at historically high levels. Should stock markets correct, we would expect a flight-to-safety bid to occur for government bonds, but underperformance of corporate issues as yield spreads widen from very narrow levels. We are also concerned that all of Trump’s threatened tariffs have not been fully implemented, so their negative economic impact has not yet occurred. And a final concern is the selection of the next Chair of the Fed. Should Trump choose a candidate that is perceived as wanting excessive easing with insufficient concern regarding inflation, bond investors may vote with their feet.