Long-term government borrowing costs have been moving higher across advanced economies—in some cases sharply. The U.S. 30-year Treasury yield briefly touched 5.2% in May, its highest level since 2007, while Canada's 10-year yield rose to 3.7% in May, a two-year high. Though both have since pulled back, they remain elevated compared to the year prior. The instinct is to attribute this to the war in Iran and its effect on oil prices with investors demanding an “inflation premium”—and that's part of the story. But the data suggests the picture is more layered, and that even a meaningful de-escalation of the war may provide only partial relief on this front.

Understanding what drives long-term yields

To make sense of the current environment, it helps to unpack what actually moves long-term borrowing costs. Economists decompose long-term government bond yields into a few broad components: First, the expected path of short-term real interest rates, which reflects where investors believe the central bank will steer policy based on future economic growth. Second, the term premium—the additional compensation investors require for the risk and uncertainty of locking up their capital over a multi-year horizon rather than rolling over safer, short-term bonds.

The term premium itself reflects several concerns: uncertainty about future inflation that shorter-dated bonds may be underestimating, uncertainty about real economic growth, the credibility of central banks’ inflation-fighting abilities, and the ability of markets to absorb the volume of government debt being issued.

The trend predates the conflict

Before the war in Iran began in late February 2026, long-term yields were already drifting higher. Canada's yield curve had been steepening through 2025, primarily through short-term yields falling as the Bank of Canada cut rates, while long-term yields moved in the opposite direction, consistent with the experience of other advanced economies.

The Bank of Canada's own researchers documented this divergence in a March 2026 article, finding that the Canadian term premium had risen to levels not seen in over a decade, and that this increase has been a global phenomenon.

What’s driving it? A key factor identified by Bank of Canada researchers was a growing unease about the market's ability to absorb the large volume of government debt being issued globally. Pandemic-era borrowing raised public debt levels substantially, and new spending pressures— most notably higher defence commitments—have kept issuance elevated. At the same time, central banks have taken a step back from purchasing government bonds and, in some cases, are actively reducing their balance sheets, leaving private investors to absorb a much larger share of government debt. As we’ve touched on in a previous Twenty-Four, in 2025, gold displaced U.S. Treasuries as the primary reserve asset, signalling yet another shift in how central banks view global risk.

The Iran shock: real, but concentrated

The war has added a layer of complexity, primarily through energy markets. The Bank of Canada's Governing Council explicitly warned that energy price volatility and the potential closure of the Strait of Hormuz represent ongoing upside inflation risks. Canadian headline inflation rose to 2.8% in April, with gasoline prices jumping 29%. However, a key distinction is worth noting. The Bank of Canada's preferred core inflation gauges—which strip out volatile categories like gasoline—showed that prices excluding gasoline rose 2%, slower than the 2.2% recorded in March, suggesting that knock-on effects from the war have not yet spread broadly.

That has implications for how durable any de-escalation relief might be. A ceasefire or reopening of the Strait of Hormuz would likely ease the inflation expectations component of long-term yields—the part of the term premium reflecting concerns that energy costs bleed into broader prices. Oil markets are sensitive to geopolitical risk, and they tend to respond quickly when those risks recede.

But that would leave the fiscal and debt-absorption concerns intact. Those pre-date the conflict, are shared across advanced economies, and are unlikely to be resolved by a change in Middle East conditions.

Canada in a global context

The Bank of Canada's research confirms that Canadian term premiums track those of other advanced economies closely—a reflection of Canada's status as a small open economy where global forces heavily influence domestic financial conditions.

Domestically, Canada is projected to have the lowest net debt-to-GDP ratio compared to the other G7 countries. However, Canada's 2026-27 fiscal estimates project $502.8 billion in spending, including over $50 billion for national defence—adding supply-side pressure to long-term yields in line with what other G7 governments are experiencing.

The Bank of Canada finds itself navigating a difficult environment: ongoing geopolitical tensions continue to generate uncertainty, core inflation is well-behaved but headline inflation is elevated, a technical recession, and long-term borrowing costs are rising independently of its policy rate decisions. Overall, the transmission of monetary policy to the broader economy has become more complicated. The Bank of Canada will have to balance managing inflation, and its recent shocks, amidst a stagnating economy.

Observations going forward

What the current episode illustrates is that long-term borrowing costs respond to more than just the near-term inflation or growth outlook — they reflect investor assessments of fiscal trajectories, debt sustainability, and the capacity of markets to absorb government borrowing over long horizons. The Iran conflict has intensified an existing trend, but the underlying dynamic was already in place. Should tensions ease, the durability of the relief to come will depend more on how governments across advanced economies — Canada included — address the fiscal pressures that were accumulating well before this conflict began.  

Answer to the previous trivia question: The world's first AI chatbot was ELIZA, created in 1966 by Joseph Weizenbaum at the Massachusetts Institute of Technology

Today’s trivia question: Why are bonds called bonds?