Provincial spreads grow more volatile as credit correlation with US weakens
US government bond yields are sitting near the top of their range since 2000, a positioning that has historically translated into stronger forward returns for fixed income investors, according to new research.
The findings come from FTSE Russell's quarterly Fixed Income Insight Report, covering the US and Canadian markets through the second quarter.
The report's authors, Robin Marshall and Belle Chang of FTSE Russell's Global Investment Research team, found that starting yields carry strong correlation with subsequent performance across Treasury maturities.
Correlation coefficients between yield levels and forward returns ranged as high as 0.95 for two-year forward returns on the 1-3 year Treasury index, and reached 0.92 for 10-year forward returns on the 7-10 year index. The report noted that peak correlations tend to occur when the investment horizon roughly matches the maturity of the underlying index.
Real yields near multi-year highs
Treasury real yields have climbed to levels not seen in years, a shift the report's authors link to a broader change in market conditions. The combination of a US capital expenditure boom tied to artificial intelligence investment, a surge in debt issuance and looser fiscal policy has pushed up demand for capital even as borrowing costs have risen.
This marks a departure from the 2007 to 2020 period, when weak productivity growth and near-zero interest rates were closely correlated, according to the report.
Marshall and Chang argue that ultra-low rates during that period may have suppressed the cost of capital below the marginal product of capital, distorting capital allocation and keeping unprofitable firms afloat. The pairing of AI-driven investment with the end of the zero-rate era could now be lifting productivity, with some evidence of correlation between real yields and productivity growth showing up in the data.
Notably, real yields have also risen in economies without a comparable capex boom, including Japan, the UK and Germany. The report attributes this to rising inflation uncertainty and higher real term premia in those markets, driven by recent inflation shocks and expectations of increased debt issuance.
Fed holds firm as inflation stays sticky
The Federal Reserve's June meeting, the first under new chair Jerome Warsh, struck a hawkish tone that pushed short-run inflation breakevens lower, reinforcing weakness already driven by falling oil prices. Persistently above-target inflation continues to limit the Fed's room to maneuver even as the capex boom continues to support growth.
The central bank has also opened a review of the size and structure of its balance sheet, though the report suggests the fed funds rate will likely remain the primary policy tool, with the balance sheet held in reserve for emergencies.
Across the border, the Bank of Canada faces comparatively little pressure to shift policy, with inflation running near target and rates close to neutral.
Canada decoupling from US
Canadian and US fixed income markets are showing increasing signs of separation, according to the report. Long-dated real yields in Canada have diverged from US TIPS, a trend that has widened since the 2022-23 tightening cycle and the Bank of Canada's subsequent move to ease policy ahead of the Fed starting in June 2024.
Provincial bond spreads have also grown more volatile since 2023, a pattern that has spread beyond Alberta to other provinces including British Columbia, where spreads widened sharply in the second quarter amid concerns over rising issuance.
On the credit side, the correlation between Canadian and US investment-grade spreads may be overstated by autocorrelation within the two data series, the report found.
When measured by first differences rather than spread levels, the correlation drops sharply, suggesting local factors, including the Bank of Canada's policy responses and differing sector composition, play a larger role than previously assumed. Financial issues, which carry close to a 40% weight in the Canadian investment-grade market, showed strong negative correlation to the yield curve and tend to move first following macro shocks.
Credit spreads hold steady despite issuance surge
US investment-grade credit spreads have remained largely stable even as longer-dated issuance climbs, driven by hyperscalers, utilities and infrastructure borrowers shifting away from funding capital expenditure through cash flow and equity toward bond markets instead. Debt issuance by these companies averaged just 28 billion dollars annually between 2020 and 2024, before jumping to 121 billion dollars in 2025, with 2026 issuance expected to climb further still. Despite this shift, the report found no meaningful steepening of the US credit curve as a result.
An earlier anomaly in agency mortgage-backed securities, where spreads had exceeded investment-grade levels, has also unwound, even as uncertainty lingers over the pace at which the Fed will offload its MBS holdings.
FX and performance
The US dollar strengthened further in the second quarter on the back of the Fed's hawkish stance, pushing most G7 currencies lower. The Japanese yen bore the brunt of the move, falling to its weakest level against the dollar since 1986 despite higher Japanese government bond yields and narrower rate differentials between the two countries.
Government bonds posted modest gains in the second quarter as oil prices fell and markets scaled back expectations for further UK rate hikes, with gilts leading gains among conventional bonds. Credit continued to outperform government debt, with emerging market high yield the standout performer for the quarter.
