Long-Term Bond Rates Are Rising Because of Real Rates, Not Expected Inflation, and That Is Bad

The OECD this week forecast that interest rates are expected to rise by a half point in most countries, including Canada, in the coming year. This is on top of recent hikes by the U.S. Federal Reserve, the European Central Bank, Japan and New Zealand. Only a year ago, we heard from experts that interest rates could fall as economies stalled.

Inflationary pressures are part of what’s causing interest rates to rise. The headline inflation rate peaked at over eight per cent in the EU, U.S. and U.K. in 2022 and hit 6.8 per cent in Canada because of over-zealous COVID spending and accommodative monetary policy. It has since fallen to about three per cent in many countries (without energy and food prices closer to 2.5 per cent), yet it is still running higher than the two per cent target most countries aim at. Though inflation is an important factor influencing interest rates, something else is now at play. Real interest rates are rising and that’s a — excuse the pun — real worry.

Consider 10-year U.S. bonds, which are viewed as relatively riskless. They sold at an average interest rate of 2.95 per cent in 2022. In the same year, 10-year inflation-protected U.S. bonds paid roughly 0.7 per cent, implying that the market was forecasting 2.25 per cent inflation over 10 years. In 2025, the story was much different. The average interest rate on 10-year U.S. bonds was 4.29 per cent, while inflation-protected 10-year bonds were paying 2.2 per cent, indicating an expected inflation rate of 2.1 per cent. In other words, the market was not perceiving a major change in long-term inflation rates. Instead, interest rates were rising because the real rate had almost tripled since 2022.

With all levels of government ramping up deficit spending, Canadians should expect real interest rates to be that much higher. Total government gross debt as a share of GDP is a worrisome 111 per cent — though at least, unlike the U.S., we have put money aside to fund public pension funds without needing to raise taxes. Public budgets will be even more difficult to balance as public debt charges rise.

Even so, Canada is vulnerable to a major financial crisis in which governments have difficulty selling their debt, especially to foreign investors, who could turn against an economy. Over a third of federal debt is now owned by non-residents. That’s a higher ratio than in 1994, when we almost had to be bailed out by the IMF.

Canada’s economic growth is currently like that of our newfound EU friends: plodding. With the U.S. tariff war, higher oil prices and manufacturing companies migrating to the U.S., growth will continue to stall. That makes the combination of higher real interest rates and uncontrolled public debt even more explosive.

A version of this article also appears in the Financial Post.