Fortifying Portfolios Amid Yield Curve Divergence: U.S. Fiscal Strength vs. Canadian Vulnerabilities

The widening spread between Canadian and U.S. government bond yields has emerged as a critical theme for global investors in 2025. Driven by divergent fiscal policies—particularly U.S. defense spending and infrastructure investments—and contrasting labor market dynamics, the gap between Canadian and U.S. 10-year bond yields has expanded to historic levels. This article examines the structural forces behind this divergence and explores how investors can capitalize on relative value opportunities while hedging against macroeconomic risks like trade wars and recession fears.

The Widening Yield Spread: A Tale of Fiscal Priorities

As of Q4 2025, the U.S. 10-year Treasury yield is projected to reach 4.58%, while Canada's equivalent is forecast at 3.23%, creating a spread of -1.35% (Can - U.S.). This stark contrast reflects fundamental differences in fiscal trajectories. The U.S. has prioritized defense spending, allocating $920 billion to defense in 2025—up 8% from 2024—while Canada's defense budget remains constrained by broader fiscal discipline. Meanwhile, U.S. infrastructure investments, including semiconductor subsidies and energy grid upgrades, have stoked inflationary pressures, prompting the Federal Reserve to maintain higher rates for longer.

Scotiabank analysts note that the U.S. fiscal stimulus has “anchored nominal growth expectations,” keeping bond yields elevated. In contrast, Canada's slower fiscal spending and softer inflation (core CPI at 2.7% vs. U.S. 3.2%) have allowed the Bank of Canada (BoC) to signal potential rate cuts by late 2025. This divergence is evident in short-term rates: the U.S. 2-year yield at 3.00% versus Canada's 2.35%, amplifying the spread across the yield curve.

Labor Markets: The Engine of Rate Differentials

The U.S. labor market's resilience is a key driver of its elevated bond yields. With unemployment at 3.4%—a 50-year low—the Fed has little urgency to cut rates despite slowing growth. Strong wage growth (4.2% YoY) and low jobless claims reinforce the Fed's “higher-for-longer” stance. Canada, while enjoying robust employment (5.2% unemployment), faces softer wage pressures (2.8% YoY) and a BoC more inclined to ease policy to counter housing market headwinds.

This labor market asymmetry has structural implications: U.S. bonds now serve as a “risk-off” hedge against global instability, while Canadian bonds are increasingly seen as vulnerable to cross-border trade tensions.

Macro Risks: Trade Wars and Yield Curve Normalization

The widening yield spread is not without risks. U.S. tariffs on Canadian steel and aluminum—now at 25%—are inflaming trade frictions, with retaliation risks escalating. Meanwhile, the U.S. yield curve's partial normalization (the 10-2 year spread at 0.75% vs. Canada's narrower 0.70%) signals market optimism about U.S. growth, even as recession fears linger.

Investors must balance these risks. A prolonged trade conflict could depress Canadian exports, further weakening its bond yields, while a U.S. recession could trigger a flight to Treasuries, widening spreads further.

Investment Strategy: Positioning for Relative Value

The current environment favors a long U.S. Treasuries/short Canadian bonds trade. Key recommendations:
1. Buy U.S. 10-year Treasuries: Target yields above 4.5%, leveraging the Fed's hawkish bias and fiscal tailwinds.
2. Short Canadian 2-year bonds: Capitalize on Scotiabank's forecast of a 2.35% yield versus U.S. equivalents at 3.00%, exploiting the steepening U.S. curve.
3. Hedge with inflation protection: Consider U.S. TIPS (Treasury Inflation-Protected Securities) to buffer against fiscal-driven inflation.

Conclusion

The Canada-U.S. yield spread is a barometer of divergent economic paths: a U.S. economy fortified by defense spending and labor strength versus a Canadian economy navigating fiscal restraint and trade headwinds. Investors who recognize this divergence can exploit relative value opportunities while hedging against macro risks. As Scotiabank's forecasts underscore, positioning for U.S. Treasury outperformance and Canadian bond underperformance offers a resilient strategy in an uncertain global landscape.

Stay vigilant, but stay long the fiscal leader.