By Douglas Porter

October 1, 2026

How should central banks respond to the dramatic run-up in bond yields over the past three months? Even with some late-week relief from lower oil prices and a soggy U.S. employment report, 10-year Treasuries are up 75 bps since the end of Q2, like-dated gilts and GoCs are up by more than 50 bps, while those in France have rocketed 125 bps.

Some would argue that the markets are doing the tightening work for the central banks—and then some. However, BoE voter Catherine Mann this week asserted that central banks “can’t rely on risk premia to do the work of monetary policy; need to raise bank rate” and that “tighter financial conditions (from higher bond yields) are no comfort when they reflect higher inflation risk premium”.

That is the hawkish take, and Mann has been among the minority voting for BoE rate hikes. But we believe the answer is more nuanced than that, and it depends on precisely why yields are rising and the specific circumstances in each economy.

For example, the bond sell-off took a darker turn this week, with yields in much of Europe suddenly ratcheting higher, especially in France. That nation has seen its 10-year yields jump more than 100 bps just since early August amid mounting fiscal concerns. The spread with German yields has surged above 120 bps, or the highest since the Euro crisis was still raging in 2012.

A draft budget looks to trim France’s deficit from 5.4% of GDP to 5.0%, but even if that passes, markets are focusing on next year’s elections and what may follow, with a far-left candidate proposing to cancel France’s debt. The possibility of gridlock also beckons, making any serious efforts at fiscal consolidation difficult. Suffice it to say that the correct answer to the opening question in this case would not be for central banks to hike rates.

Alas, France’s interest rates are set by the ECB, which must consider the entire region’s economic outlook. And the major data point in Europe this week was a nasty 0.6% m/m rise in the September CPI, which cranked the annual inflation rate six ticks to 3.8%.

The relatively good news was that core inflation only nudged up to 2.5%, but all three of the largest Euro economies saw headline inflation far above expectations—including France at 3.4%. The ECB has already lifted rates by 50 bps this year to 2.50% on the deposit rate, taking them (unusually) even above Canada’s overnight rate.

While a pullback in oil this week, to about $102 for Brent, and Friday’s announced release of G7 diesel reserves will provide some inflation relief, we still look for one more ECB hike by year-end. And there certainly is precedent for the ECB to hike in the teeth of a fiscal crisis; recall it raised rates 50 bps in 2011 (before promptly more than reversing course over the next year).

The broader issue for Europe and some other regions is that the sharp back-up in global yields is moving far beyond their underlying economies’ capacity to handle higher rates. A major factor behind the upswing in yields is the voracious demand for capital from the AI build-out.

BoC rate expectations were dialed back this week along with others, as a hike in October is now viewed as unlikely. You probably know our outlier view — no rate hikes unless and until we have less trauma on the trade front.

That’s also a big reason the U.S. economy has been mostly resilient this year, and has even led to some specific inflation pressures in related goods (e.g., memory chips). But that AI spending boom hasn’t done much to juice European growth, so its economy is feeling the pressure from high energy prices and higher yields, without the associated bounce in growth.

One key measure of fiscal sustainability for any economy is whether its underlying growth rate (g) is above borrowing costs, or interest rates (r). Put another way, is g > r? If yes, then interest rates alone are not going to drive finances into an unsustainable situation. We’ll look at this in nominal terms to keep it straightforward.

Over the past 10 years, France’s nominal GDP has risen at an average annual rate of 3.2% (and just 1.9% in the past year). The situation was sustainable when bond yields were zero or even negative in the years before and during COVID, became a bit dicier by the start of this year when yields topped 3%, but is quite problematic with yields now suddenly approaching 5%.

The U.K.’s backdrop, which has been somewhat overshadowed by France’s struggles, is not much friendlier. While nominal GDP growth has generally been firmer in Britain, averaging 4.7% over the past decade (in part due to stronger inflation), its long-term interest rates have also been consistently higher.

As far back as the ill-fated mini-budget in 2022, the U.K. has been faced with gilt yields approaching or even above GDP growth trends, and that is very much the case now with 10-years near 5.4%. Britain’s budgetary backdrop is less problematic than France’s, and the political landscape is less uncertain, but fiscal restraint looms.

Even so, it certainly appears that the BoE will soon join other major central banks on the tightening trail, with the market fully expecting at least one rate hike before year-end.

The fiscal math from rising yields is less troubling for the U.S., with economic growth riding well above interest rates. In the past year, nominal GDP has risen by a sturdy 6.3% (real GDP up 2.2% and GDP prices up by just over 4%), and it has averaged 5.7% over the past decade. Even with 30-year yields above 5.5%, growth remains hearty enough to avoid a vicious fiscal circle on rates alone. However, g > r is only one part of the calculation, and the current large primary budget deficit (i.e., excluding interest costs) is not sustainable.

Arguably, the U.S. is the clearest case where the bond market is sending a message to the central bank that it should be hiking. While fiscal concerns may be playing a moderate role in the yield back-up, firm underlying inflation, solid economic growth, and robust borrowing from the mega tech companies are the major drivers, and all would lean in favour of tighter policy.

However, those factors took a back seat this week to some mildly dovish remarks by Fed speakers (a number said there was no urgency to hike again), cooler energy costs, and a surprisingly docile jobs report. Payrolls rose just 29,000 in September, clipping the three-month trend to 51,000; the jobless rate ticked up for the first time since February to 4.2%; and average hourly earnings cooled to just 3.0% y/y—back to pre-pandemic levels, and below headline inflation. As a result, fading odds of an October Fed rate hike melted further, and even December is no longer seen as a sure thing.

Canadian yields have clearly felt the gravitational pull of rising global yields, but have mostly managed to remain calmer, especially over the past month. For example, since the end of August, U.S. 10-year Treasury yields are up 53 bps while like-dated GoC yields are up “just” 20 bps. They are now thus a whopping 135 bps below U.S. 10s—that’s not quite a record wide, but not far from the 151 bp extreme reached in January 2025 (as the first tariff threats were weighing).

Canada’s cooler growth backdrop, in part because of the trade tussle, slightly milder inflation, and less-fraught government finances have all played a role in dampening the yield back-up. Note that Canada’s fiscal sustainability is much less of an issue than for others, with the 10-year trend in nominal GDP at 5.6% (and 7.1% in the past year alone), versus 10-year yields below 4%. As well, BoC rate expectations were dialed back this week along with others, as a hike in October is now viewed as unlikely. You probably know our outlier view—no rate hikes unless and until we have less trauma on the trade front.

Policy Contributing Writer Douglas Porter is Chief Economist for BMO.