In the five years since the onset of the COVID-19 pandemic, fiscal expansion has become a defining feature of economic policymaking across the globe. Governments in major economies, including the United States, Canada, and even traditionally fiscally conservative nations like Germany, have significantly increased spending. While this approach has provided critical support to economic growth in the short term, it has also introduced notable complexities into financial markets, particularly in the realm of fixed income. This paper explores the implications of fiscal expansion, focusing on its effects on bond markets, private sector activity, and central bank decision making, while also examining how these factors impact fixed income portfolio management.

Fiscal expansion and bond market dynamics

The global surge in fiscal spending has had profound effects on bond markets. In the United States, trillions of dollars in projected deficits over the next decade are reshaping economic expectations, while in Canada, rising investments in defense, infrastructure, and resource projects are driving similar trends. This uptick in fiscal activity has exerted upward pressure on bond yields over the past year, particularly at the longer end of the curve. The result has been a steepening of the yield curve, as longer-term rates have risen meaningfully. This reflects heightened uncertainty around growth, inflation, and the supply of new bond issuance, with investors demanding higher yields to compensate for these risks.

Another notable development has been the heightened sensitivity of bond markets to fiscal announcements. Day-to-day fluctuations in yields have become more pronounced, and government bond auctions are now more volatile than in previous years. While these shifts have not yet reached levels that would cause alarm, they reflect an underlying recalibration of market dynamics in response to persistent fiscal expansion.

Federal fiscal balance as a share of Canadian GDP

As at November 7, 2025. Source: Finance Canada, RBC Economics.

Broader implications of sustained fiscal expansion

While fiscal expansion has undoubtedly supported economic growth in the near term, it comes with significant trade-offs. One of the most concerning is the phenomenon of “crowding out,” where higher interest rates driven by government borrowing make it more difficult for the private sector to access affordable credit. Evidence of this can be seen in Canada’s sluggish credit growth, with banks increasingly accumulating securities rather than expanding lending to households and businesses. This dynamic raises questions about long-term productivity and the sustainability of growth fueled by government spending at the expense of private sector investment.

Contributions to deposit growth

As at August 31, 2025. Source: Statistics Canada, Bank of Canada, RBC GAM

Over the longer term, persistent deficits and rising debt levels could lead to increased interest costs, straining government budgets and raising sustainability concerns. While these issues have been a topic of debate in the United States, they could pose broader risks if fiscal expansion persists across developed markets. Another concern is the potential for fiscal dominance, where central banks may face pressure to support government spending, potentially undermining their ability to maintain inflation targets.

Impacts on central bank policy

The implications of sustained fiscal expansion extend beyond the bond market, complicating the decision-making processes of central banks. Historically, fiscal policy has been countercyclical, expanding during periods of economic weakness and contracting during times of strength. However, the current environment is characterized by fiscal expansion that appears to occur regardless of the economic cycle. This dynamic places central banks in a difficult position, as they must navigate the inflationary pressures that can arise from deficit spending while also managing the broader economic impacts of higher interest rates.

Shelter inflation remains sticky

As at September 30, 2025. Source: Bloomberg, RBC GAM.

For the BoC, inflation remains a central concern. Despite having moderated in recent months, certain components, such as shelter costs, remain persistently elevated. If fiscal spending exacerbates these pressures, the BoC may be forced to keep rates higher for longer, even at the risk of stifling private sector activity. At the same time, higher rates increase borrowing costs for both governments and households, potentially creating a feedback loop of fiscal stress. This delicate balance between fiscal and monetary policy is becoming increasingly important in today’s economic environment.

Portfolio management in a new fiscal era

The shifting dynamics of fiscal and monetary policy have significant implications for portfolio management. One of the most notable changes has been the weakening of the traditional negative correlation between bonds and risk assets. Historically, bonds have served as a reliable hedge during equity sell-offs, but this relationship has become less stable since 2020. Initially, this shift was driven by the high inflation levels that followed the COVID-19 pandemic, which placed upward pressure on bond yields. Today, with inflation largely contained, the primary catalyst has shifted toward fiscal expansion.

Although this instability is unlikely to be permanent, it challenges conventional portfolio strategies and compels investors to adapt to a more uncertain environment. Traditionally, holding duration exposure during risk-off periods – when yields decline – has been an effective way to hedge credit risk in portfolios. Yet, as correlation dynamics continue to shift, investment managers are increasingly exploring alternative strategies, with yield curve positioning being one such example. Historically, when credit spreads have widened, the yield curve typically steepens, offering a layer of protection against credit risk. This strategy can help investors manage the challenges associated with fiscal expansion while maintaining portfolio resilience.

Conclusion

The era of sustained fiscal expansion is reshaping the financial landscape, particularly in bond markets. Yield curves are steepening, volatility is rising, and traditional asset correlations are being disrupted, creating new challenges for investors and policymakers alike. While fiscal spending has supported near-term growth, it has also introduced long-term risks, including the crowding out of private sector activity, rising debt sustainability concerns, and increased complexity for central banks.

For institutional investors, these dynamics underscore the importance of working closely with your investment managers to navigate the evolving market environment. As fiscal policy continues to play an outsized role in economic dynamics, understanding its implications will be essential for managing risk and capitalizing on opportunities in fixed income markets and beyond.

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