Macro Markets and Machines_The Economic and Market Transformation Driven by AI_GWM report - Flipbook - Page 17
Macro, Markets, and Machines
November 2025
Section 2.4: The Fixed Income Perspective
The impact of AI extends beyond equities, influencing fixed income markets through its effects on interest
rates and bond yields. While the inclination may be to view AI as a long-term deflationary force due to the
associated boosts to productivity growth and reduction in unit labour costs, research from the Bank for
International Settlements (BIS) and the IMF – discussed later in this report – point to a more nuanced outcome.
Both research reports find that inflation may be biased higher in the short to medium term due to offsetting
forces via stronger aggregate demand – though this depends on labour market outcomes, as heavy job losses
will likely be a net negative for demand – before easing later. Assuming labour market conditions do not
meaningfully deteriorate, the BIS research report projects that even though inflation pressures may diminish,
they will remain elevated relative to the baseline over the forecast horizon, while the IMF forecasts a mild
deflationary effect over the long haul, helped in part by central banks pulling the necessary monetary policy
levers to restore price stability. In other words, the inflation outlook is uncertain, resulting in a range of
possibilities for fixed income investors to consider.
In one scenario, the investment required to get AI off the ground may exert upward pressure on inflation and
bond yields before productivity gains fully materialize. Firms deploying AI must commit substantial capital to
computing infrastructure, data centres, semiconductors, and skilled labour. This surge in demand for hardware,
energy, and construction capacity may also create bottlenecks on the supply side. As is the case with most
transformative technologies, there is typically a lag between investment and measurable output gains. During
this interim period, aggregate demand rises due to the scale of capex and income gains for beneficiaries of the AI
build-out (with capital market gains possibly resulting in wealth effect tailwinds for spending) while aggregate
supply must catch up. Central banks may respond by keeping monetary policy restrictive, pushing short-term
yields higher, while long-term yields may rise less amid expectations that productivity improvements will
eventually offset price pressures, resulting in a mild bear flattening of the yield curve.
Once productivity gains begin to filter through the broader economy, inflation pressures should ease, growth
may stabilize at healthy levels, and higher output per worker amid improving productivity may soften unit labour
costs and anchor inflation expectations. Over time, this environment may favour longer-duration exposure as
easing inflation leads to looser monetary policy settings, bringing short-term yields lower, while long-term yields
remain supported or fall less due to strong growth expectations offsetting disinflationary forces, causing the
curve to bull steepen.
In an alternative scenario, productivity growth lifts the economy’s underlying potential, causing the neutral
interest rate (i.e., the rate that neither stimulates nor restrains economic activity) and yields to rise or remain
elevated. Against this backdrop, the curve could bear steepen as long-end yields adjust upward to reflect
stronger growth prospects and a higher long-run neutral rate. From a positioning standpoint, this argues for a
more balanced duration posture by maintaining exposure to capture carry and potential disinflation benefits but
remaining cautious about overconcentration at the long end if yields structurally reprice higher.
The fiscal side of the ledger may also matter. Fiscal projections from the U.S. Congressional Budget Office (CBO)
are premised on a relatively modest pace of productivity growth. However, if technological innovation lifts
potential output – and by extension tax revenues – the fiscal outlook could improve (Exhibit 12), reducing the risk
premia embedded in long-term yields (provided there is not an equivalent increase in fiscal spending). A decline
in risk premia due to an improved fiscal picture could offset the pressure on long-term yields from higher neutral
rate expectations, dampening the relative rise in long-term yields versus short-term yields. This may pave the
way for investors to extend duration profiles to capture the compression in term premiums, reducing concerns
about debt sustainability. Of course, the opposite scenario may unfold should technological innovation plateau
and productivity gains diminish.
Scotia Wealth Management
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