The U.S. economy appears to be in a new era of higher-for-longer bond yields. In theory, this should be a more challenging environment for equity investors, but Wall Street’s stellar performance in recent years suggests that is not necessarily the case.
Treasury yields have hit new multi-year highs in recent weeks, with the 30-year yield reaching the highest level since the mid-2000s.
Yields, which were floored after the global financial crisis of 2008, rose when the Federal Reserve began aggressively raising interest rates in 2022 to fight inflation. They have remained elevated ever since, even as the policy rate was gradually lowered in 2024 and 2025, and are rising now as bond investors anticipate a resumption of Fed tightening.
So what does this mean for equity investors?
Intuitively, higher borrowing costs should be a headwind for stocks.
From a macro perspective, they make it more expensive for consumers and businesses to borrow, spend and invest. All else being equal, this should weigh on economic growth and corporate profits. Higher borrowing costs are a particular concern for U.S. hyperscalers like Alphabet, Microsoft, Meta and Amazon, which are burning through their free cash flows and increasingly turning to the debt markets to help fund the trillion-dollar AI capex boom.
Looked at through an investment lens, higher bond yields make fixed-income assets more attractive relative to equities, shrinking the so-called equity risk premium. More importantly, higher yields translate into a higher discount rate, which reduces the present value of future earnings – a particular concern for tech and other growth-sensitive sectors.
Of course, strong earnings can offset rising bond yields, as the “Magnificent Seven” U.S. tech giants showed in recent years. But some of these firms’ shares, notably Tesla, Microsoft and Meta have fallen sharply this year and are in technical bear markets. Even the high-flying Philadelphia semiconductor “SOX” chip index has slipped into bear market territory. These slumps could simply indicate investors’ growing concerns about the durability – and profitability – of the AI spending spree, but they could also be a signal that higher bond yields are starting to weigh on equity performance for all the reasons noted above.
But you don’t have to zoom out far to see the other side of this argument. The S&P 500, Dow Jones Industrials and Russell 2000 small cap indexes are all just 3 per cent off their all-time highs. Granted, the Nasdaq is down 8 per cent from its June 1 peak, but the tech-heavy index has notably outperformed the other three benchmarks in recent years. This hardly looks like an equity market under stress.
All things considered, Wall Street still appears to be taking higher bond yields in stride, an indication that equity investors are focusing more on stronger growth rather than fiscal or inflation fears.
There are good reasons why buyers might be tempted to continue ploughing cash into equities despite the higher-for-longer bond outlook.
Rising yields are not automatically bearish if they are being driven by strong nominal growth and earnings, which currently appears to be the case.
Nominal annualized GDP growth in the first quarter was just under 6 per cent – and real GDP growth of around 2 per cent this year would keep nominal growth near that level, perhaps even higher. True, inflation is above target and sticky, but it’s not spiralling out of control.
Meanwhile, earnings growth expectations are running at an extraordinary pace – close to 40 per cent for the second quarter and nearly 30 per cent for the calendar year. However, one should note that these hopes rest largely on AI, with almost 75 per cent of earnings growth in the April-June period expected to come from the tech and communications services sectors.
Perhaps what we’re seeing is a return to an equity environment that is less dependent on multiple expansion than in recent decades. As Jim Caron at Morgan Stanley Investment Management notes, the bond market repricing following the zero-rate “anomaly” of the pre-pandemic years shows investors are being weaned off their “obsession” with dovish Fed policy and putting greater faith in the durable growth story.
“What is the biggest market misunderstanding? In my view, it is the idea that higher rates automatically mean recession,” Caron wrote last month, adding that a “disorderly” rise in long-dated yields is a worry, but only if it is driven by deficits rather than growth.
Of course, the underlying U.S. fiscal picture is hardly encouraging, and it’s safe to say investors are not banking on a sudden outbreak of fiscal discipline in Washington. With defense spending and interest payments soaring, the federal deficit isn’t shrinking any time soon. This should put a floor - or perhaps a springboard - under the term premium and longer-dated yields. If this becomes the main driver of higher bond yields over time – rather than a scramble for capital to fuel a technological boom – then equities could be in trouble.
But, for now, strong earnings and solid, steady growth appear to be helping stocks learn to live with rising bond yields. We may soon discover whether that’s the new normal or merely a calm before the storm.