When will higher Treasury yields pressure equities?

Treasury yields have been marching higher this year due to a trifecta of factors: 1) higher energy prices leading investors to price in a Fed rate hiking (not cutting) cycle, 2) a resilient U.S. and global economy suggesting that the “normal” interest rate might have moved up and 3) elevated sovereign and corporate bond issuance leading to a higher cost of capital. This has now pushed up the 10-year yield +112bps since December 31st, including a move up of 53bps just in September. Earlier this week, the 10-year yield briefly touched 5.36%, the highest level since 2002. The speed of the move, the multi-decade high level it reached and the spike in rates volatility is leading investors to wonder when these higher Treasury yields will pressure equities?

Since 1968, yields and stocks have tended to move together when yields were low (yields up, stocks up) until reaching a certain yield level when that relationship flips (yields up, stocks down). [1] Intuitively that makes a lot of sense. When yields are rising from low levels, that’s probably for a good reason: economic growth is improving and inflation is in the sweet spot where it’s helping revenue growth more than it’s hurting margins (and vice versa). After crossing a threshold, yields are likely rising for the “wrong” reason: inflation is moving above the desired target, leading to margin pressure for corporates and/or rate hikes by the Fed which could be damaging for future real economic growth. Additionally, at that point higher yields are likely to pressure stock valuations and fixed income might be competing with stocks for investor dollars.

So what’s the line in the sand for stocks? The reality is that the relationship between yields and stocks has changed over time, depending on the macroeconomic and earnings context. We can separate history into 3 different time periods:

1. The old normal: From 1965 to late 2008, yields and stocks tended to move together until yields rose to 4.5% when they then moved in opposite directions.
2. The new normal: From 2009 to mid-2021, the same relationship held, but the hurdle for it to flip was lower, at 3.5%. This was due to more muted economic growth and inflation – and hence a lower “normal” interest rate for the economy and markets.
3. The new new normal? Since mid-2021, the relationship between yields and stocks has not followed as clear of a pattern as before. Correlations have flipped between positive and negative, without a clear yield differentiator. In fact, if anything, the relationship has been more negative than positive even at low yields (probably because inflation shocks have been the dominant concern). 

The looser relationship between yields and stocks is also likely due to the changing nature of the market and its dominant earnings driver. The ten largest companies now represent 40% of the S&P 500 index – and are driven much more by the AI theme than by the real economy. While the hyperscalers have begun to issue debt to fund their capex spending, higher rates (at least at this level) seem unlikely to derail their trajectory. Bond yields and stocks may continue to beat to the sound of their own drum - and the most important sound is that of the AI capex boom, the ability of the hyperscalers to monetize that investment, and ultimately the adoption of that technology across sectors.

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