The Big Picture
Briefing.com Summary:
*Rising Treasury yields increasingly threaten stock valuations by reducing future cash-flow values and offering attractive risk-free alternatives.
*Markets no longer expect Fed rate cuts; futures now imply growing odds of another rate hike by early 2027.
*Bond markets signal inflation concerns and slower growth ahead, contradicting stock investors’ optimism surrounding AI-driven economic strength.
Stock prices (some, not all) have been rising along with interest rates. It hasn't mattered much to some stock market participants (not all) that interest rates have been rising, but it is getting harder to ignore.
The 2-yr note yield is at 4.08%, yet the target range for the fed funds rate is just 3.50-3.75%; the 10-yr note yield is at 4.60%; and the 30-yr bond yield is at 5.13%.
With the AI boom unfolding, one might interpret the jump in interest rates as an expression of strong economic growth. On the other hand, with the recent surge in inflation, one might interpret the jump in rates as an expression of inflation concerns that could ultimately give way to demand destruction and slower growth.
The latter isn't readily apparent yet, but the Treasury market, as opposed to the stock market, is attuned to the inflation concern. Accordingly, the stock market should start tuning into that.
Higher Equals Lower
Higher interest rates lower the present value of future cash flows, and there is no question that the stock market has been assigning a lot of value to the future cash flows for many companies tethered to the AI buildout.
There is a valuation headwind forming, then, for the stock market. Beyond that, higher interest rates—and specifically higher Treasury yields—pose a competitive threat for stocks. Treasuries are essentially risk-free, whereas stocks are far from it.
A 2-yr note yield north of 4.00%, or even a 1-year T-bill yield of 3.80%, stacks up nicely relative to the 1.34% dividend yield for the S&P 500. The counterargument is that stocks still offer a better return opportunity in a rising inflation environment that enables companies to raise prices and to protect profit margins.
To wit: the 1-yr T-bill rate of 3.80% looks pretty good as a return metric, but adjusted for inflation (CPI), the real yield is 0.00%. Nothing, however, can be a whole lot of something if stocks slide into a correction, so the choice one has to make revolves around capital preservation versus the pursuit of total return. That decision is ultimately informed by an individual's risk tolerance.
All else equal, lower interest rates are better for the stock market than higher interest rates, but higher rates don't have to be a death knell for the stock market if they are rising for good reasons, namely strengthening economic growth that bodes well for earnings prospects.
The Treasury market, however, isn't seeing things in that light. If it were, the yield curve would be steepening, with long-term rates rising faster than short-term rates. What is unfolding now is a flattening of the yield curve, with short-term rates rising faster than long-term rates.
That connotes concerns about inflation and the possible need for the Fed to raise rates to tamp it down, which would then slow economic growth. That perspective is being corroborated in the fed funds futures market and in rising breakeven inflation rates.
When the year began, the market expected two rate cuts before the end of 2026. That expectation has been wiped away and has been replaced by a belief that the next move by the Fed is more likely to be a rate hike. Currently, there is a 58.9% probability of at least a 25-basis-point hike at the January 2027 FOMC meeting, according to the CME FedWatch Tool. Meanwhile, the five-year breakeven inflation rate has climbed from 2.26% at the end of 2025 to 2.70% today.
Briefing.com Analyst Insight
Kevin Warsh is walking into the Fed chair position amid a fine mess of expectations, and his pre-confirmation view that there is scope to cut rates is looking less polished now with CPI inflation up 3.8% year-over-year, PCE inflation up 3.5%, and PPI inflation up 6.0%.
The stock market continues to operate largely with the view that those inflation prints are transitory, which is partly why it managed to set new record highs as they were released. The Treasury market is less convinced, or certainly more leery, about that idea given the broad-based advance in wholesaler services inflation seen in the April PPI report and the stark 0.6% increase in the shelter index seen in the April CPI report.
These inflation pressures, though, aren't just local. They are global, and they have contributed to Japan's 30-yr bond hitting 4.00% for the first time since 1999 and the UK's 30-yr gilt rising to its highest level in 28 years.
The higher rates abroad present a risk here, as they might have more appeal than years past for foreign buyers to keep their capital at home. If they do, that could sap some of the demand that has in the past helped keep Treasury yields under wraps.
Altogether, higher rates here and abroad are more about inflation and fiscal concerns than they are about a confident growth outlook. Those higher rates will weigh on loan demand, add to financing costs, and presumably create a barrier for multiple expansion.
Then again, momentum can be a powerful driver of stocks for a market running with AI blinders on. If rates keep rising, though, the stock market will be forced to see the light of a fundamental challenge that it hasn't accounted for during this monstrous rally, as higher rates in this context are a precursor to slower growth, not faster growth.
