WILL HIGHER INTEREST RATES BE A BULL-BUSTER?
Long-term bond yields are going up around the globe. The countries affected have a wide variety of fiscal backdrops and central bank policy rates suggesting the cause is something other than a deficit or a signal from a central bank’s recent policy. In the U.S., the entire yield curve is shifting upward (all maturity lengths). As shown below, the yield on the 10-year U.S. Treasury is up substantially this year:
Source: Bloomberg
What is going on? The sharp rise in yields here in the U.S. has sparked a wave of explanations including:
- Resilient U.S. economic growth around the 2% level on an annualized basis. Or might growth be accelerating because of the AI capex boom?
- Sticky inflation. Last month’s CPI, PPI and PCE inflation measures all point to inflation above the Fed’s long-term goal of 2%. Inflation is stuck around the 3% level and has been a problem now for about five years.
- Fiscal concerns. Last week the gross U.S. debt surpassed a record $40 trillion. The federal debt has ballooned to 100% of GDP from 32% in 2008. When is the day of reckoning?
- Fed credibility questions. A failure to hike rates in the absence of declines in either inflation or payroll growth could threaten Fed credibility. This has been a market concern since Mr. Warsh became Fed Chairman. This is a bit odd to us as Warsh is seen as the most hawkish central banker since Volcker. Yet the market still questions whether Kevin Warsh is too dovish – or is he looking for excuses to be more dovish? He certainly didn’t sound that way last Friday at Jackson Hole. The key line about the upcoming September Fed meeting: “While this summer’s PCE and CPI readings were better than expected, they do not tell me that underlying trends have meaningfully improved . . . We must be confident that underlying inflation is moving to our objective, clearly and at sufficient speed. Otherwise, we have work to do.” The “work to do” is clearly a reference to tightening. But the markets are still not fully convinced the Fed will deliver. Market odds of a tightening in September only rose to 57.1% after his speech (up from 35.8%). We would place the odds higher than 57% after his clear warnings.
- AI investment. Is the boom in AI capex investment crowding out other borrowers and pushing rates up? After all, the five largest hyperscalers had already issued $159 billion in bonds by mid-2026, surpassing the entirety of 2025.
Those are five powerful reasons for interest rates to rise. The key question for investors to ask: Is this a short-term phenomenon (cyclical) or long-term (structural)? Our take is that this is structural and a return to normal levels. Apparently “rout” is the new word for interest rates returning to a historical norm. The low-rate era following the 2008 financial panic is over, in our view. Borrowers of all kinds will have to adjust – not least the Western governments that have spent and borrowed as if near-zero interest rates would last forever. For businesses, rising yields mean higher borrowing costs. For the public, rising Treasury yields could mean paying higher rates on auto loans, mortgages and other loans. In conclusion, the markets seem to be managing an adjustment to rates rather than anticipating a significant new hiking cycle.
Can the stock market handle higher interest rates? We think so. After all, the historical record of stock returns when interest rates were higher (“normal”) is strong. Both the economy and markets will have to adjust to their old pre-2008 ways but it doesn’t mean the bull market in stocks must end. However, it may slow down future gains because higher interest rates mean equilibrium valuation levels for stocks may be lower.
Higher interest rates also mean revisions to our equity strategy. For example: Since higher interest rates affect valuations more on longer duration stocks (growth stocks), value stocks become more attractive on a relative basis. In fact, value stocks have outperformed growth since interest rates started rising. We expect this to continue. Our focus on new purchases is now tilted to value stocks, including dividend stocks. Also, smaller companies often have floating rate debt. The increase in debt cost may slow down earnings growth going forward for this group. Bigger is better.