Must high bond yields crack stocks?

Good morning. Oil passed $100 yesterday, for the first time since July. Perhaps as a result, a $6bn Treasury buyback announcement from Scott “I am the house now” Bessent was not enough to keep Treasury yields from rising. Perhaps Bessent, the US Treasury secretary, is only “the house” in Japan, where the yen has risen since the US and Japan intervened in that market? Does this make him more of a vacation house? Or perhaps an Airbnb? Send your thoughts: [email protected].

Yields up, stocks down?

The 10-year Treasury yield, at 4.85 per cent, is now just a few basis points from its 2023 highs and the symbolically important 5 per cent level. This has the punditocracy asking, when do yields crack the stock market? Here is Michel Lerner of the UBS Holt team:

History suggests bond vigilante episodes rarely remain contained given the challenges of curbing deficits without weakening growth or fuelling inflation. Among highly indebted economies, US equities appear particularly vulnerable to a spillover.

And here is Ruchir Sharma in the FT this week:

Going back 300 years, every major bubble ended only when borrowing costs rose significantly for the companies at its core . . . the marker to watch is the yield on 10-year US Treasury bonds . . . When it decisively breaches 5 per cent, the upper end of its range since the dotcom period, the AI bubble could pop.

On to Freya Beamish and Davide Oneglia of TS Lombard:

While we don’t think there is any magic number that tips over equities, we stand by our long-held view that macro fundamentals suggest the US 10-year should be at least 5% to compensate for this environment . . . term premium in the US still looks too low to compensate for the loss of hedging capacity for equities . . . eventually these things have to come back into line and compression of US equity premium does not look sustainable.

I share the feeling that something is wrong about the combination of high yields and high stock prices. But what is the causal mechanism by which high yields force stocks down? I can think of four possibilities:

1. High rates slow the economy by raising the cost of financing for cyclical business sectors, profits fall and stock prices follow.

2. High rates — a higher discount rate — reduce the present value of companies’ future cash flows, making stocks less valuable.

3. High rates pull capital flows away from stocks by offering more attractive prospective returns.

4. High rates force governments to cut deficits, and the reduced deficit spending is balanced — as it often has been historically — by lower corporate profits.

Consider each in turn.

On #1, the traditional view is that the crucial sector is housing. Higher rates make mortgages more expensive, fewer houses get bought and all the activity that goes into residential investment — construction, renovation, transport, furnishings and so on — slows. This activity is the key “swing factor” for the economy. Or as Edward Leamer put it 20 years ago, “Housing is the business cycle.”

But the housing market is already bad! More precisely, it is frozen, with moderate new home sales, existing home sales at historically low levels, and residential investment low and falling as a share of GDP:

Why is the economy humming along when housing is persistently weak? Ajay Rajadhyaksha of Barclays says data centre construction has taken up the slack:

US data centre construction spending has reached $85bn in 2026, up from $45bn just two years earlier. By our estimate, 74 new facilities have broken ground this year across 28 states . . . When a hyperscaler builds a data centre complex a quarter the size of downtown Manhattan — and several are doing exactly that — it hires roofers, electricians, plumbers, steel workers, concrete crews and general contractors . . . This is why the traditional rate transmission mechanism has not worked.

And hyperscaler spending has not been rate sensitive, or indeed sensitive to anything at all. The Big Techs see themselves as fighting for survival, so no price is too high. But data centre spending isn’t perpetual, Rajadhyaksha points out: after they are built, data centres are not big employers. If and when we have built enough compute capacity, old cyclical forces will be relevant again.

It is not clear to me that investors in data centres will remain rate insensitive forever, however. At some point, returns on the trillions of dollars in AI investment will become salient to decisions about further investment. At that point, discount rates will matter, possibly a lot. One might argue that it is already happening to the financially and/or technologically weaker AI players such as Oracle, for whom the question of returns on investment are already pressing.

On #2, the net present value maths works, but reality does not always co-operate. In 2021-2022, when rates rose with inflation, equity valuations duly fell — but rates stayed high and valuations bounced right back:

Part of the rebound is due to profit growth, which is the other component in net present value calculations. Still, we are not talking about an “automatic” process, where higher rates force valuations down if growth is constant. Animal spirits are involved. Human beings have to decide, en masse, that stocks are just too expensive given the opportunity costs. Moods before maths.

Putting it that way shows how mechanisms #2 and #3 are closely related. The old “Fed model” said that when the forward earnings yield on the S&P 500 (currently about 4.6 per cent) was below the 10-year Treasury yield (4.85), stocks are too expensive — the intuition being you should get a higher yield on stocks, which are riskier than bonds. How big the gap should be is disputed, of course. In a moment when inflation uncertainty looms large, you’d think everyone would demand more return from bonds (but it is worth noting that inflation-adjusted Treasury yields are near long-term highs, too). Again, animal spirits are a factor: investors have to care about relative valuations for the numbers to matter, and a lot of the time they just don’t.

If flows into US investment funds are any indication, we are not seeing signs of a reallocation towards bonds and out of stocks. Equity flows spiked this summer, and have come down recently. But bond flows are softening too.

Of course, the mechanism may take time. As bond prices fall and investors with fixed allocations rebalance, there could be a drip-drip move away from equities, at least until stocks fall too.

As for #4, I am confident that significant government austerity would crack the stock market. The federal deficit in this fiscal year will be about $2tn. To scale that, total US after-tax corporate profit is $4.3tn. If the borrowed government money were to stop flowing, the shock to the economy and stocks would be huge.

But I don’t think austerity is going to happen any time soon. My guess is that rates will have to go quite a bit higher to change the federal government’s habits. So I’m more concerned about the first three mechanisms, but as I have indicated, “mechanism” may be the wrong word. The emotions of data centre investors and equity portfolio managers will be decisive, and emotions follow no law.

One good read

Look how they massacred my deli.