The 10-year Treasury Yield Has Been the Greatest Enemy of the Markets for Years. Why Now Does It Look Different?

The recent surge in the 10-year Treasury yield above 4%, a level that often raises concerns, may not be as worrisome for the U.S. stock market or the economy as it has been in the past. Historically, when the 10-year yield surpassed 4%, Wall Street would react with alarm, fearing that higher borrowing costs could reduce corporate profits, dampen stock performance, and even push the economy into a recession. These concerns were particularly pronounced following the 2007-2008 financial crisis, which led to an era of low interest rates and mild inflation. Back then, the U.S. economy was seen as fragile and ill-equipped to handle significant increases in borrowing costs.

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However, things appear to be different this time. Even as the 10-year Treasury yield hit its highest levels since late July, the stock market has continued its upward momentum. The S&P 500 and Dow Jones Industrial Average have gained 21.4% and 12.8%, respectively, for the year, as per FactSet data. This rally has persisted despite the 10-year yield rising sharply from 3.62% on September 16 to over 4%, just two days before the Federal Reserve cut interest rates for the first time in four years.

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Rather than reacting negatively, the 10-year yield has climbed by around 40 basis points since that rate cut. According to Luke Tilley, an economist at Wilmington Trust Investment Advisors, this reflects an economy that continues to grow steadily, with fears of a recession largely diminishing. Tilley anticipates that the 10-year Treasury yield will stabilize between 4% and 4.25%, marking a new chapter for an economy that has struggled to recover from the scars left by the global financial crisis.

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In response to the financial crisis of 2007-2008, the Federal Reserve took aggressive action, slashing short-term interest rates and engaging in large-scale asset purchases. This helped stabilize financial markets and the broader economy, though it also contributed to an era of ultralow rates. The period that followed saw a surge in negative-yielding bonds globally, as investors sought returns amid low yields. The COVID-19 pandemic then triggered another round of extreme rate cuts, more asset purchases by central banks, and a sharp rise in inflation, which has only recently begun to recede toward the Fed’s 2% annual target.

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The low-rate environment during the pandemic also allowed many U.S. companies to refinance their debt at historically low rates, providing a buffer against the recent rise in borrowing costs. Weaker companies that may have been more vulnerable to higher interest rates moved out of mainstream financial markets, such as high-yield bonds, and into areas like leveraged loans and private credit. This shift, along with a mini default cycle during COVID-19, removed many of the most at-risk borrowers from the high-yield bond space, according to Jordan Lopez, head of high-yield strategy at Payden & Rygel, which manages about $160 billion in assets.

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Lopez acknowledged that higher Treasury yields are generally unfavorable for bonds, but he pointed out that with high-yield bonds yielding near 7%, investors have been drawn back to the sector during bouts of market volatility. For example, in early August, volatility prompted money to flow into high-yield bonds.

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However, long-term yields can also rise due to concerns about the U.S. government's borrowing needs. When "bond vigilantes" become active, they can drive yields higher, making it more expensive for the government to borrow for extended periods. Although the U.S. deficit isn’t an immediate concern, it remains a background issue for the $28 trillion Treasury market.

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Timothy Chubb, chief investment officer at Girard, explained that the market's focus in 2024 has shifted between concerns about economic growth and inflation, a dynamic he described as a "growth and inflation tango." Despite this, Chubb doesn’t believe the rise in long-term yields will alter the Federal Reserve’s approach to easing monetary policy. He sees the increase in long-term rates as a sign of growing confidence that the Fed will achieve a "soft landing" for the economy, avoiding a severe downturn. However, Chubb also cautioned that while interest rates remain restrictive, corporate earnings growth could slow further in 2025.

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When interest rates are low, stock prices, particularly those of technology companies and other rate-sensitive sectors, tend to rise. But when yields increase significantly, they can reduce the present value of future earnings, weighing down stock prices. This scenario could feel similar to a recession next year, Chubb noted, akin to how the housing market has been impacted since the Fed began raising rates in 2022 to combat inflation.

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Despite the recent climb in the 10-year Treasury yield, Chubb believes it has likely overcorrected both downward and upward in recent weeks. He expects yields to trend lower over the next 12 months, though the path may be uneven. This suggests that while higher yields present challenges, they might not be the formidable obstacle to economic growth and market performance that they once were.

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