Rising government bond yields have not triggered the kind of equity rout some market participants feared. Despite a sharp uptick in U.S. Treasury and global sovereign yields in recent weeks, the S&P 500 sits less than 3% below its August 13 record high, supported by expectations of AI-led profit expansion and a broadly resilient economy that has encouraged investors to buy price dips - and limited a wholesale shift into bonds.
Market observers note the 10-year U.S. Treasury yield's brush with the 5% level in October 2023 resulted in a modest one-day stock selloff. They also recall a more prolonged period above 5% in 2007 - in the run-up to the global financial crisis - that preceded a nearly 5% fall in the S&P 500 over two months and a larger subsequent decline. Still, the current environment has not produced comparable equity distress.
What is underpinning stocks
AI-related growth - Rising yields typically weigh on high-growth stocks because greater discount rates reduce the present value of profits expected further into the future. In the current episode, however, prominent technology companies such as Apple and Microsoft trade just shy of their record highs as the AI adoption narrative continues to support earnings momentum. High-performing semiconductor names have eased back in recent weeks, including a broad pullback on Monday, amid investor concern over a potential moderation of domestic AI investment. Market participants describe at least some of that weakness as a normalization after very large gains earlier in the year.
"We're leaning more into semiconductors; we think there's going to be an even tighter supply-demand dynamic next year when it comes to memory," said Laura Cooper, global investment strategist and head of macro credit at Nuveen.
Robust earnings trajectory - Corporate profitability has provided a central pillar for the market's resilience. Second-quarter earnings for S&P 500 companies are expected to have risen 53% year-on-year, or 49.5% when excluding the energy sector, according to LSEG I/B/E/S data cited by analysts. Forecasts point to profits climbing 35% in 2026, a marked acceleration from the 14% growth recorded last year. The cloud divisions of Alphabet and Amazon have shown particularly strong growth tied to AI demand; excluding mark-to-market gains at those firms, the adjusted growth rate stands at 35%.
"The double headwinds of rising bond yields and oil prices are now testing the market's resilience, but stocks have not lost their key pillar of support, which is fast-rising earnings," said Angelo Kourkafas, senior global strategist-investment strategy at Edward Jones.
Macroeconomic backdrop
The U.S. economy has continued to show underlying strength even as inflationary pressures have persisted, with price moves linked in part to the geopolitical developments that have influenced oil markets. Labor market data showed a sharp acceleration in job growth in August, including a rebound in leisure and hospitality employment after two straight monthly declines. Analysts highlight that consumers, the labor market and corporate balance sheets have generally performed better than many investors had anticipated during the past several years, when recession expectations were more widespread.
Consumer spending, a key component of U.S. economic activity, appears to have held up through the first half of the year. The Bureau of Economic Analysis revised up its estimate of consumer spending growth to 3.4% from an initially reported 3.2%, signaling that individual consumption remained reasonably solid during that period.
Small caps and market breadth
Smaller companies, which often rely more heavily on external borrowing, can be more vulnerable when interest rates rise. Nevertheless, the Russell 2000 index of smaller U.S. firms has markedly outperformed the S&P 500 so far this year, bolstered by strong earnings and investor interest in areas of the market beyond mega-cap technology names. Although higher yields have pressured small-cap stocks recently - pushing the index down more than 5% from its mid-August record high - many market participants still expect momentum to continue.
"Almost all of the lead was built in the first half, when the domestic growth story was doing the heavy lifting: reshoring, an M&A pickup, deregulation and earnings that are far more levered to the U.S. economy than to the mega-cap AI trade. If the Fed holds, that is a tailwind for the Russell, because the group has the most to gain the moment the market stops pricing higher for longer," said Tracy Shuchart, senior economist at NinjaTrader.
Changing relationship between stocks and bonds
Under typical adverse conditions, investors seek the perceived safety of government bonds while risk assets such as equities decline. The recent market dynamics have been different: rising oil prices linked to geopolitical tensions have raised expectations for further interest-rate increases, which in turn sparked a bond-market rout that sent sovereign yields to multi-year highs across several countries as investors demanded higher compensation for holding debt.
Strategists point out that since the inflation shock that followed the COVID-19 pandemic, the correlation between stocks and bonds has at times moved positive, meaning both assets can trend in the same direction and diminishing the role of sovereign bonds as a diversification tool. As a result, allocations to bonds have fallen and investors have increasingly used short-term hedging approaches, while equity allocations have risen and helped support higher valuations.
"Given that sovereign bonds no longer diversify or hedge risk assets as effectively, allocations to bonds have been falling while investors have turned to short-term hedging strategies," strategists at HSBC said in a note. "Allocations to equities have soared, supporting higher valuations."
Outlook and what markets are watching
Investors are monitoring whether the current blend of robust corporate earnings, steady consumer spending and a resilient labor market will continue to offset the pressure from higher yields and energy prices. Key indicators that market participants are watching include further moves in Treasury yields, possible shifts in AI-related capital spending, and upcoming corporate earnings reports that will test the persistence of profit growth.
For now, markets exhibit cautious composure: dips in stock prices have been met with buying interest, and the rotation into traditional bonds has been less pronounced than in some past yield spikes. Whether that equilibrium holds will depend on the interplay of earnings momentum, economic data and the path of yields in the weeks and months ahead.