One economy, two markets, one message

Global bond markets have repriced sharply higher in recent months, pushing borrowing costs to levels that would typically challenge risk assets. Yet equities have remained remarkably resilient. It comes down to the power of economic growth that the bond and stock markets are interpreting in very different ways. The divergence highlights a defining feature of the investor psyche: Bond investors are increasingly focused on inflation, deficits and a new normal in interest rates, while equity investors remain fixated on corporate earnings and the next wave of artificial intelligence innovation.

Rate volatility is back

Higher bond yields have become the norm over the last few months, but volatility in the bond market is a relatively new development. Convention suggests that the margin of the move is more significant than the level of yields themselves. If the move is gradual, investors can digest and reprice risk assets accordingly. When yields jump more than their average, it can serve as a jolt to the system.

But even as Treasury yields have risen this summer, the bond sell-off has largely been orderly. And the ripple effect across other asset classes has been relatively muted. For example, a 14 basis point move in the 10-year Treasury yield in just one trading session was met with a less than 1% drop in the S&P 500. It marked the biggest jump in yields since Liberation Day, when President Trump announced tariffs on a variety of trade partners, and risk assets—although weaker—did not crumble.

Over the summer, the Treasuries market was largely driven by hawkish monetary policy, artificial intelligence investment–driven economic growth and corporate issuance, but this week’s rate volatility was spurred by several other factors:

• Business activity rose to 5-year highs: The S&P Global US Composite Purchasing Manager’s Index (PMI) rose to 58.4 versus an expected reading of 55.3. Although investors are not as sensitive to this data metric as they are to others, it does measure new orders, production, employment, supplier deliveries and inventories. In the context of an economy that is already demonstrating resilience and growth, the significantly higher print reinforced the narrative of more growth and therefore higher yields.
• Oil marches higher: Oil prices continue to rise. The spread between Brent and West Texas Intermediate (WTI) is now at levels that it was at when the conflict in Iran first began. That shows that even if oil prices continue to trade in a range, the geopolitical risk premium remains. Meanwhile, pressure in refined products like diesel and gasoline continues to build. Given the increased correlation with bonds, the moves in the energy market are contributing to the rise in yields.
• Pricing in more interest rate hikes: In the face of stronger growth and higher energy prices, investors are now pricing in nearly four interest rate hikes, with another as soon as at the October Federal Open Market Committee (FOMC) meeting.
• A very weak 5-year Treasury auction: After an upside Purchasing Managers’ Index (PMI) surprise, and front-end rates already having risen sharply in recent weeks, demand for 5-year Treasury supply disappointed. The bid-to-cover ratio, which measures investor demand for new government debt issuance, fell to 2.21. That is the lowest since December 2018. The lack of appetite pushed the 5-year Treasury yield by nearly 17 basis points to its highest level since 2007.

A global phenomenon

In the United States, real yields have moved higher as resilient economic growth and sticky inflation raise expectations for a higher interest rate environment. And whereas the United States has a growing deficit, fiscal policy plays a much larger role in Europe.

Whereas the tolerance for a larger national debt burden in the United States is showing up in term premium, investors are also demanding greater compensation in countries with weaker fiscal trajectories. France has become a focal point of those concerns.

The difference in yields between French 10-year OATs and German Bunds, which are viewed as the safest assets in Europe, widened to levels last seen during the eurozone debt crisis 14 years ago. The move in the spread serves as a key measure of waning investor confidence in French public finances. By comparison, countries previously associated with irresponsible finances like Italy, Spain and Greece, are being treated by investors as safer investments. In other words, the risk premium in their relative debt offerings are lower.