Why rapidly rising bond yields are bad news for the economy and stock markets

Why rapidly rising bond yields are bad news for the economy and stock markets

The global bond sell-off is becoming increasingly difficult for equity investors to ignore. US Treasury yields have surged to levels last seen more than two decades ago, while borrowing costs across Europe and Japan have also returned to multi-year or multi-decade highs.

The US 10-year Treasury yield climbed to 5.34% on 1 October, its highest level since 2002, while the 30-year yield reached around 5.68%. The move is particularly striking because softer-than-expected US inflation has reduced expectations of an immediate October Federal Reserve rate increase.

US 10-Year Treasury yield quarterly candlestick chart

At the same time, Germany's 10-year Bund yield reached 3.65%, its highest level since 2009, while Japan's 10-year government bond yield has approached 3.1%, its highest level since the mid-1990s. In the UK, the 30-year gilt yield has breached 6% for the first time since 1998.

UK 30-Year yield monthly candlestick chart

The important point for investors is that rapidly rising long-term yields can tighten financial conditions even without central banks actually raising interest rates.

Those looking to trade around the impact of rising yields across equities, currencies and commodity markets can do so through spread betting or CFD trading on our trading platform.

Why do higher bond yields matter?

Bond yields effectively set a benchmark for the cost of money throughout the economy. Government bonds are generally regarded as relatively low-risk assets, so when investors demand a higher return from them, other borrowers typically have to pay more too.

That affects governments, companies and households.

For consumers, higher yields feed through into more expensive mortgages and other forms of borrowing. In the US, for example, mortgage rates have already risen above 7%. In the UK, higher gilt yields can put upward pressure on fixed-rate mortgage pricing and increase refinancing costs for households.

The result is potentially less disposable income available for spending.

For companies, higher borrowing costs make it more expensive to finance acquisitions, investment, working capital and expansion. Businesses refinancing existing debt also face higher interest bills when older, cheaper debt matures.

That can have a direct impact on corporate profits.

A company generating £100 million of operating profit looks very different if its annual interest bill rises from £10 million to £20 million. Even if revenues remain unchanged, higher financing costs reduce the amount left for shareholders.

Higher yields can slow the economy

This is where the bond market becomes particularly important for the wider economy.

Higher borrowing costs tend to discourage consumption and investment. A household may postpone buying a house; a company may delay building a new factory; a developer may shelve a property project; and a government may have less money available for public spending because more of its tax revenue is required to service its debt.

This creates a potentially powerful feedback mechanism:

Higher bond yields → higher borrowing costs → less spending and investment → slower economic growth → weaker corporate earnings.

There is an important caveat: higher yields are not automatically bad for the economy. If yields rise because investors expect stronger economic growth, the accompanying increase in corporate revenues and profits can offset some of the damage. The problem comes when yields rise rapidly because of persistent inflation, fiscal concerns, increased debt issuance or a rising term premium.

That is closer to the situation currently confronting markets.

Why rising yields are particularly uncomfortable for stocks

The relationship between bond yields and equity valuations is especially important.

When investors value a company, they are effectively calculating what its future profits and cash flows are worth today. Those future cash flows are discounted back to the present using a required rate of return.

As bond yields rise, that discount rate generally rises too.

This means that the present value of future profits falls.

The effect is particularly significant for growth companies whose valuations depend heavily on profits expected many years into the future. Technology and other high-growth stocks can therefore become more sensitive to rising long-term Treasury yields.

It also changes the relative attractiveness of equities.

When a 10-year government bond yields 2%, an investor may be willing to accept a relatively low earnings yield from a company in exchange for the prospect of stronger future growth. But if a relatively low-risk government bond suddenly offers a yield above 5%, investors can demand more compensation for taking equity risk.

That can put downward pressure on stock-market valuations even if company earnings have not yet deteriorated.

For those wanting to understand more about how shares are valued and how interest rates influence the stock market, our resources on investing for beginners cover the key concepts in accessible detail.

The problem with a rapid rise

The speed of the move matters almost as much as the level.

A gradual increase in yields can give companies, households and governments time to adjust. A sudden jump can cause problems because the financial system is built around assumptions about interest rates, asset prices and funding costs.

The US 10-year yield rose by around 81 basis points during the third quarter, its largest quarterly increase since 2022.

That represents a significant repricing of the cost of long-term money in a relatively short period.

It can also create losses for existing bondholders. Because bond prices move inversely to yields, a sharp increase in yields means investors holding older bonds with lower coupons suffer capital losses.

Those losses can matter for pension funds, insurers, banks and investment funds with large fixed-income portfolios.

There can even be a self-reinforcing element to a severe sell-off. Falling bond prices can lead some leveraged investors and funds to reduce positions or rebalance portfolios, creating additional selling pressure and pushing yields even higher. Recent reports have described such technical pressures as contributing to the current global bond market sell-off.

Government finances are another pressure point

Higher yields are also bad news for heavily indebted governments.

When government debt matures, it eventually needs to be refinanced. If the new debt has to be issued at a significantly higher interest rate, the government's interest bill increases.

That creates a difficult choice: raise taxes, reduce spending, borrow even more or accept a larger deficit.

And borrowing more can itself worry bond investors, potentially creating another feedback loop:

Higher debt → greater investor concern → higher yields → higher interest payments → larger deficits → even more borrowing.

This is one reason why long-term yields can rise even when investors are no longer expecting an imminent central-bank rate increase.

The bond market is not simply pricing the next central-bank meeting. Long-term yields also reflect expectations for inflation, economic growth, government borrowing, debt supply and the compensation investors demand for holding long-duration bonds.

Why this matters for markets now

The current sell-off is particularly notable because it is happening despite some evidence that US inflation is moderating.

August US PCE inflation came in below expectations, while core PCE inflation slowed to 3%. At the same time, stronger-than-expected second-quarter GDP growth has reinforced the argument that the US economy remains sufficiently resilient to tolerate higher interest rates.

This helps explain the unusual combination of softer inflation but higher long-term yields.

Markets may be less concerned about an immediate October rate hike than they were previously, but they remain concerned that inflation will prove difficult to bring fully back to central-bank targets, particularly with energy prices elevated. They are also demanding greater compensation for holding long-term government debt amid high borrowing requirements.

The result is that the bond market itself is tightening financial conditions.

And that is the key message for equity investors: the Federal Reserve does not necessarily have to raise rates for financial conditions to become more restrictive. If the 10-year Treasury yield moves from 4% to 5.3%, the economy and stock market are effectively dealing with a substantial increase in the cost of long-term capital anyway.

What it means for investors

For stock markets that have benefited from strong earnings expectations and enthusiasm around artificial intelligence, the question is increasingly whether corporate profits can continue to grow fast enough to offset the valuation and financing pressures created by a much higher risk-free rate.

The longer yields remain elevated — and the faster they rise — the greater the risk that what initially looks like a bond-market sell-off eventually becomes a broader tightening of financial conditions, with consequences for economic growth, corporate profits and equity valuations.

Those looking to navigate the current market environment can access a wide range of global markets through our trading platform, including forex trading, gold trading and share dealing, with the ability to go long or short via spread betting or CFD trading.

How to trade rising bond yields

1. Do your research on the bond market, the key yield levels to watch and the macro drivers most likely to influence financial conditions in the near term
2. Decide whether you want to trade via spread betting or CFD trading 
3. Open a trading account with us
4. Search for the market you want to trade — whether indices, forex, commodities or individual shares — in our trading platform
5. Place your trade