A rise in the 10-year Treasury yield above 5% could negatively impact stock markets, particularly the AI trade, according to Ruchir Sharma of Breakout Capital. Higher yields increase the discount rate for future earnings, diminishing stock valuations.
Factors like high oil prices and persistent inflation are driving yields up, prompting the Federal Reserve to continue its monetary tightening. This environment, coupled with increased government debt servicing costs and AI companies tapping bond markets, presents challenges for equities.
A significant increase in the 10-year Treasury yield, particularly if it breaks decisively above the 5% mark, could spell trouble for the stock market, with the artificial intelligence sector facing particular pressure, according to Ruchir Sharma, founder and chief investment officer of Breakout Capital.
"If we do move into a new interest rate regime, where we decisively break 5% on the 10-year … I think that will pose a problem for equity markets in general and the AI trade," Sharma stated on CNBC. He highlighted the 10-year Treasury as the "most important asset in the world," given its influence on stock valuations and borrowing costs across the economy.
Sharma pointed to historical data suggesting that the relationship between stocks and bonds shifts when the 10-year yield surpasses 5%. Beyond 5.25%, the correlation between equities and bonds tends to become positive, meaning both asset classes may decline simultaneously. "For any yield above 5.25%, equity prices go down," he explained.
The Impact of Higher Yields on Stocks
Elevated bond yields put downward pressure on stocks primarily by increasing the discount rate that investors apply to future corporate profits. This higher discount rate effectively reduces the present value of those future earnings, making stocks less attractive.
The 10-year Treasury yield recently touched 5%, reaching a 19-year high, before pulling back slightly. This rise has been fueled by several factors, including high oil prices driven by geopolitical tensions in the Middle East and concerns over escalating inflation. The benchmark yield dropped 5 basis points to 4.94% on Thursday.
Persistent inflation remains a key concern. With inflation exceeding the Federal Reserve's 2% target for five years, the central bank has been tightening monetary policy. The Fed recently raised the federal funds rate by a quarter percentage point to a range of 3.75% to 4%, signaling that further hikes might be necessary to combat stubbornly high price increases. Policymakers anticipate inflation remaining above the 2% target until 2029, suggesting a prolonged period of higher interest rates.
When Bubbles Burst
Sharma noted that major market booms or bubbles often end with rising interest rates and monetary tightening. Above 5% on the 10-year Treasury, the government's fiscal situation also becomes more challenging due to the increased cost of servicing its substantial debt exceeding $40 trillion.
"If the 10-year gets unhinged … that's when you end up getting problems," Sharma warned. He contrasted the current situation with the 1990s, noting that the government's balance sheet is now three times larger, potentially creating more competition for corporate borrowers in the bond market.
Currently, large technology companies, particularly those involved in AI infrastructure, are tapping the bond market to fund significant capital expenditures, impacting their free cash flows. While earnings from tech companies remain strong, Goldman Sachs pointed out that the combination of higher capital costs and increased capital intensity in the tech sector has diminished the present value of their future cash flows. Consequently, their forward stock valuations, as measured by price-to-earnings ratios, are now closer to the market average.
Despite these headwinds, Sharma acknowledged one mitigating factor: corporate balance sheets are in a stronger position today compared to the 1990s.
