Fixed Income What higher interest rates could mean for stocks and bonds

Bonds have been anything but boring this summer. With US Treasury yields climbing amid rising national debt, elevated inflation and massive AI-related investments, some investors are asking whether recent volatility signals a looming crisis or a broader shift to a world of higher interest rates.

“Rates are normalisng toward levels more consistent with long-term economic growth and inflation trends,” says John Queen, fixed income portfolio manager. “I don’t see an imminent crisis, but the adjustment process may bring periods of pain for investors along the way.”

“One reason Treasury yields are higher is because the US economy has shown resilience through years of rising interest rates,” Queen adds. “Importantly, AI-related companies extended their streak of blockbuster earnings, and many other sectors broadly delivered solid profits.”

Inflation may settle above pre-pandemic lows

More than five years of above-target inflation has left many consumers wondering whether higher prices are the new normal. The US Personal Consumption Expenditures Price Index rose 3.7% in July from a year ago, while core PCE, which strips out food and energy and is the US Federal Reserve’s preferred inflation measure, increased 3.3%.

“The world has changed since the pandemic, and inflation is less likely to return to the persistently low levels that prevailed after the 2008 global financial crisis,” says Tom Hollenberg, fixed income portfolio manager. “But I do believe core PCE inflation will ease from current levels and settle closer to the 2% to 2.5% range.”

“Price increases for major drivers of inflation such as car insurance and shelter, including rent, have slowed and are now helping bring overall inflation down,” Hollenberg says. “That cooling trend should continue as the job market shows signs of softening, and many businesses are reluctant to push through price increases.”

Still, inflation remains a key risk for bond investors given the scale of AI-related investment. “If capex continues to rise and accelerates growth before AI-related productivity gains show up, inflation could move higher. Under that scenario, the Fed could feel more pressure to embark on a renewed hiking cycle, which could push the yield on the 10-year Treasury above 5%. It’s not my base case, but something I’m tracking closely.”

Fed returns to pre-crisis playbook

As rates and inflation normalise, US Federal Reserve Chair Kevin Warsh is embracing a communication strategy that relies less on forward guidance, echoing the Fed’s approach before the global financial crisis.

“I’m comfortable with the Fed making fewer promises about where rates will be six or 12 months from now, but investors still need to understand what evidence would change monetary policy,” Hollenberg says. “If I have no idea what could cause the Fed to raise or lower interest rates, I will likely demand more compensation to hold long-term bonds. This may ultimately be an iterative process where markets learn Warsh’s reaction function over time.”

Uncertainty about Warsh’s reaction function after the Fed kept rates steady at its July meeting put volatility on full display. The 30-year Treasury hit a 19-year high of 5.3% in August before receding on Treasury Secretary Scott Bessent’s surprise move to increase buybacks of long-dated Treasury securities.

“Bessent is signalling to the market that the Treasury Department may intervene if bond yields move above levels it believes are justified by the fundamentals,” Hollenberg explains. “They can do that to a certain extent, but there are limits. If Treasury pushed that strategy too far, it could become more difficult to sell bills to fund those bond purchases and ultimately risk undermining demand for dollar-denominated assets.”

As the Treasury market whipsawed, the US hit an alarming milestone: The national debt surpassed $40 trillion, roughly double the amount just 10 years ago. Queen notes that worries about US borrowing have been around for decades and remain a top question from investors.

“The idea that the US won’t repay its debt in a currency that it prints is unlikely. The real concern is whether people will continue to buy additional Treasuries. If they don’t, borrowing costs could rise further and pressure the government to reduce deficits,” Queen says. “While that is certainly possible, the US economy remains one of the strongest in the world, with a large and very liquid government bond market. These factors should help prevent a near-term debt crisis.”

History shows stocks can handle higher rates

“Most rising rate environments correspond with economic growth, so they’re more common than investors may think,” says Cheryl Frank, equity portfolio manager.

“Markets tend to wobble when long-term rates jump 50 to 100 basis points, but generally shake it off, which is where we are today. Stocks typically begin to fall apart only after rates have risen much further — historically when long-term bond yields climbed 2% to 2.5%.”

Frank does not expect Treasury yields to surge from here, partly because the Trump administration has shown it wants to keep borrowing costs down. “Still, I’m mindful of volatility in the rates market. I’m working to make sure my portfolios are not leaning too heavily into high-growth, high-valuation stocks since they tend to reprice lower as rates rise,” Frank explains. “That means diversifying into industries such as financials, insurance, energy and certain commodities. Many of these companies trade at more reasonable valuations, generate strong cash flows and pay attractive dividends.”

Of course, the AI boom should not be ignored, and a balanced portfolio includes investments in AI and AI-related companies, Frank says. “This could be one of the biggest technological advancements in our lifetime, with profound impacts on every part of the economy. I’m optimistic about AI’s potential to broaden beyond semiconductors and early beneficiaries of the AI build-out.”

Back to the future

Higher rates and a quieter Fed mark a return to the economic environment prior to the global financial crisis, when markets were guided by inflation, growth outlook and fundamentals, Queen says.

“At the start of my career in the early 1990s, many investors thought long-term Treasury yields of 5.75% were unusually low and had little room to fall. Instead, bonds spent the decades that followed moving lower. That taught me that investors tend to anchor on recent events,” Queen adds. “Today, many investors are more familiar with the ultra-low rate environment. But if you take a step back, the current interest rate makes sense in a world where inflation is above 2% and economic growth is healthy.”

He notes there may be periods of volatility, particularly if inflation remains higher than businesses and consumers would prefer. “But ultimately, the reason you own bonds is to offset equities, which offer greater upside but more volatility. Today’s starting yields of around 5% mean that bonds are better positioned to offer income and a measure of stability.”