High Treasury yields aren't breaking the stock market yet, economists say

Investors are closely watching whether surging Treasury yields will become a significant headwind for the stock market. Late Thursday, the benchmark 10-year Treasury yield reached 4.97%, continuing a months-long bond sell-off driven by factors including higher oil prices, persistent inflation, substantial government borrowing, and expectations that the Federal Reserve will maintain higher interest rates for an extended period. This trend persisted despite the Treasury's move to triple the size of a long-term bond buyback.

Economists at TS Lombard, Freya Beamish and Davide Oneglia, argued in a Wednesday note that the current increase in yields is not indicative of an overheating economy that typically signals the end of a bull market. Instead, they attribute it to supply shocks and shifts within the Treasury market.

One key factor contributing to the stock market's resilience is the ongoing boom in artificial intelligence (AI) spending. Beamish and Oneglia noted that companies continue to invest heavily in data centers and AI infrastructure, fostering a cycle of sustained investment and demand. They observed that it is difficult to significantly slow down companies driven by the pursuit of "infinite demand" with minor increases in interest rates.

The economists highlighted that the long-term sustainability of this investment trend depends on whether it expands beyond the tech sector. Currently, much of the demand originates from within the tech industry itself. If businesses outside of technology do not increase their spending on AI, or if leading AI models face challenges to their competitive edge, growth could eventually decelerate, even for major technology firms.

TS Lombard's economists advised investors to look beyond interest rates and focus on the build-up of corporate borrowing and leverage. They suggested that an eventual overshooting of credit and leverage is almost inevitable, particularly given the Federal Reserve's stance. They also noted that Fed Chair Kevin Warsh has demonstrated a readiness to increase interest rates when necessary.

The firm does not identify a specific Treasury yield level that would automatically trigger a stock market sell-off. However, they contend that the 10-year yield should be at least 5% in the current economic climate, and they cautioned that high bond yields will make it increasingly challenging to justify current stock valuations.