Making Sense of Rising Yields
October has arrived and I am loving it. The Guards are playing for a spot in the World Series, I still have 20 apples from the Orchard to eat through, and not to mention flannels! October also marks the close of Q3, so let’s take a look at how markets finished the quarter.
Large stocks continued trucking along in Q3, with the S&P 500 returning just over 3% and international developed markets increasing 1%. Small cap stocks and aggregate bonds struggled, falling 4.5% and 3.9%, respectively. Bonds were once again a primary talking point, and a sore spot in many portfolios.
Last month, I noted the 10-year Treasury yield had climbed to 5.04%, a level not seen since 2007. The 10-year then briefly touched 5.36%, the highest level since 2002. Two of the main factors have done most of the work in pushing yields up. Higher energy prices and thus higher inflation have led investors to price in a rate hiking cycle rather than the cuts expected at the start of the year, and a resilient economy may be pushing up what’s considered a “normal” level for interest rates.
The question many investors are now asking is when higher yields begin to pressure stocks. Historically, stocks have tended to rise alongside yields when they’re climbing from already low levels. A move like that typically reflects healthy reasons like improving growth. Beyond a certain level, that relationship has tended to flip because yields are more likely rising for unhealthy reasons, like inflationary pressure. According to JPMorgan’s Chief Market Strategist of the Americas Gabriela Santos, that tipping point was around 4.5% in the past and closer to 3.5% in the years following 2009. Since 2021, the pattern has been far less clear, which could mean there is no longer a single yield level worth circling on the calendar.
This cycle may not follow the old pattern, though. The ten largest companies now make up roughly 40% of the S&P 500, and their earnings are tied more closely to the AI buildout than to the broader economy. Santos’s view is that higher rates seem unlikely to derail those companies, and that stocks and yields may continue to “beat to the sound of their own drum.” The picture could look different further down the market cap spectrum, however. Smaller companies tend to be more sensitive to borrowing costs, and this quarter’s decline in small caps may be an early sign of that, although there are likely other factors at play as well.
For clients, the takeaway is less about picking a yield level to watch and more about making sure each part of the portfolio is doing its job. We want bonds to behave like bonds, which is why we pay close attention to duration and interest rate sensitivity in the fixed income allocation. There is also a flip side to the price pain, as higher starting yields have historically been associated with stronger forward bond returns, so the same move that has weighed on bonds this year could be setting up a better entry point for the years ahead. With no clear yield threshold telling us when stocks might stumble, we would rather not base portfolio decisions on one. Where yields and the Fed go from here remains to be seen, but a diversified portfolio built around a long-term financial plan is designed to hold up through periods like this one.
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