Insight Rising yields won't break the economy or stocks

Higher yields are a real thing

September has had its share of macro stories, but one of the biggest is the US 10-year Treasury yield rising above 5%, its highest level in nearly 20 years. The US 30-year yield is at its highest since 2004. And the US is not alone. Yields are also rising in other developed markets, including Japan, where the 10-year yield has hit 3%, its highest since 1996.

These yields may feel high, but not to those of us old enough to have had a mortgage before the Global Financial Crisis. For bond yields, the decade after the crisis was the exception, not the norm. Policy rates sat near or even below zero for years, and central banks bought trillions of dollars of government debt, holding borrowing costs down. Over the past century, inflation has averaged about 3% in the US and 4% in the UK¹. If that's the norm, a 10-year yield of 5% offers only a modest real return.

The question now is why yields have returned to something like normal. The answer should help us judge where they go next and what that means for portfolios.

Why are yields rising?

There are many reasons for rising yields, both cyclical and structural. Some matter more than others.

Cyclical forces: To see which matter most, it helps to split the yield into two parts: the real yield and the inflation component. For the US 10-year Treasury, the real yield has driven the recent rise, while inflation breakevens have barely moved in three years.

Real yields reflect expected monetary policy, growth expectations and the term premium (the extra return for holding long bonds). 

• Monetary policy expectations have not driven the recent move.
• The term premium has risen over the past three years but has been broadly flat over the past year. It's closer to normal than it has been for two decades. So over the past year, despite wider deficits and larger debts, investors have not demanded much more reward for holding longer-dated US bonds. (The same cannot be said for France, where the term premium is rising fast.)
• That leaves one conclusion: real yields mostly reflect stronger growth. That's good news. It suggests the economy and risk assets can absorb higher yields, and that this cycle is not over.

A lasting theme of 2026 is that, despite the Middle East conflict, higher energy prices and other shocks, growth has been stronger than many expected on most measures and in many parts of the world.

In the US, nominal GDP growth is running at 6.6%, and the Atlanta Fed's GDPNow estimate of real growth is 5%. The labour market has kept adding jobs this year, despite warnings that AI would put people out of work.

In Europe, unemployment is near record lows and growth in most countries is beating consensus forecasts, despite higher rates and an energy price shock. The UK is similar: its labour market is weaker than the US's, but growth has surprised the pessimists this year and has been among the strongest of developed nations.

Emerging markets are gaining from AI spending and wider export growth as global supply chains shift. Some of those most exposed to the energy shock, such as Indonesia, have suffered badly, but they are the exception rather than the rule.

Structural forces: Large fiscal deficits and more borrowing by the AI hyperscalers mean more bonds for markets to absorb. When people talk about 'crowding out', they mean buyers may choose corporate debt over government debt. More supply means lower prices and higher yields.

Readers will likely have heard that foreign investors are wary of US assets, including Treasuries. There is something in this, but it's not necessarily new. Foreign demand for Treasuries has been fading for nearly two decades. In 2008, foreign investors owned nearly 60% of outstanding US Treasuries. Today they hold a little over a third. US banks and households have filled the gap, and both tend to prefer shorter-dated bonds. The US pension system holds fewer government bonds than many others, so there is less natural domestic demand for long-dated debt. That adds some upward pressure on long-dated yields, but it's far from a crisis. These forces build slowly and matter most at the long end. They have not driven the past year's move, but they are why we think yields have further to go.

Overall, our bias is for yields to move gradually higher. We don't think they have peaked.

The case for inflation, and why we don't buy it yet

Inflation in 2026 is clearly higher than many of us expected at the start of the year. The Middle East conflict and the energy shock that followed are pushing prices up. But this is a supply shock, not a demand shock. If inflation expectations stay in check, any rate hikes should be modest. Importantly, the Fed's first rate hike under its new chair has earned it some credibility. Markets appear to believe that the Fed and other central banks are serious about tackling inflation.

Underlying inflation pressure is more visible in the US, but weaker than in late 2021 and early 2022. In the UK, we see fewer signs of second-round effects taking hold, and services inflation keeps trending lower. The European Central Bank, whose single mandate is price stability, has reacted earlier to higher energy prices than the Fed or the Bank of England. 

Higher rates aren't felt equally

Higher rates hurt borrowers and help savers. After years of cutting debt since the Global Financial Crisis, households and companies in much of the world are far less sensitive to rates than before. Many now see their interest income rise faster than their interest costs. In aggregate, UK households now receive more interest than they pay.

The flip side is that governments have borrowed more. Government debt in many developed countries is at multi-decade highs. But what matters for public finances is not the level of yields but how they compare with growth.

If nominal growth runs above the average interest rate a government pays, the debt burden can hold steady even with a modest deficit. If borrowing costs overtake growth, the burden snowballs. Two things matter here. First, the average cost of debt lags market yields, because only debt being refinanced resets at today's rates. That's why refinancing walls matter.

Second, the real damage comes when growth slows while yields stay high. On this measure, the US is in better shape than the headlines suggest. US debt of $40 trillion sounds scary, but nominal growth is still above borrowing costs.

In the US, about a third of publicly held marketable debt matures in the next 12 months, and bills alone make up more than a fifth. Yet the average interest rate on US government marketable debt was 3.475% in August, up just 0.06 percentage points on a year earlier and more than 1.5 percentage points below the 10-year yield. Even so, the cost is already showing. Net interest passed $1 trillion in the first 11 months of the fiscal year, about 9% more than a year earlier, and the Congressional Budget Office expects it to take about 14% of federal spending this year¹. That's not a crisis. But each year that yields stay above the average cost of debt, that average creeps higher and the margin for error shrinks.

In France, the picture is less reassuring. France's problem is not how fast higher yields feed through; it is growth. Its negotiable debt has an average maturity of about 8.5 years, and bills are less than a tenth of the total, so higher yields feed through more slowly than in the US. Real GDP was flat in the second quarter after falling in the first, and was just 0.7% higher than a year earlier. Even with inflation at 2.4%, nominal growth is only about 3%. That's below the 3.5% average yield on bonds issued this year, and well below the 10-year yield of about 4.8%, its highest since 2008¹. At the margin, France is borrowing at a higher rate than it is growing. That explains why yields and the term premium have risen so much there.

The UK is in better shape. Growth is decent, though slower than in the US, and its debt has a longer maturity than US or French debt, which slows the pass-through of higher yields to interest costs. We think fears about UK public finances are overdone, which makes gilts look a little more attractive to us today.

In credit markets, not every company locked in cheap debt when it could, and at the riskiest end of the market that is starting to show. US CCC-rated spreads are now 0.5 percentage points above their long-run average of 11%¹, after a poor September added 1 percentage point. Some issuers are businesses disrupted by AI, but many simply face higher refinancing rates. Higher-quality companies are a different story: investment-grade spreads have held steady. We see this as a canary, not a crisis. It is not the end of the cycle, but it is later than we'd like. If oil and yields hold at these levels, the pressure could spread.

What does this mean for investors?

For bonds, rising yields mean price losses. But starting yields are now high enough that income cushions much of the damage. Bonds are behaving like bonds again.

This is illustrated by the chart below. If 10-year bond yields in the US, UK and France increase by 0.5 percentage points in the next year from their current levels, investors would still have a small, positive return for the year. A 0.5 percentage point rise in 10-year Bunds or Japanese government bonds (JGBs) would leave investors underwater.

Shorter maturities or floating-rate instruments tend to work better when yields are rising. With fiscal pressure and geopolitical risk likely to keep long-term yields volatile, we think two- to five-year bonds and short-term strategies offer a good middle ground. They give high income with less rate sensitivity than longer bonds, avoid the supply risk that still hangs over 30-year bonds, and can steady a wider fixed-income allocation. Floating-rate bonds can also help, as their income resets higher when rates rise.

Historically, equity markets have tended to keep rising after a Fed hike, and to do well when yields rise alongside robust growth. Given strong earnings growth, we expect some further compression in equity multiples but positive equity market returns.

Within equities, the traditional view is that growth stocks come under most pressure. Much of their value rests on profits far in the future, so they behave like long-duration assets. Higher yields could trigger a rotation out of some of the more crowded areas. But the argument is not as clean as in the past. Many growth companies have some of the strongest balance sheets, so the pressure from interest costs is low. That argues for being highly selective and avoiding areas where balance sheets are weak.

At this stage of the cycle, late-cyclical sectors have typically done better. These include resources, construction & materials, and industrial goods & services, which are also somewhat geared to the continued AI build-out. Consumer sectors are likely to stay under pressure as households face higher energy prices.

In short: in fixed income, we favour shorter maturities and letting income do the work. In equities, we still prefer non-US markets and would be more selective in AI growth areas, preferring those geared to the build-out where valuations are lower. Consumer sectors are likely to stay under pressure, while commodity plays remain attractive.

What would make us rethink our views?

The facts could change, and if they do, so must our views. Critically, our conclusions would change if growth slows.

Plenty of things could cause that, but the most obvious is a consumer squeezed by higher energy prices. Crude oil has risen this year, but by less than many feared given the Middle East conflict, and in real terms it is still well below its 2022 and 2008 highs. But few readers buy barrels of crude and keep them in their garage. Industry, airlines and households use refined products – diesel, petrol and jet fuel – and these cost much more because refining capacity has been taken offline in the Middle East and Russia. Diesel is at a record high in the US and close to its high in the UK. The pressure is such that the US administration is openly considering a one-month ban on diesel exports. 

If consumer spending slows meaningfully and unemployment starts to rise, we will rethink our views.

Until then, keep calm and carry on.