Markets and Economy Growth vs. crisis: Markets weigh a higher-rate reality

It's become a cliché to describe something as a Rorschach test. You see two human figures. I see an elephant. We look at the same image and come away with entirely different conclusions.

But the original Rorschach test was likely never meant to be analyzed in isolation. Psychologists probably didn't look at a single inkblot and make a diagnosis. The results were interpreted alongside other tests, observations, and evidence. Context mattered.

The same could be said of markets today.

Investors can look at a chart of the 10-year US Treasury yield and reach very different conclusions. Some may see a debt reckoning long foretold. Years of large fiscal deficits, mounting government debt, and rising borrowing needs¹ may finally be catching up with the United States. Others may see something different. They see an economy that remains surprisingly resilient,² massive investment related to artificial intelligence,³ and the prospect of stronger productivity growth pushing real interest rates higher.⁴

Both groups are looking at the same chart.

Early-stage debt crisis debate

The debate has intensified as bond yields have continued to climb. Adding fuel to the crisis narrative, French government bond spreads versus Germany have widened sharply,⁵ raising questions about whether developed economies can continue to sustain large deficits in a higher-rate world. France is being viewed by many as an important test case for bond markets globally.

Yet if we want to determine whether we’re witnessing a debt crisis, it helps to examine the results of other tests as well.

If investors were genuinely losing confidence in the fiscal sustainability of the United States, one might expect a collapsing dollar. Instead, the dollar has remained firm.⁶ One might expect inflation expectations to become unanchored as investors demand compensation for deteriorating fiscal discipline. Yet longer-term inflation expectations have remained relatively contained.⁷

Credit markets have been telling a slightly more nuanced story. To be sure, there are areas showing stress. Spreads in the lower segments of the high yield market have widened noticeably.⁸ That shouldn’t be surprising. Lower quality businesses reliant on refinancing can naturally be vulnerable when borrowing costs rise.

But the picture can be less alarming when viewed more broadly. Investment grade spreads and high yield spreads outside the lowest quality tier have widened only modestly and have remained relatively tight by historical standards.⁹ Credit markets have been displaying caution, not panic, in my view.

That makes it difficult for me to embrace the idea that we’re in the early stages of a debt crisis.

Impact on cyclical parts of the economy

What I do think is happening is that higher interest rates and higher oil prices have begun to have a meaningful impact on more cyclical parts of the economy. The long-anticipated and momentarily realized broadening trade has struggled recently as sectors tied more closely to economic activity have faced increasing pressure from financing costs and energy prices.¹⁰ The economy isn’t immune to higher rates. I believe it has responded exactly as economic textbooks would suggest.

And perhaps that’s the most important point. The solution to higher rates has often been higher rates.

At some level, borrowing costs could become restrictive enough to cool demand, slow economic activity, and relieve the pressures that drove yields higher in the first place. If rates move high enough, growth may slow. If growth slows, rates may eventually stop rising and may even begin to fall.

That’s why I increasingly view the debate as being less about growth versus crisis and more about strong growth versus slowing growth.

Constructive backdrop for stocks

Both outcomes can be consistent with a constructive backdrop for stocks. The difference may likely be found in leadership. Strong growth had been favoring cyclical sectors and the overall broadening of markets.¹¹ The prospect of slower growth appears to have shifted leadership back toward higher quality and mega-cap growth companies.¹²

The inkblot may look different depending on who’s viewing it. But when I step back and consider all the tests together, I see an economy and markets that have adjusted to higher rates, not one that has fallen into crisis.