Earlier this month, the 10-year Treasury yield crossed the 5% level for the first time since October 2023. The 30-year Treasury yield just hit its highest mark in 19 years.
Conventional wisdom says that rising interest rates are bad for stocks. They make bonds more competitive with equities, increase borrowing costs for businesses and consumers, and reduce the present value of future corporate earnings.
History, however, tells a surprisingly different story.
Sharp increases in long-term interest rates generally create more short-term volatility for equities. Yet some of the biggest rate shocks of the past several decades also resulted in double-digit percentage gains for the S&P 500 (^GSPC -0.75%) over the subsequent 12 months.
Let's take a look at why this may be the case.
Image source: Getty Images.
Rising rates don't always mean falling stock prices
If we look at the course of history, there have been several instances where stocks have held strong despite rising rates.
For instance, consider 1994, one of the sharpest bond sell-offs in modern history. In October 1993, the 30-year yield was around 6%. By November 1994, it was above 8%. Throughout that period, the S&P 500 had gained roughly 3%. The index was actually up as much as 6% through the early part of 2024, but dropped sharply in Q2 2024 when rates rose their fastest.
But from April through November, when the 30-year yield went from 7% to 8%, the S&P 500 rose from around 440 to around 470. The Fed's tightening cycle managed to help contain inflation and avoid a recession, helping to spur both economic growth and stock prices.
Or how about 2009? The 30-year rose from roughly 2.5% around the end of 2008 to 4.3% by June. During the first quarter of the year, the S&P 500 fell by 25%.
But from there, it was a strong, consistent rally. By June, the index had recovered all those losses and entered positive territory. The 30-year yield rose another 100 basis points or so during that time, but it was driven more by improving economic data, turning credit markets, and investors slowly becoming more optimistic that the worst of the financial crisis was over. For the calendar year as a whole, the S&P 500 gained 23% in 2009.
The 2012-2013 "taper tantrum" might be the best example. In July 2012, the 30-year yield was again around 2.5%. By the end of 2013, it had briefly touched 4%. Fed Chair Ben Bernanke later signaled that the Fed would begin reducing bond purchases. The S&P 500 dropped around 6% during the initial rate shock due to the belief that less liquidity would hurt stocks.
But even as the 30-year yield climbed by around 100 basis points in total during May and June, the S&P 500 managed to hold steady. The rally continued, and the index gained roughly 15% in the second half of the year, even as the 30-year yield rose from 3.5% to 4%.
S&P 500 Index
Key Data Points
Why higher yields and rising stock prices can happen at the same time
The key to understanding the correlation between rising yields and rising stock prices is understanding why interest rates are rising.
A jump in yields due to rising inflation or concerns about debt and fiscal policy is likely to be damaging to stocks. That should, in theory, be the case right now, but those risks are being offset by high AI infrastructure spending and strong corporate earnings growth.
On the flip side, if investors are rotating out of bonds and into stocks as the economic outlook improves, that can be a good thing. Increasing investor sentiment and a shift from risk-off to risk-on can create an environment in which long-term yields and stock prices rise in tandem.
What should investors do now?
Inflation is the biggest risk right now, which suggests an environment where stock prices are more likely to fall than rise.
But the AI revolution is a generational event that's throwing any previous playbook out the window. Corporate earnings are expected to remain strong for at least the next several quarters. But that only happens if companies deliver on expectations. If growth starts to slow or AI investment begins to fall, the market could look more like 2022, when rates rose and stocks fell.
Long-term investors will probably benefit more from staying the course instead of trying to guess what happens next. But inflation is likely to be the key. Without some cooling on the inflation front, equity upside will probably be limited here.
