The U.S. stock market can rise while bond yields are rising because higher yields are only one part of the equation. Higher Treasury yields normally put pressure on stocks because they increase the discount rate investors use to value future profits. But if investors believe corporate earnings will grow quickly enough, stocks can still rise even while yields move higher. The market is essentially saying that strong earnings growth, particularly from large technology and AI-related companies, is currently more important than the negative effect of higher interest rates.

Rising yields do not always mean bad economic news

The reason bond yields are rising matters enormously. If yields rise because investors expect stronger economic growth, that can actually be supportive of stocks. Stronger economic growth can produce higher consumer spending, higher corporate revenues and higher profits. Investors may sell Treasuries because they expect better economic conditions, causing Treasury prices to fall and yields to rise, while simultaneously buying stocks because they expect corporate earnings to increase. In that situation, stocks and bond yields can rise together.

Earnings growth can overwhelm higher interest rates

A stock’s value depends on both its future earnings and the valuation investors are willing to put on those earnings. Higher yields tend to reduce valuations because investors have a more attractive return available from bonds. But rapidly rising earnings can compensate for that. It would be a mistake to interpret the current rally as evidence that interest rates no longer matter. They absolutely matter. The market is effectively making a different argument: investors believe the growth in corporate earnings is currently large enough to compensate for the higher return available from bonds. If earnings continue to surprise positively, stocks can keep rising despite high yields. If earnings growth slows significantly, the same high yields become much more dangerous.

AI is a major reason this is happening

The biggest support for the U.S. market is the enormous earnings and investment story surrounding artificial intelligence. Companies such as Nvidia, Microsoft, Amazon, Alphabet and Meta are benefiting from massive spending on AI infrastructure, data centers, semiconductors, networking equipment and cloud computing. Investors believe this spending can generate substantial future revenue and profit. That expectation allows the market to tolerate higher Treasury yields. But it also creates a major concentration risk. If these companies begin reporting that AI investment is generating lower returns than expected, investors could quickly reduce their earnings forecasts. That could cause technology stocks to fall at the same time that high bond yields prevent valuations from expanding.

The biggest companies dominate the index

Another reason the market can rise despite high yields is that the S&P 500 is heavily influenced by a relatively small number of enormous companies. When companies such as Nvidia, Microsoft, Amazon, Meta and other mega-cap technology companies rise strongly, they can pull the entire index higher even if many smaller companies are struggling. This means the strength of the S&P 500 does not necessarily mean that every part of the U.S. economy or stock market is equally strong.

Smaller companies are more sensitive to higher rates

Higher yields generally create more problems for smaller companies because they often have greater dependence on borrowing and less financial flexibility. A small company with significant debt may face substantially higher interest expenses when it refinances. A mega-cap technology company with billions of dollars of cash and enormous free cash flow is much better positioned to handle higher interest rates. This can produce a situation where large technology stocks continue rising while small-cap stocks perform much worse.

Existing corporate debt does not immediately become more expensive

Higher Treasury yields don’t instantly increase the interest expense of every American company. Large companies often issued bonds years ago at fixed interest rates. If a company issued 10-year debt at 3%, it continues paying that rate until the debt matures. The company only faces the higher interest rate when it needs to refinance. This creates a delay between higher Treasury yields and their impact on corporate earnings. Over time, however, refinancing at higher rates can become a significant headwind.

Investors are looking at future earnings

Markets are forward-looking. Investors aren’t buying stocks simply because today’s economic conditions are good. They are buying based on what they expect corporate profits to look like months and years into the future. This is particularly important for technology companies because investors believe their future earnings could be dramatically larger than their current earnings. If investors believe those future cash flows are large enough, they can continue buying stocks despite a higher discount rate.

The key relationship is yields versus earnings growth

The most useful way to think about the current situation is not simply to ask whether Treasury yields are rising. The more important question is whether yields are rising faster than earnings expectations. If the 10-year Treasury yield rises from 4.5% to 5% while earnings expectations increase substantially, stocks can continue rising. But if yields rise from 5% to 5.5% while analysts simultaneously cut earnings expectations, the situation becomes much more dangerous. You would have a higher discount rate and weaker expected cash flows at the same time.

Lauren Hua is a private client adviser at Fairmont Equities.

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