Over recent months, our client conversations have centered on geopolitical tensions in the Middle East, the AI investment boom, and the opportunities and risks within private credit. Rates markets, by comparison, have featured less prominently—partly overshadowed by a powerful semiconductor-led equity rally since April, and partly because U.S. rates had remained relatively calm over the past few months despite significant macro uncertainties.
That changed last week. Government bond yields came back into sharp focus as fears over the inflationary impact of the Middle East conflict drove yields higher across the curve in most developed markets. The U.S. was hit particularly hard: 30-year nominal and real yields reached multi-decade highs, while the 10-year and two-year climbed to levels not seen since early 2025. Japan government bonds have also been severely impacted, with yields on the 30-year and benchmark 10-year rising to late-1990s levels.
Moves of this magnitude carry weight. Rising long-end yields pose a direct challenge to equity valuations—a dynamic investors experienced acutely in 2022, when aggressive Federal Reserve tightening sent long-term yields sharply higher and triggered a significant equity drawdown, particularly among long duration growth stocks with no or low dividend yield.
This is not 2022, as we have argued here before. But with equities still trading near record highs and U.S. rates rising, the question of correction risk is important to consider.
Confident But Cautious On Equity Strength
So what’s going on? First, equities have had a phenomenal, albeit narrow, run since early April, with the S&P 500 index punching through a series of record highs, driven in the main by an extraordinary rally in the semiconductor sector. The IPO market is also primed, with SpaceX, Anthropic and OpenAI all expected to list this year at combined valuations potentially approaching or exceeding $3 trillion.
Pivotal to the broader rally has been the strong first-quarter earnings season—in aggregate, S&P 500 companies grew revenues and earnings per share by 11% and 22%, respectively—helping to reignite conviction in the AI investment cycle.
In our view, such earnings strength underscores why the equity market still has room to run—indeed, history tells us that rallies can continue for months and even years after periods of “irrational exuberance”— but even as we remain constructive over the medium term, there are reasons for short-term caution.
For instance, market breadth is at historic lows—only 22% of S&P 500 names have outperformed the index over the last 30 days (to May 21), a 30-year low—momentum indicators are at extreme historical levels, and materially higher long-term rates may now act as a gravitational pull on soaring indices.
Reading the Rates Picture
How do we read rising rates?
In our view, the move reflects a combination of higher inflation expectations and higher real rates.
On inflation, the market has shifted from pricing in around 2.25% long-term U.S. inflation to approximately 2.5%, with some risk that near-term pressures bleed through to longer-term expectations. We are relatively comfortable here—we expect modest pass-through of energy prices into core inflation, and market pricing for inflation remains relatively benign and appropriate.
The real rates story matters more, and two drivers stand out. First, markets appear to be pricing AI as a structural force raising the equilibrium growth rate—and with it, neutral real rates. If AI were truly disinflationary, you would expect to see long-dated inflation breakevens falling and more pressure on the labor market, for example. The evidence today points the other way: AI is consuming enormous amounts of capital and appears to be pushing up “R-star,” the central bank term for a neutral rate of interest.
Second, demand for borrowing has increased materially. AI hyperscalers are issuing aggressively across investment-grade credit, asset-backed, and private markets. Combined with elevated government borrowing, real rates may simply reflect intensifying competition for capital.
Finally, a fiscal feedback loop is emerging: higher rates increase future government interest expense, pressuring debt sustainability—and potentially becoming self-reinforcing.
What This Means for Equities
Within the current range, neither higher inflation breakevens nor higher real yields are necessarily negative for equities. The inflation move is a mild positive; the real rate rise may simply be reflecting what equity markets are already pricing—that the growth outlook, turbocharged by AI, is genuinely strong. AI is raising equilibrium growth, pushing up real yields, increasing borrowing demand from corporates and governments alike, and equity markets are pricing the productivity upside.
That said, an important risk deserves careful attention: if the long end of the curve loses the confidence of the market and becomes unanchored, the impact on equity valuations could be meaningful. The U.S. fiscal backdrop compounds this concern—between tariff-related refunds, higher defense spending, and near-term deficit expansion, the trajectory is not a comfortable one. At 120% debt-to-GDP, the situation is not yet critical, but the direction of travel is worrying.
The crossover point is growth. If growth slows materially, the fiscal picture deteriorates further. That non-trivial tail risk—lower growth and higher rates—should not be dismissed. Rates have been overshadowed recently. Don't lose sight of them.
What to Watch For
Tuesday 05/26:
- U.S. CB Consumer Confidence
Thursday 05/28:
- U.S. Core PCE Price Index
- U.S. GDP
- U.S. Initial Jobless Claims
- U.S. Durable Goods Orders
- U.S. New Homes Sales
- Japan Tokyo Core Consumer Price Index
Friday 05/29:
- Germany Consumer Price Index
- U.S. Chicago Purchasing Managers’ Index