Insight & Outlook: Fidelity Market Signals Weekly

Is the rate hike and a rising 10-year Treasury ominous?

A Fed rate hike, 10-year Treasury yields near 5%, and rising oil prices present the kind of backdrop that can end bull markets. Look closer, however, and there are reasons to think de-risking portfolios early could be a mistake.

Are markets right to fear higher yields?

Let’s start by decomposing the yield. In simple terms, a nominal Treasury yield is expected inflation plus a real yield that compensates investors for growth and risk.

If the move toward 5% last week reflected inflation fears, it would have shown up in the inflation-linked market.

But it didn’t. Breakevens across the curve are currently pricing in just north of 2% inflation, even with oil rising and ongoing conflict in the Persian Gulf.

Why? We believe the market has learned to treat oil-driven price spikes as shifts rather than regime changes. The rise in the 10-year Treasury yield is likely not because the market is pricing in runaway inflation. Rather, it appears to be mostly a real-yield story tied to stronger growth.

Is the term premium a U.S. debt problem?

The compensation investors demand for holding long-dated bonds has widened as the nation’s sovereign debt has ballooned. The U.S. debt stands at roughly $40 trillion, the deficit is tracking toward $2 trillion this year, and interest costs now run around $1 trillion annually.

Debt is indeed a problem, although not a unique one. Gross government debt for the U.S. and most other G7 countries, including Japan, Italy, France, and Canada, stands at or above 100% of GDP.¹ Partly as a result, 10-year yields in Germany, Japan, and the U.K. also are at multiyear highs.

Therefore, it’s hard to call the long-end sell-off for bonds a verdict on U.S. fiscal credibility.

It’s also hard to attribute the higher term premium primarily to AI-related issuance. While corporate borrowing can influence market rates at the margin, we believe it does not fully explain the move toward 5% Treasury yields.

If not inflation or debt, then what’s driving 10-year Treasury yields?

Growth appears to be the biggest reason behind the higher yields. Higher real yields (adjusted for inflation) are not necessarily a warning sign; they can reflect stronger anticipated economic activity.

Strip out the inflation scare and the fiscal narrative and what remains is an economy that keeps outrunning expectations. Second-quarter S&P 500 earnings grew more than 20% year over year. The labor market remains healthy in a low-hire, low-fire environment. Economic activity has continued at a solid pace despite geopolitical headwinds.

We’ll soon see what’s in store for the third quarter, although last week, the Atlanta Fed upped its estimate for third-quarter real (adjusted for inflation) GDP growth to 5.1% annualized.

We'd resist equating "the Fed is hiking" with "the cycle is ending."

Does Fed hiking derail the stock market?

Last week, the Fed raised rates for the first time in three years and signaled in its “dot plot” analysis that another rate hike could be coming by the end of 2026. The stock market turned lower after Warsh’s comments came to an end.

Is it time to position more defensively? History suggests it’s not the right move. Fidelity's research shows that when the Fed has raised rates within a contained range (up to 1.25% in a hiking cycle) equities generally continued to advance. Since 1962, the S&P 500 has risen 83% of the time in the 12 months following such hikes.

It could be a mistake to treat the first hike of a phase as a sell signal; the historical record has rewarded the opposite.

What does the yield rate cycle mean for bonds?

Rising yields have hurt the Bloomberg U.S. Aggregate Bond Index year to date.

Yet high-quality bonds now offer income levels unavailable for most of the past two decades and provide a larger cushion against further rate increases.

Those factors, combined with tight credit spreads, are key reasons our fixed income teams have become more constructive on U.S. Treasuries. It’s not because rates must fall, but because today's yields provide more compensation for risk and potential ballast against equity volatility. Treasuries remain part—and arguably an increasingly important part—of the overall bond mix.

Where does energy fit—and what would change our mind?

The clearest risk to our constructive view rests with the energy market. A sharp, sustained move higher in crude—the kind a meaningful escalation in the Persian Gulf could produce—would feed into headline inflation.

This is something we continue to monitor. Rate hikes driven mostly by rising energy prices could derail our positive thesis. To date, that’s not what we believe is happening.

The main takeaway for advisors

The recent move toward a 5% yield appears to reflect stronger economic growth, as opposed to widespread inflation fears or concerns about U.S. fiscal credibility.

Growth-driven increases in yields have historically been far less damaging to risk assets than inflation-driven ones. Historically, equity markets have weathered modest Fed tightening far better than many investors assume.

For advisors, the key is helping clients distinguish between rates rising because the economy is weakening and rates rising because it remains stronger than expected.