For most of the past two years, the conversation around interest rates has focused on what the US Federal Reserve will do next. Will they cut? How quickly? By how much? But that's not really the right interest rate to watch today. The number that matters most from here in my opinion is the US 10-year bond yield, and in particular what happens if it moves above 5% for a sustained period. The 10-year is already around 4.7%, while the 30-year is above 5.2%, so we are getting increasingly close to that point.
There is nothing special about 5% itself. The US economy has lived with much higher interest rates before. The problem is the environment those rates are being applied to today. US Government debt has passed $40 trillion, mortgage rates are already close to 7%, consumers are carrying more debt and corporate borrowers face years of refinancing ahead. At the same time, economic growth is slowing, employment has weakened and the energy shock is adding another layer of pressure.
At around 5%, I think there is an immediate risk to financial markets. Higher bond yields make equities relatively less attractive and increase the discount rate investors apply to future earnings. That puts downward pressure on the sharemarket and stock valuations. It doesn't require a recession to produce a correction. Investors simply have to decide they are no longer prepared to pay the same price for the same dollar of future earnings.
The more concerning scenario begins around 5.25% to 5.5%. At that point it becomes less about sharemarket valuations and more about the economy itself. Higher Treasury yields flow through to mortgages, corporate borrowing, commercial property and private credit, and eventually into employment and consumption. If earnings begin falling at the same time valuation multiples are contracting, a relatively ordinary market correction can quickly become a 20% or 30% bear market.
There is another complication I am mindful of. Normally when an economy weakens, the Federal Reserve cuts interest rates, bond yields fall and financial conditions begin to improve. But if the Fed cuts interest rates and long-term bond yields don't fall because investors are demanding a higher return, that’s a serious problem. If investors are worried about inflation, government debt and huge new issuance of bonds, monetary policy becomes considerably less effective. The Fed can control short-term rates. It cannot really control what investors demand to lend the US Government money for ten or thirty years.
So the 10 year bond yield is really important to watch right now. A 10-year yield of 5% is a real warning for equity markets. At 5.25% the economic risks become considerably more serious. At 5.5%, particularly if sustained, I think something probably breaks.
It is important to note that none of these numbers exists in isolation. A 5.5% bond yield in a strong economy with healthy employment and moderate debt would be one thing. A 5.5% yield alongside slowing growth, weakening employment, an energy shock and enormous government borrowing is something very different.
We aren't at crisis levels yet. But we are getting closer to the point where higher bond yields stop being just another number and start having meaningful consequences for markets and the economy. That is why the US 10-year bond yield may now be the most important number to watch in financial markets.
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