Quick Thoughts: Bond Market Blues—Real or Inflationary?

US Treasury yields have moved sharply higher, with the 10-year yield rising roughly 45 basis points over the past month to about 5.25%. That has understandably revived concerns about what higher bond yields could mean for equities.

But the source of the increase matters. And today’s rise in yields looks very different from the bond-market selloff of 2022.

• The rise in yields is overwhelmingly about real rates—not inflation. Over the past month, the 10-year Treasury yield has risen about 45 basis points (bps). Just 1 bp of that increase reflects higher long-term inflation expectations, while roughly 44 basis points of the increase reflects higher real yields. In other words, about 98% of the increase has come from higher real rates. The “real rate” ≈ nominal Treasury yield minus expected inflation.
• The same story holds over the course of the year. From the low in 10-year Treasury yields at the end of February, nominal yields have risen about 125 bps. Long-term inflation expectations have risen by only about 9 bps, implying an increase in real yields of roughly 116 bps. That means approximately 93% of the increase in nominal yields has come from higher real rates.
• Why has the real rate risen? Some of the increase likely reflects temporary or cyclical factors, including stronger-than-expected growth, reduced expectations for near-term Federal Reserve easing, and heavy Treasury issuance that has pushed investors to demand more yield. But there may also be more persistent forces at work, including larger fiscal deficits, a structurally higher supply of government debt, stronger investment demand tied to artificial intelligence, infrastructure and energy, and a higher term premium after years in which long-duration bonds offered unusually little compensation for risk. The key question is how much of today’s rise in real yields will fade as growth slows and how much represents a lasting increase in the economy’s real cost of capital.
• That is very different from 2022. During the first four months of 2022, the 10-year Treasury yield rose by a similar amount—roughly 120 bps. But about one-third of that increase reflected rising inflation expectations, as markets reacted to the sharp post-pandemic acceleration in realized inflation.
• Today’s inflation backdrop is much less threatening. Inflation is considerably lower than it was in 2022. It remains sticky in some areas, but there are also signs that price pressures are gradually abating. That means today’s rise in bond yields does not carry the same inflationary message that it did four years ago.
• Strong profits give equities an important cushion. Corporate earnings growth in 2026 has comfortably outpaced the rise in the S&P 500 Index. As a result, valuations have actually improved, with the forward price-to-earnings ratio falling from roughly 22x at the beginning of the year to about 18x today.¹ And with another strong earnings season about to unfold, today’s equity market appears better equipped to absorb higher yields than it was in 2022.
• But higher real rates are still a tightening of financial conditions. Even without rising inflation expectations, higher real yields increase the cost of capital across the economy. An already-soggy housing market will face additional pressure, while lower-quality household and corporate borrowers may find it increasingly difficult to absorb higher financing costs.
• The bigger risk may emerge in 2027. Today’s higher yields are likely to create some drag on economic activity next year. That could coincide with a diminishing contribution from fiscal policy and a peak in capital-expenditure growth rates. If economic growth ebbs, corporate profit margins may also struggle to expand further, raising the risk that realized earnings fall short of today’s relatively lofty expectations.
• What could go wrong? Inflation could reaccelerate, forcing nominal yields even higher. Or real yields could simply continue marching upward, tightening financial conditions further even if inflation remains contained. Either outcome would become increasingly difficult for equities to shrug off.
• What are we watching? Both nominal and real bond yields. The distinction matters because this is not the inflation shock of 2022. But sustained increases in real yields can still act as a brake on economic activity, profitability and equity-market returns.
   

This is not a repeat of 2022. But higher real yields are not benign.