Seema Shah
A growth story: Not all rising yields are equal
Over the past quarter, rising bond yields have fuelled market volatility and renewed concerns about the durability of the bull market. Yet, while higher energy prices and elevated fiscal deficits have contributed to the move, not all of the increase reflects deteriorating fundamentals. Robust global growth and a powerful capex cycle, led by AI-related investment, are increasing demand for capital and pushing up the long-term cost of capital.
While growth expectations across several major economies have softened from earlier highs, reflecting the drag from higher oil prices, most are still expected to deliver at least trend growth in 2026. The outlook for Asia ex-Japan has improved, with the investment cycle helping to offset higher commodity prices and supporting regional growth.
The resilience of global activity is perhaps most evident in the U.S., where nominal GDP is expanding at 6.6% year-on-year, the strongest pace since 2005 outside the post-pandemic rebound. With nominal growth and investment demand remaining robust, higher bond yields should not be viewed solely as a headwind for markets. They also reflect an economy that continues to generate opportunities for earnings growth and capital deployment, providing a constructive backdrop for risk assets.
A less interest rate sensitive U.S. economy
Economic slowdowns typically emerge as higher borrowing costs constrain spending and investment. Yet despite net interest payments reaching cycle highs, the economy has proven unusually resilient, reflecting reduced interest-rate sensitivity across key parts of the economy.
Households and corporates locked in exceptionally low borrowing costs during the pandemic, leaving effective borrowing rates well below current market rates. As a result, even with 30-year mortgage rates above 7%, much of the household sector remains insulated from higher financing costs. Meanwhile, strong earnings growth and record-high profit margins have enabled businesses to continue investing.
Moreover, AI-related spending is increasingly driving the investment cycle. Supported by strong expected returns and strategic capacity requirements, it has remained relatively insensitive to higher borrowing costs. Rising household wealth, supported by resilient labour markets and equity markets, has also helped sustain consumer spending.
The government sector stands in contrast. Unlike households and businesses, governments largely failed to extend debt maturities when rates were near zero, leaving public finances considerably more exposed to higher borrowing costs.
Federal Reserve: “We have work to do”
The Federal Reserve has resumed policy tightening. However, because policymakers are responding primarily to energy-driven inflation pressures and currency dynamics rather than a materially overheating economy, this is likely to be a relatively shallow tightening cycle.
Our base case is for an additional Fed rate hike in December, followed by one further hike in 2027. Additional tightening beyond that remains possible should energy prices stay elevated, and policymakers become less willing to tolerate a gradual return to 2% inflation. Markets remain somewhat more hawkish than our forecasts, although current pricing implies only limited additional tightening.
Inflation and currency pressures are also shaping policy outside the U.S. The ECB continues to respond to energy-driven inflation pressures, while the BOJ has slightly accelerated the pace of policy normalisation in response to persistent yen weakness. In both cases, only modest additional tightening appears likely.
The policy reassessment of recent months reflects both a more challenging inflation outlook and more resilient economic growth. As such, central banks have become more willing to tighten policy further and keep rates restrictive until inflation shows clearer signs of returning to target.
Strong earnings enable U.S. equities to defy rising rates
Despite renewed central bank tightening and a sharp rise in bond yields, U.S. equities remain close to record highs. The key reason is that the same force pushing rates higher—resilient growth—is also supporting earnings. Consensus earnings growth for 2026 is over 30%, with gains increasingly extending beyond the tech sector. Earnings, rather than multiple expansion, have driven equity returns this year.
The AI capex cycle has remained largely insensitive to higher borrowing costs, increasingly viewed as a strategic necessity rather than discretionary spending. This has helped sustain earnings expectations despite a higher-rate environment.
The key risk is that inflation proves more persistent, forcing the Fed to tighten beyond current expectations. In that scenario, higher rates could begin to weigh on growth, limiting companies’ ability to offset rising discount rates through stronger profits. At the same time, increasingly ambitious 2027 earnings expectations leave equities vulnerable should AI spending fail to translate into profits.
More broadly, higher bond yields are providing a more credible alternative to equities, increasing the importance of earnings delivery and creating greater return dispersion across companies and sectors.
Rate dislocations amid a global competition for capital
Bond yields across developed markets have continued to rise, challenging assumptions about where interest rates can stabilise amid resilient economic growth. The move has been pronounced in the U.S., where 10-year Treasury yields have moved above 5.2%, their highest level since 2007.
Although stronger growth has been the immediate catalyst, the rise in long-end yields has also exposed a broader reassessment of duration risk. Rising government borrowing requirements and growing demand for long-term capital are increasing the cost of funding at the long end of the curve, while more volatile inflation outcomes have reduced investors’ willingness to lock in returns for extended periods. Markets are increasingly pricing a higher long-run cost of capital.
While Treasury buybacks and renewed Fed credibility have helped stabilise market conditions, the fundamental drivers of the sell-off remain intact, with 30-year Treasury yields climbing beyond 5.5%, levels last seen in 2004.
Interest rates are likely to remain elevated relative to the pre-pandemic era. A meaningful decline in bond yields would probably require either a significant weakening in economic activity or a credible fiscal adjustment.
You miss 100% of the shots you don’t take
Growth remains stubbornly intact, earnings continue to surprise positively, and structural investment remains a powerful source of demand. While macro and geopolitical risks remain elevated, the broader backdrop remains supportive.
Importantly, accelerating earnings growth has continued to reward investors who stayed the course through heightened volatility, policy uncertainty and market dislocations. The key lesson of this cycle is that economic and corporate resilience have repeatedly exceeded expectations.
Looking ahead, market outcomes are likely to depend more on earnings delivery, productivity gains and thoughtful capital allocation. Higher rates are not simply a headwind to markets, but increasingly reflect stronger growth, rising investment demand and greater competition for capital.
While AI and infrastructure remain important drivers, broader earnings growth, improved income potential and a wider distribution of growth across sectors and regions are creating a more diverse investment landscape. The opportunity set is broadening, but so too is the need for selectivity and diversification.
By Semma Shah, Chief Global Strategist
