Santoli: Why all the fuss about bond yields is happening now

Get Mike Santoli's Market Memo in your inbox first. SUBSCRIBE HERE

It's a ripe summer in the American economy, and the AC thermostat hangs in the hottest room in the house, the kitchen, where the sun streams in and the oven is always set to broil.

The thermostat in this case is the bond market, working to offset the blistering demand for debt from governments and companies by raising borrowing costs to multiyear highs. The kitchen is the AI-buildout sector, desperate to turn some $2 trillion into vast reserves of computing capacity by the end of next year.

The lift in bond yields isn't having much effect in moderating the pace of capital-raising and corporate investment. But it could threaten to overcool other parts of the economy, such as housing and Main Street spending.

This is the backdrop in which Treasury Secretary Scott Bessent sought to restrain longer-term Treasury yields last week by expanding an existing program to buy back small amounts of less-liquid government debt in the open market.

The move prompted a rather overheated response from market participants and commentators, as either a bad look for a Treasury Secretary who had charged his predecessor with untoward massaging of market rates, or too small to matter, or both. The criticism intensified after the initial drop in yields reversed a day later, while sharp declines in the U.S. dollar and jump in gold prices held, a combination that could be read as a vote of no confidence in the stewards of the financial-policy apparatus.

And, of course, the selloff in bonds inevitably inflames worry over a long-threatened fiscal breakpoint becoming reality. Unease over the U.S.'s ability to finance structural deficits is like an autoimmune condition: It flares up under the stress from adverse market stimuli, such as overheating capex and war-inflation feedback loops, then often goes dormant again.

But would it come as a surprise to learn that the 10-year Treasury yield's rise last week amounted to a mere 4 basis points, to 4.74%? That the yield has been up here before a couple times over the past three years, if only briefly? What about the fact that the yield on investment-grade corporate debt remains below its peak from a few years ago, because spreads over Treasuries are so snug?

The absolute yield level isn't broadly punitive yet to big companies. Nor, for now, is it a strong undertow pulling down equity values. With nominal GDP growth (real growth plus inflation) running near 5-6% right now, how much lower would one expect 10-year yields to be? The steepness of the yield curve is likewise not extreme relative to historical ranges.

So why all the fuss?

The orderliness of the move so far has allowed the stock market to hang relatively tough for now. There are no clear trigger thresholds for yields that instantly undercut equities, even if equity investors are watching warily.

The textbooks say the cycle high in real yields – the 30-year real yield, or nominal yield minus market-projected inflation, now exceeds 3% – should act as a restraint on economic growth and equity valuations.  Such effects can be subtle, long-gestating and offset for a time by exciting corporate growth in the here and now.

It's also important to recognize that the S&P 500 has lived pretty comfortably in that same sweltering kitchen with the AI builders. About a third of its recent earnings growth is directly from AI infrastructure companies. It truly is a capital-goods and business-to-business benchmark more than a gauge of broad U.S. consumption. The consumer-discretionary sector makes up 9.2% of the S&P, but its weight drops below 4% if AI/tech proxies Amazon and Tesla are excluded.

Thus, the market hovers within a couple of percent of record highs, even as last week showed July housing starts fell 12.4% and Walmart posted its weakest quarterly comparable-store sales growth since 2020.

This isn't to suggest the underlying economy is struggling broadly; not at all. Consumer-spending growth oscillates in a stable range, unemployment is low, the aggregate consumer debt-service burden manageable.

Yet wage growth is sagging while inflation remains elevated, tax-refund windfalls are in the past and the real juice in the economy remains corporate spending fueled by ample earnings – a capital-over-labor dynamic that makes rising interest rates play to the public as an exacerbating factor on "affordability" rather than a positive sign of household-sector momentum.

Countertrend rally in bonds? 

For investors, the same fattening of real yields embedded in Treasuries that raises the hurdle rate for borrowers represents compensation paid to the owners of the debt. Is value therefore building in bonds, just as conventional wisdom turns against their role as a diversifier for equities?

Barry Knapp of Ironsides Macroeconomics notes the latest climb in yields has occurred in the face of softer inflation and employment readings and spottier consumer data: "Although we continue to be secular bond bears, and do not view the Treasury Secretary's actions as a significant positive catalyst, we still think there is scope for a countertrend rally in long maturity [Treasuries]."

The S&P 500 did slouch 1.4% last week as the bond market dominated the chatter. Equity investors are watching the bond market ration capital through higher yields to the public and private sectors. The main thing stock folks are worried about – the voracious consumption and headlong deployment of capital for AI – is now the thing lifting rates and potentially restraining growth elsewhere.

Semiconductor stocks fell more than 5%, their rebound rally stopping right at "logical" resistance levels, while there was some slippage in the market's clockwork rotations. Banks did not love the Treasury-market ructions, sliding 4%. Industrials, a pricey shadow AI play, lost more than 3%. The S&P 500 itself receded back toward the top of its prior multi-month range that held from May through July before bouncing modestly.

Rick Bensignor, a veteran macro and technical strategist now at Bensignor Investment Strategies, reads the tape as saying that tech has peaked in relative terms and healthcare and financials are better positioned. He spies some technical warnings in the action: "The S&P 500 shows 10 of the last 13 sessions with 'closed' candles, suggesting real institutional selling after the Aug. 4 upside breakout day. If Nvidia doesn't bring new material buying [with its results on Wednesday], I really raise the caution flag."

This indicator from John Kolovos of Macro Risk Advisors uses several data points to reflect both what investors are saying and what they are doing.

Kolovos on the latest reading: "A jump in sentiment partially explains this week's pullback in stocks.  Of concern remain low levels of implied volatility, while sentiment surveys are starting to show more bullish respondents. We've been advocating tactical VIX call spreads as an insurance policy despite my bullish forecast for the market."

— "The Money Game," by the writer who published under Adam Smith, is rightly esteemed as one of the best chronicles of Wall Street ever set to paper. Appearing in 1968, it captures a previous technology boomtime in the markets, when mainframe computers (and space-and-defense tech) were exciting imaginations and inflating valuations.

The discussion of today's "circular financing" of customers' tech purchases by the big hardware manufacturers finds an echo in this anecdote, in which a grizzled veteran asks a "kid" investor how he made a 100x profit in six months:

"Computer leasing stocks, sir!" he said, like a cadet being quizzed by an upperclassman. "The need for computers is practically infinite," said Billy the Kid. "Leasing has proved the only way to sell them, and computer companies themselves do not have the capital. Therefore, earnings will be up 100% this year, will double next year, and will double again the year after that. The surface has barely been scratched. The rise has scarcely begun."

— The Wall Street Journal delivers an engaging obituary of Victor Niederhoffer,  a roguish, infamous trader who lived a vivid life and died earlier this month.

Niederhoffer would email me now and then back when I wrote a column for Barron's, typically delivering a patronizing backhanded compliment suggesting one of my pieces showed that I "almost got it."

His most acute scorn was reserved for my then-colleague, Alan Abelson, the longtime lead columnist and former Barron's editor known for his florid, literate and persistent bearishness. Vic likened Alan to "a priest who doesn't believe in God – a stock-market writer who hates the stock market."

Vic never hated the market, but it didn't always love him back: He made and lost two fortunes, blowing up by effectively shorting volatility before market collapses.

The way earnings growth has outraced rising stock prices in recent quarters has allowed bullish voices to celebrate valuation compression done the easy way.  

This is true if focusing on the standard price-to-earnings ratio, which has ebbed from 23 to 20 in the past 10 months. But, as we know, the biggest earners are reinvesting furiously to bankroll the AI buildout. Now what's scarce, along with memory chips and gas turbines, is free cash flow.

Here we see the S&P 500 price-to-free-cash-flow ratio, using projected FCF, sitting just under 30, a multi-decade high. 

Another way to express this: Stocks have a free cash flow yield of 3.4% as 10-year Treasuries sit at 4.74%.

The corporate cash burn is largely a choice, of course, though the heavyweight tech platforms are not behaving as if they see plausible alternatives to competing in the arms race toward superintelligence. Or at least to accrue enough data center capacity to rent to those trying to create a new collective consciousness out of silicon.

SUBSCRIBE TO MIKE SANTOLI'S MARKET MEMO HERE