September 8, 2026 I 11 minutes read
Markets continued to rally in August, with the All-Country World Index rising by 3%. Still, investors remain jittery, with sentiment measures declining during the month. Beyond concerns about the AI boom and the Strait of Hormuz, another risk has come to the forefront: bond yields.
30-year Treasury yields reached 5.26%, the highest level in 19 years. In his recent speech at Jackson Hole, Fed Chair Kevin Warsh also shifted to a more hawkish stance. The pressure at the long end of the Treasury yield curve has prompted the White House to act. On August 19th, Treasury Secretary Scott Bessent announced a buyback of long-term debt to contain the long end of the curve.
Should we be worried about this increase in yields? Our take is that investors are overestimating the threat 5% bond yields pose to both equities and the economy.
An investor might not infer it from President Trump’s impatience with the bond market, the Iran conflict, and the tariff wars, but the U.S. economy is doing just fine, which keeps us positive on the outlook for risk assets.
- Nvidia Silences the Bubble Talk
- Midterm Elections Risk Premium?
- The Global Economy is Doing Well
- Are Rising Bond Yields a Problem?
- Higher Bond Yields Don’t Hurt Stocks
- Fixed Income Looks Attractive
- China Is Not Stimulating
- Our Portfolio Positioning
Nvidia Silences the Bubble Talk
Nvidia reported second-quarter earnings and forecast 70% revenue growth for 2028, much higher than expected, sending a positive signal for the overall AI ecosystem. As its CFO put it on the call with analysts, “Incredibly, we are seeing demand acceleration even at our scale.”
The news that the world’s largest company by market cap is still growing this fast calmed the fears about a bursting AI bubble and sparked a broader NASDAQ rally.
Another market concern is the level of vendor financing. Vendor financing only becomes a problem when you are financing customers who cannot repay you. During the dot-com bubble, Lucent showed a clear deterioration in cash conversion before the bubble ended. Until now, Nvidia’s cash conversion has been very healthy.
Away from AI, the U.S. economic expansion remains intact, with real final sales to private domestic consumers growing at a 4.2% annualized rate in this week’s revised second-quarter GDP data.
Midterm Elections Risk Premium?
Unexpected policy shifts from the Trump administration are likely to add to stock-market volatility in the final stretch before the midterms. Online betting odds now put Democrats at roughly 50/50 odds of winning the Senate. A Democratic victory in both the House and the Senate would severely limit the Trump administration in the next two years.
The administration seeks foreign policy wins with potential ceasefires in Iran and Ukraine, but both remain elusive. Gasoline prices are still too high for voters to feel conditions are improving.
Treasury Secretary Scott Bessent has also intervened in the Treasury market and declared economic war on Iran, but markets are unconvinced, and China refuses to implement sanctions on Iran.
President Trump appears to be reviving the trade war and nationalism to energize his base ahead of the election, including new tariffs on Canada. Yet those measures would add to price pressures, limiting how far the administration may ultimately go.
The midterms could bring greater market volatility, especially if a surprise Democratic Senate victory raises the odds of bipartisan legislation in 2027 to regulate the AI boom and control prices, potentially weighing on market sentiment.
The Global Economy is Doing Well
The August Philadelphia Fed survey points to strong manufacturing momentum without a renewed pickup in price pressures. The strength was broad. New orders and shipments edged down but remained near multi-year highs, while firms’ expectations for the next six months improved. Labor indicators were also strong, with both employment and work hours ticking up. At the same time, overall price pressures eased as input prices and delivery times declined. Price pressures should continue cooling as commodity prices normalize, pointing to slower goods inflation.
The U.S. economy remains in a growth sweet spot, neither slowing meaningfully nor booming. Positive macro momentum should remain a tailwind for earnings and warrants favoring equities over bonds, as U.S. nominal GDP growth stays strong.
Euro area manufacturing also continued to improve and surprised to the upside, while services data was in line with estimates. Japanese PMIs also remained strong, rising across the board. UK PMIs were mixed, with manufacturing softening and services improving. Meanwhile, input prices cooled globally, pointing to easing price pressures.
Are Rising Bond Yields a Problem?
Government bond yields in the U.S. and globally have been rising recently, with the U.S. 10-year Treasury yield now at 4.8%.
The rise was large enough to prompt a reaction from the Trump administration, prompting Treasury Secretary Scott Bessent to initiate a buyback program to limit the rise in yields.
The effect of buybacks on the long end of the curve is likely to be temporary. The buybacks by the Treasury work effectively like an “Operation Twist”, however, they are unable to create any extra liquidity without the Fed deploying its balance sheet.
To see why, it’s worth considering the two different ways the Treasury might implement this buyback program.
The first possibility is that the Treasury could finance its purchases of long-dated bonds by issuing new T-bills into the market. Mechanically, this would be equivalent to the Fed’s “Operation Twist” in 2011-12. Long-maturity debt would be removed from the market and replaced by short-maturity debt.
The constraint on this method comes from the market. If the Treasury pushes this Operation Twist too far, the market will become oversupplied with T-bills.
The second possibility is that the Treasury could finance its purchases of long-maturity bonds by drawing down its cash balance. Mechanically, this would be equivalent to when the Fed conducts Quantitative Easing (QE). But while Fed QE is potentially unlimited, the Treasury is once again constrained in what it can accomplish with this method. This time the constraint comes from its limited cash balance. Currently, the Treasury holds about $950 billion in cash.
Unless the Federal Reserve deploys its balance sheet, any efforts by the US government to suppress bond yields will fail. In fact, they could even be counterproductive if investors start to sniff out that the administration is getting desperate.
Higher Bond Yields Don’t Hurt Stocks
We think concerns about the threat posed by the current level of interest rates to equities and the economy are overdone. Despite rising yields, the spread between high-yield borrowing costs, nominal growth, and corporate profits is at a five-year low and continues to narrow.
The level of yields matters less for equities than how quickly rates move, making implied rate volatility the more useful gauge of risk to the equity market. Stocks have delivered positive returns across different rate regimes, with yields rising and falling. What matters is what is driving rates. When inflation is the market’s focus, stocks and yields tend to be negatively correlated. When growth is the focus, that correlation is usually positive.
Equity markets can absorb higher yields, but they struggle with rapid spikes. Conversely, while lower yields are mechanically supportive for valuation multiples, a sharp decline often signals weaker earnings.
Despite elevated yields, interest rate volatility has remained comparatively low. Chairman Warsh’s Jackson Hole speech signaled a conventional policy approach and a willingness to respond if inflation reaccelerates, which should help to calm the Treasury market.
Almost certainly in response to rising long-maturity bond yields, Fed Chair Kevin Warsh moderated his “no forward guidance” policy in his Jackson Hole speech last week by offering his take on the outlook for the economy, something he’d previously been unwilling to do. Markets took that economic outlook as hawkish and now think a rate hike later this month is more likely than not. A rate hike this month is possible, but we think the Fed will hold rates steady if core inflation continues to trend down, and core inflation has been soft for a few months in a row.
Fixed Income Looks Attractive
After the recent jump in bond yields, we think bonds are now more attractive than at any point in the past 10 years.
Even though core inflation remains relatively high, we believe inflation expectations will not rise much further. We think inflationary pressures will come down in the coming months. Combined with the Fed’s messaging that it will act if inflation does not come down, we do not see any good reason for the U.S. 10-year Treasury yield to rise much above 5%. As the 10-year yield currently stands at 4.8%, we do not expect much downside in bond prices, while higher yields provide a good buffer against any further declines. Over a 12- to 18-month horizon, we think bonds will outperform cash and potentially deliver 5-8% returns.
China Is Not Stimulating
We thought it was likely that China would stimulate its economy in the second half of 2026. This hasn’t happened so far, and there are no signs that the government is planning any new fiscal initiatives.
As the credit growth in the Chinese economy continues to decelerate, fiscal stimulus will be needed at some point. This is happening at a time when investment growth is falling at the fastest pace in at least 30 years. Chinese policymakers have remained steadfast in their commitment to keep stimulus limited, counting on exports to sustain economic growth.
We believe this strategy is eventually unsustainable. By relying on its external sector, the Chinese economy is making itself vulnerable to retaliation by trade partners. While we remain positive on the long-term outlook for Chinese equities given their valuations, the growing trade deficit between China and Europe is raising the risk of tariffs and other policy headwinds in the near term. As we argued before, China will need to further develop its domestic economy, and the only way to do that while the property sector is still deflating is through fiscal stimulus. Any signs of potential fiscal stimulus will likely be a positive for Chinese stocks, which have been underperforming this year.
Our Portfolio Positioning
Our portfolio positioning worked well in August, and we did not make changes to our allocation. As we are turning more positive on fixed income, we are considering adding more duration in the portfolio in the coming weeks.
Becoming more positive on fixed income from an absolute return perspective does not mean we are less positive on equity markets. In this environment, we believe investors should stay diversified and fully invested.
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