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While the stock market powers ahead with new daily heights, backed by a boost from improving odds of a Republican win, the bond market is sending a different message and the market does overlook the fact!

Lower growth, potential for higher rates, and lingering inflation

The nominal 10-year Treasury yield reflects different elements: the inflation-adjusted, or “real,” yield (a proxy for expected economic growth) and the “inflation breakeven rate” (a measure of investors’ future inflation expectations). Both components have helped drive the 10-year nominal yield higher—to around 4.2%—over the past month.

According to Morgan Stanley research, the real component has risen about 35 basis points to more than 1.9%. On one level, this makes sense: Metrics tied to real economic growth have been much better than forecast lately. However, the levels of real rates also matter critically to equity investing, with higher rates typically weighing on valuations and raising the cost of capital. Currently, real rates are near levels associated with market conditions seen during the post-COVID cycle.

The inflation expectation component, has risen about 25 basis points to about 2.3%. By now, many investors consider the resurgence of inflation as very low while in reality, the menaces are not fading away. In fact, the deflationary pricing conditions for general goods and failing energy prices have impacted negatively the broader inflation readings while at the same time prices for housing and wages kept up.

More importantly, inflation expectation could rise to unexpected level in the case of the former President Donald Trump is retaking office and implementing new tariffs on China goods and amend immigration law. In essence, both end up having a higher inflation rate and lower growth as new tariffs will make goods more expensive and immigration jobs need to be filed with higher paid workers. All in all, this will be resulting in lower growth and ultimately stifled by consumers and investors as pressure on rich stock valuations sensibly increases.

Rising policy uncertainty

Another way to understand the move in the 10-year yield is to analyze the so-called term premium. The term premium is the extra yield investors require to hold a long-term bond (normally 7 to 10 years, and the plus 10-year segment) instead of a shorter duration, let’s say 1 to 3 years.

The previously negative 10-year term premium has risen more than 40 basis points to about 0.20%, one of the highest readings in the post-COVID cycle. While US based investors haven’t increased their exposure to US debt, international investors have while at the same time requiring a higher risk premium. This suggests non-US investors may be increasingly concerned about fiscal and monetary policy, as unsustainably high U.S. debt and deficits. Given that the US growth is mostly financed through debt, which was financed with an above average growth rate, the future path of rates is more than certain as growth is no longer above average.

Investment ramifications

While U.S. equity investors remain optimistic (because of their US-tilted view), other investors, including major gold buyers like global central banks, actually have a more sobering opinion. Precious metals are considered as “safe haven” for period of political and geopolitical instability. While there are some concerns for a larger conflict in ME and lingering conditions in Ukraine, they are locally and concerns for a wider conflict are not given. Therefore, gold’s recent ascent needs to have another background.

According to our research, the potential for stronger-than-expected GDP growth may be fading quicker than expected while at the same time, the Chinese economic conditions continue to worsen. Therefore, there are increasing risks that are not accounted for in current equity valuations.

Given this, it is opportune that investors consider a maximum diversification across stocks (in terms of both regions, sectors, and market cap), bonds (reducing duration skews), and offsetting interest rate risk related real assets.