By Daniela Hathorn, senior market analyst at Capital.com
Markets are heading towards the end of the week with the divergence between US equities and the bond market they key theme. Wall Street reached fresh record highs earlier in the week, supported by continued enthusiasm around artificial intelligence and expectations for another exceptionally strong earnings season. But momentum has faded as Treasury yields remain elevated, oil prices rebound and investors reassess whether corporate profits can continue justifying valuations in an environment of significantly higher borrowing costs.
Bond yields remain the biggest challenge for equities:
The Treasury market has continued to dominate the macroeconomic narrative this week. The US 10-year yield has remained around 5.3%, close to its highest levels since 2002, while the 30-year yield has approached 5.7%. These levels start to question the relative attractiveness of equities and fixed income. When investors can earn more than 5% on US government bonds, companies trading at elevated earnings multiples need to deliver considerably stronger growth to justify the additional risk.
US 10-year bond yield (monthly chart)
Past performance is not a reliable indicator of future results.
The interesting part is that the bond sell-off has continued despite last week’s disappointing employment figures, which reduced expectations for another immediate Fed hike. That suggests the rise in long-term yields is about more than the next monetary policy decision. Resilient economic activity, elevated real yields, substantial government borrowing and growing competition for capital from the AI investment boom are all contributing to the pressure. As a result, equities have been supported by expectations of strong earnings growth, while bonds are increasingly pricing a world in which the cost of capital remains structurally higher.
Fed minutes reinforce the higher-for-longer narrative:
Wednesday’s release of the September FOMC minutes provided another important development. The Fed raised interest rates by 25 basis points at its September meeting, taking the target range to 3.75–4.00%. The minutes reinforced policymakers’ concerns about persistent inflation, although they also highlighted differences over how much additional tightening might be required.
The central bank remains particularly sensitive to the possibility that higher energy prices could generate second-round inflation through wages, services and broader price expectations. However, the weakening labour market complicates that assessment. September’s disappointing employment report suggested that hiring momentum is slowing, reducing the urgency for consecutive rate increases.
Oil rebounds as Middle East tensions intensify:
Brent initially traded around $100 as improving Middle Eastern exports and diplomatic efforts between Washington and Tehran encouraged hopes that the geopolitical premium could continue unwinding.
However, those expectations were challenged by renewed attacks on commercial shipping around the Strait of Hormuz. A tanker was struck off Qatar, while maritime security reports indicated that attacks on vessels around Hormuz had intensified. Brent subsequently surged above $105 on Thursday before retreating towards $103 as hopes of diplomatic progress resurfaced.
AI optimism faces its first major earnings test:
Technology has remained the most important source of support for US equities, but this week’s price action suggests investors are becoming more selective. The Nasdaq reached another record earlier in the week, supported by continued optimism surrounding AI infrastructure, cloud computing and the commercialisation of artificial intelligence.
However, Thursday’s semiconductor sell-off demonstrated how sensitive the sector has become to changes in expectations. Reports questioning the scale of OpenAI’s annualised revenues contributed to renewed scrutiny of AI-related valuations, with chipmakers among the weakest performers.
US Tech 100 daily chart
Past performance is not a reliable indicator of future results.
The underlying issue is increasingly one of returns on investment. Investors want evidence that the extraordinary amounts of capital being committed to data centres, chips and infrastructure can generate sufficient revenue and cash flow to justify that spending. Therefore, the upcoming earnings season will be a key test. The largest technology companies have so far demonstrated earnings growth strong enough to offset much of the pressure from rising yields. But with valuations elevated and market leadership increasingly concentrated, the consequences of disappointing results could be more significant.
Week ahead: Earnings season and US CPI take centre stage:
Next week could prove particularly important because investors will receive two very different assessments of the US economy. Corporate earnings will reveal how businesses are performing, while Wednesday’s CPI report will help determine how much flexibility the Federal Reserve has to respond.
Third-quarter earnings season begins on Tuesday with several major US banks scheduled to report. JPMorgan, Goldman Sachs, Citigroup and Wells Fargo are among the first companies expected to release results, followed by Bank of America and Morgan Stanley on Wednesday. Thursday also brings earnings from Taiwan Semiconductor Manufacturing Company, providing an early indication of demand across the semiconductor and AI supply chain.
The banking sector will be particularly interesting because it sits at the intersection of several important macroeconomic trends. Higher interest rates can support net interest income, while resilient economic activity and capital-market volatility can benefit trading and investment banking. However, the same elevated borrowing costs can eventually weaken loan demand and increase credit losses.
Investors will therefore be looking beyond headline earnings towards management commentary on lending conditions, consumer credit, corporate borrowing and the broader economic outlook. The results could provide an early indication of whether higher rates are beginning to damage the economy or whether businesses and households remain capable of absorbing them.
The other major event is Wednesday’s US inflation report, with investors particularly focused on whether underlying price pressures are showing signs of moderation following the recent energy shock. August headline inflation stood at 3.4% year-on-year, while core CPI was 2.4%. The September figures will provide an important indication of whether higher energy costs are beginning to spread into other parts of the economy.
For equities, a hotter-than-expected CPI report would be particularly uncomfortable if it coincides with earnings results that fail to meet elevated expectations. Conversely, softer inflation could provide some relief to the bond market and create a more supportive environment for equity valuations.
