Before the Federal Reserve's decision, U.S. long-term bond yields broke through 5%, what signal does this send?

In the global bond market sell-off, a key financial market indicator is approaching an important psychological threshold.

The U.S. stock market faced pressure and fell on Tuesday, with the Nasdaq 100 index down 0.8%, and all seven "tech giants" closed lower. The S&P 500 index also dropped 0.7%. Meanwhile, the Cboe Volatility Index (VIX) surged from its lowest levels in recent years, indicating a rise in market risk aversion.

At the core of this storm is the fact that the yield on the U.S. 30-year Treasury bond has surpassed 5% for the first time since July. This trend is not an isolated case, as long-term bond yields in the UK and Japan have also seen similar increases. Although the market generally expects the Federal Reserve to cut interest rates later this month, the rise in long-term rates highlights concerns about inflation and government fiscal conditions, which have surpassed worries about the central bank's short-term monetary policy.

For investors, a 5% yield is not only a technically significant level but also a psychological warning line. After the U.S. stock market recorded an astonishing 29% increase since early April, the rising cost of borrowing is forcing the market to reassess high stock valuations, especially for interest rate-sensitive growth stocks, raising questions about the sustainability of future economic and earnings growth.

Global Sell-off and Fiscal Concerns

The surge in long-term U.S. Treasury yields is a reflection of the broader context of a global government bond sell-off. This week, long-term bonds are facing new pressures, reflecting investors' concerns over two core issues: the increasingly swollen budget deficit and the upcoming increase in bond issuance this month.

A significant divergence is emerging in the market: On one hand, the money market is betting that the Federal Reserve will cut rates by 25 basis points at its meeting on September 17, which would push down the yield on the interest rate-sensitive two-year Treasury bonds; on the other hand, investors are worried that the growing U.S. federal debt will lead to an oversupply of long-term Treasury bonds, thus demanding higher returns as compensation.

According to Matt Maley, Chief Market Strategist at Miller Tabak + Co.:

“If inflation is allowed to rise again, regardless of what the Federal Reserve does with short-term rates, the market will push long-term rates higher.”

The 5% Psychological Threshold and Stock Market Valuation Pressure

When the yield on a key asset reaches an integer level like 5%, it often triggers significant fluctuations in market sentiment. Michael Purves, CEO and Founder of Tallbacken Capital Advisors LLC, stated:

“For stock investors, when they see the 30-year Treasury yield reach an integer level like 5%, market volatility typically increases, because some investors feel that the government is losing control.”

He added that, additionally, “there are also some algorithmic trading programs that start selling stocks when yields reach specific thresholds.” Historical experience shows that when the 30-year Treasury yield breaks 5%, it has brought different signals to Wall Street. In May of this year, after the yield broke 5%, the S&P 500 index quickly fell by 2.3%; however, when it surged again in July, it barely hindered the market's upward momentum.

However, the current environment is different. After a significant rise in the S&P 500 index over the past four months, its valuation has become stretched. The forward price-to-earnings ratio of the index has reached 22 times, a level that has only been surpassed during the internet bubble and the rebound after the COVID-19 pandemic in the past 35 years.

Policy Game and Economic Outlook Uncertainty

The current market dynamics are also intertwined with a complex policy environment. Trump has intensified his criticism of the Federal Reserve, calling for significant interest rate cuts, a move that could exacerbate any price pressures stemming from his tariff policies. Meanwhile, a federal appeals court has ruled that most of Trump's tariff measures are not permissible. Eliminating tariffs could reduce a source of revenue for the government but could also alleviate price pressures.

In any case, rising interest rates have a direct impact on stock market investors. Higher rates raise concerns about future economic growth and how increased capital costs will affect businesses and consumers. As Maley stated:

“This raises questions about future earnings growth, which is not good news for an expensive stock market.”

Looking ahead, the market is closely watching the U.S. job vacancy data set to be released later on Wednesday for new clues regarding the Federal Reserve's room for interest rate cuts. Economists predict that job vacancies in July will drop to 7.382 million.

Evelyne Gomez-Liechti, a strategist at Mizuho International Plc, stated:

“If the job vacancy data shows an unexpected decline, especially if accompanied by an increase in layoffs and a decrease in voluntary resignations, this could create a favorable combination that prompts investors to buy U.S. Treasuries on dips.”