The 10-Year Treasury Yield Just Hit the Significant 5% Threshold. Here's What That Means for the Stock Market.

The 10-Year treasury yield briefly hit 5% on Monday, peaking at 5.012%, its highest level since 2007.

Rising Treasury yields reflect, above all else, that investors see inflation as entrenched over the longer term and that the Federal Reserve will have to keep the Fed funds rate elevated to rein it in.

Factors like sustained inflation above the Fed's 2% target for more than five years, elevated oil prices from the conflict in the Middle East, signals from new Fed Chair Kevin Warsh, and the ballooning national debt are all contributing to rising Treasury yields.

While it's impossible to predict whether they will continue to rise or come back down, their reaching their highest level in nearly 20 years has several implications for the stock market.

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The big picture on interest rates and the stock market

Treasury yields and stocks tend to have an inverse relationship. All other things being equal, stocks get more attractive when interest rates fall because bond yields go down, beckoning bond investors to rotate into the S&P 500 (SNPINDEX:^GSPC) as bond returns go down.

When bond yields go up, the opposite happens. Stock investors see an attractive yield and sell stocks to buy bonds. In particular, this rotation tends to be hardest on dividend stocks and growth stocks. Dividend stocks compete directly with bonds, as investors hold both assets primarily for their yield. If bond yields are higher than a given dividend yield, then it makes sense to sell a dividend stock and buy a bond.

Growth stocks are sensitive to interest rates because of their long-dated earnings, meaning much of the earnings in the discounted cash flow model is from several years into the future. When the interest rate goes up, the discount rate goes up, so expected profits from five or ten years from now are worth less.

Economic impacts of higher interest rates

In addition to the market rotation that takes place as interest rates fluctuate, higher Treasury yields also have a real-world effect on the economy and, therefore, the stock market. First, other key borrowing rates are set based on the 10-year yield, including 30-year mortgage rates. The housing market has been stagnant in part because rates spiked after the pandemic, and pushing them even higher will only drive more potential homebuyers out of the market.

Additionally, higher interest rates raise borrowing costs and increase rates on variable-rate debt, which in turn raises interest expense and makes it harder to fund growth through debt. Small-cap stocks are particularly sensitive to interest rates, since smaller companies tend to have weaker balance sheets and are more at risk of bankruptcy.

Should investors be worried?

Higher treasury yields are clearly a negative for the stock market, but they won't necessarily derail the bull market. First, investors simply don't know if rates will continue to move higher, so it would be a mistake to make a knee-jerk reaction to the 10-year rate reaching 5%. Second, the dominant narrative in the stock market remains AI, and the companies funding AI expansion, like Nvidia, have very deep pockets to spend on its success. In other words, modestly higher interest rates aren't going to derail AI funding, chip purchasing, or data center capex.

Overall, investors should be mindful of interest rates and keep an eye on the 10-year yield, but at this point, it's not a reason to change your investing strategy.

Jeremy Bowman has positions in Nvidia. The Motley Fool has positions in and recommends Nvidia. The Motley Fool has a disclosure policy.