The Bond Market Sell-Off Could Be a Red Flag for Wall Street, and History Says Investors Should Make This 1 Move

Long-term Treasury yields continue soaring to multidecade highs.

The 10-year Treasury yield recently touched 5.2%, its highest level since 2007. The 30-year yield is up to 5.5%, a level it hasn't hit since 2004.

In general, higher yields can be bad for stocks. They increase borrowing costs, lower stock valuations, and can give investors an attractive alternative to stocks.

But they're also not automatically bad for stocks. A lot of factors go into determining the relationship between stocks and bonds. With artificial intelligence (AI) capital expenditure (capex) spending still going strong and many segments of the market enjoying surging earnings growth, conditions could be healthy enough that the economy withstands some of those headwinds for a while longer.

Here's what history shows us typically happens during periods of rising rates.

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Why Treasury yields are surging

There are several factors pushing up Treasury yields right now, many of which have been in place for years.

Inflation, obviously, is a big one. It started in 2022, when the Federal Reserve began raising rates aggressively to bring 9% inflation back under control. But even after inflation cooled, the annualized rate rarely fell below 3%, above the central bank's 2% target rate. The Fed was able to reduce rates somewhat, but it's never gotten the data that supported a more sustained rate-cutting cycle.

The Iran war has only increased the pressure on yields and inflation. Brent crude prices have pushed above $100 per barrel, and overall inflation could soon trend toward 4%. As long as this conflict is ongoing, yields are going to have a tough time moving much lower.

And let's not underestimate the impact of government fiscal spending and debt levels. Congress is still running annual budget deficits in the trillions of dollars, and there's likely no end in sight. Global investors are already shying away from Treasury exposure, and this will only push yields higher.

What history says about 5% Treasury yields

None of this means that stock prices have to fall. Higher yields can be a headwind for equities, but they're not the only factor that drives prices.

According to a Hartford Funds study, the S&P 500 (SNPINDEX: ^GSPC) has performed better since 1991, when the 10-year yield was above 5% (around a 12.6% annual return), than when it was higher than 4.5% (a 9.1% annual return).

But whether stocks can continue to do well really comes down to the factors that are driving rates higher.

If rising yields reflect stronger economic growth and higher expected future nominal growth, higher interest rates may be less meaningful in suppressing equity returns. Healthy macroeconomic fundamentals can push stock prices higher even amid higher rates.

But if rising yields are due to inflation expectations, it's usually trouble. This is what we saw during 2022 when inflation was soaring, and the Fed was raising rates aggressively to try to rein it in.

What to do with equities in your portfolio right now

This year looks like a combination of both of the above drivers.

Inflation is already above 3% and threatening to move closer to 4% in the coming months. That's going to be trouble, especially if it looks like there's no end in sight to the Iran conflict.

But AI spending continues to power strong corporate earnings growth. With S&P 500 earnings still expected to grow in the double-digit percentages next year and price-to-earnings (P/E) multiples shrinking modestly, it's easy to make the case that fundamentals could drive further gains for equities.

If you're of the belief that rates will eventually have an impact, I wouldn't be a seller of high-quality stocks. Instead, I'd keep long-term asset allocations intact.

If your time horizon is a decade or more, a slump can still give you the chance to purchase shares at lower prices and potentially capture outsized gains from those shares in the future. Maintaining systematic purchase plans during down markets can enhance long-term returns for these reasons.

The bond market is sending a warning that shouldn't be ignored. But history doesn't necessarily support the idea of selling equities just because long-term Treasury yields move above 5%.

David Dierking has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.