Three Warning Signs from Bond Markets

Jun 4, 2025

Optimistic stock investors may be ignoring cautionary bond-market signals at their own peril. See what could weigh on asset prices.

Author
Lisa Shalett

Key Takeaways

  • Equity investors’ optimism centers on “Magnificent 7” AI dominance and the possibility of manageable tariff levels – yet bond markets signal caution.
  • Policy uncertainty, concerns about growing U.S. debt levels and the ongoing shift toward a “multipolar world” are likely contributing to higher interest rates globally, which weigh on asset valuations.
  • Consider active stock-picking, diversifying with international equities and favoring certain investment grade bonds.

U.S. stock investors drove up the S&P 500 Index by 6% in May, believing that the “Magnificent 7” mega-cap U.S. tech stocks will remain globally dominant in AI and that the U.S. administration’s on-again, off-again approach to tariffs is now nothing more than trivial noise. But this optimism overlooks continued uncertainty around tariff and tax policy, as well as warning signals from bond markets.

 

Morgan Stanley’s Global Investment Committee agrees with equity investors that the U.S. economy’s resilience and current momentum reduce the odds of an imminent recession, and that the S&P 500 may now be on track to return 5%-10%, with a 12-month price target of 6,500. Still, we question the bullish outlook. Equity valuations are stretched, and many investors continue to ignore the reality of rising global interest rates, which increase the risk of higher borrowing costs and lower asset prices.

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Wealth Management

Reflexivity

Gains in US stocks reflect investors’ search for a new bullish narrative. Equity investors may be missing some key risks, though, as they shrug off signals from the global bond market.

Consider that U.S. 30-year Treasury yields recently approached a multi-year high around 5.15%, up 15 basis points since the start of the year. German 30-year bund yields have risen about 40 basis points in that time, and Japanese 30-year government bond yields are up 70 basis points.

 

With bond yields rising as their prices drop, what is the surge in yields telling us?

 

  • First, investors remain highly uncertain about U.S. government policy. Tariff implementation is still likely, but it will probably now be even more dragged out and sector specific. This is likely contributing to higher Treasury “risk premiums,” i.e., the extra yield that investors tend to demand during periods of elevated policy uncertainty.

 

  • Second, the federal budget bill that recently passed the U.S. House of Representatives, known as “The One, Big, Beautiful Bill,” is stoking concerns about unsustainable U.S. debt levels. A growing government debt pile likely means higher interest costs, which could push the share of tax dollars spent on interest payments even higher. This expectation is reflected in 10-year inflation-adjusted, “real,” Treasury rates, which at 2.15%, are at their highest levels since 2008.

 

  • Finally, the shift to a “multipolar world” is likely driving rates higher globally. As countries strive for greater economic self-reliance, it will likely necessitate heavier monetary and fiscal stimulus, especially in Japan and EU nations. This, in turn, could fuel higher government borrowing that pressures sovereign bond valuations and boosts yields. Additionally, global central banks continue to shift away from holding U.S. assets like the dollar as foreign reserves; this may similarly push Treasury rates upward, further contributing to elevated costs of capital globally.

How to Invest

Given these dynamics, investors should consider:

  • Increasing active stock-picking, rather than relying on passive exposure to major stock indexes.
  • Rebalancing portfolios and positioning for U.S. equity returns around 5%-10%, amid increased volatility, higher real rates and a weak U.S. dollar.
  • Adding diversifying positions in international equities, commodities, energy infrastructure and hedge funds.
  • Maintaining higher-than-normal allocations to investment grade and municipal bonds with short to neutral duration.

 

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from June 2, 2025, “Reflexivity.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report. 

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