How Much Interest Rate Pressure Can Equity Markets Withstand?

• Long-term government bond yields are rising worldwide, driven by inflationary pressures, an unprecedented AI investment boom and substantial government deficits.
• For investors, the key question is not so much the level of interest rates, but whether economic growth and corporate earnings can offset the pressure on equity valuations.
• Since 1960, rising interest rates in the United States have rarely led to equity market losses on their own, provided they were not followed by a recession.

Yields on long-dated government bonds worldwide have risen sharply recently, reaching levels last seen in the early 2000s. Several factors are driving this development. The energy price shock triggered by the war in Iran is keeping inflationary pressures elevated and shifting monetary policy expectations. At the same time, the exceptionally strong AI investment boom is increasing demand for capital. This is compounded by substantial fiscal deficits and a growing supply of government bonds, for which investors are demanding increasingly higher risk and term premia.

How are equity markets coping with the changing interest rate environment? The relationship between interest rates and equities is complex. On the one hand, higher bond yields push up discount rates, thereby tending to put downward pressure on equity valuations. On the other hand, rising interest rates can reflect robust economic activity and strong demand, which in turn support corporate earnings. The key question, therefore, is not so much whether a particular level of interest rates is inherently too high for equities. What matters most is why interest rates are rising and how these increases feed through to corporate valuations and earnings.

Two Opposing Forces: Valuations and Earnings

In simple terms, a share price can be broken down into two components: share price = earnings per share × price-to-earnings (P/E) ratio. Rising interest rates primarily affect the second component: the higher the yields on safe government bonds, the more attractive they become relative to equities and the higher the discount rate applied to future cash flows to shareholders. Both factors tend to put downward pressure on equity valuations. However, if interest rates rise as a result of strong economic growth, corporate earnings may also increase. Whether equities can withstand rising interest rates therefore depends on which of these two effects dominates.

Historically, Recessions Have Been the Decisive Factor

To better understand the underlying dynamics between interest rates and equities, it is useful to examine historical trends. The following analysis looks at periods of rising interest rates in the United States since 1960. A period of rising interest rates is defined as any phase in which the yield on 10-year US Treasury bonds increased by at least one percentage point from a trough to the subsequent peak.

Figure 1 shows that 16 such periods of rising interest rates can be identified since 1960. All US recessions over this period are also highlighted. In twelve cases, the economy remained resilient (grey). In four cases, a recession began while interest rates were still rising (orange).
 

Earnings Can Offset Valuation Pressure

For each of these periods of rising interest rates, the inflation-adjusted change in the S&P 500 is measured from the interest rate trough to the peak and broken down into contributions from earnings and valuations. Figure 2 shows the price performance and the corresponding breakdown, grouped by whether or not a recession occurred. A relatively clear pattern emerges: In the absence of a recession, the S&P 500 rose in real terms in 9 out of 12 cases and remained unchanged in one other case. Gains were generally moderate, but substantial in periods such as 1998–2000 (+34 percent) and 2012–13 (+31 percent). The two declines were limited, with the larger amounting to 11 percent (1983–84). By contrast, when a recession began, the index fell in real terms in all four cases, with losses ranging from 12 to 39 percent.

Rising interest rates alone cannot explain this difference. The breakdown into earnings and valuations provides the explanation. Valuations generally came under pressure in both groups: The price-to-earnings (P/E) ratio fell in 8 of the 12 cases without a recession and in all four cases with a recession. Earnings made the difference: Real earnings per share rose in all twelve cases without a recession, but in only one of the four cases with a recession.

The underlying driver is the economic cycle. During a strong economic expansion, the same forces drive both interest rates and corporate earnings higher: strong demand for credit to finance investment and consumption, high capacity utilisation and a central bank seeking to prevent the economy from overheating all push up bond yields. At the same time, corporate revenues and profits increase. As long as economic growth remains the main driver of higher interest rates, earnings tend to rise alongside them and can offset the negative impact on valuations. However, if a recession begins while interest rates are still rising, this relationship breaks down: interest rates continue to rise even as economic activity weakens. Earnings growth then becomes limited or earnings may already be declining, reducing their ability to offset valuation pressures. In the recessionary episodes of 1967–70, 1976–81 and 1989–90, earnings were already declining during the period of rising interest rates. In the remaining episode, 1971–74, earnings continued to grow. However, double-digit inflation forced the US Federal Reserve to tighten monetary policy aggressively. The economy tipped into recession, and the P/E ratio fell by more than half – far more than earnings growth could offset.

What Does This Mean for Investors Today?

In October, the yield on 10-year US Treasury bonds rose above 5.30%, its highest level since 2002 and 125 basis points above its October 2025 low. So far, however, corporate earnings have more than offset the downward pressure on valuations: since October 2025, the S&P 500 has gained around 10% in real terms, despite a 13% decline in its P/E ratio. This was made possible by a 26% increase in real earnings per share.

The current rise in interest rates reflects both growth-driven forces and more challenging factors. The AI investment boom is increasing demand for capital and thereby pushing up bond yields, while also supporting the revenues and earnings of companies benefiting from this trend. By contrast, the energy price shock is adding to inflationary pressures and raising the prospect of tighter monetary policy. In our view, there are several reasons to believe that the growth impulse currently outweighs these headwinds, particularly as corporate earnings have continued to grow strongly. Nevertheless, historical experience suggests that investors should remain vigilant if economic activity begins to weaken under the weight of higher interest rates and the earnings cushion starts to erode. In September, the US Federal Reserve raised interest rates for the first time since 2023. If it is forced to tighten monetary policy significantly further, the risk of the economy coming under pressure will increase. For now, earnings continue to support the equity market – but whether this remains the case will depend less on the level of interest rates than on how aggressively the Federal Reserve needs to apply the brakes.