US Treasury yields are nearing 5%! The probability of a rate hike next week has risen to 70%, and the market is worried that this will be the start of a new round of tightening.

The continued rise in U.S. Treasury yields is pushing the market toward a critical tipping point.

The 10-year U.S. Treasury yield rose to 4.96% on Thursday, nearing the psychological threshold of 5%, which many investors consider a potential threat to the stock market, marking a nearly three-year high. Meanwhile, market expectations for a Federal Reserve rate hike next week continued to rise. According to LSEG data, federal funds futures indicate a roughly 70% probability of a 25-basis-point rate hike this month.

Rising yields coupled with expectations of interest rate hikes have put pressure on the S&P 500, which has already fallen 2.7% from its mid-August record high. " We are in a period of great uncertainty, with rising yields and rising interest rate expectations moving in tandem, and the overall market nervousness must be priced in," said Cayla Seder, macro multi-asset strategist at State Street.

Interest rate hike expectations are rising, and the market is betting on a "razor's edge."

The speech delivered last month by newly appointed Federal Reserve Chairman Kevin Warsh was widely interpreted by the market as a hawkish signal, which significantly increased bets on interest rate hikes. The Fed has kept interest rates unchanged so far this year, but strong employment data has provided new support for a rate hike—the latest non-farm payroll report showed that monthly job growth exceeded expectations.

Regarding inflation, the core personal consumption expenditures (PCE) price index, which is a key reference for the Federal Reserve, grew by 3.3% year-on-year in July, still significantly higher than the policy target of 2%, further reinforcing the market's assessment of sticky inflation.

BNY Wealth Chief Investment Officer Alicia Levine described the current situation as "razor-thin," saying, "For the first time in a long time, the market is really feeling that the outcome could be completely divisive." Federal funds futures currently indicate about a 70% probability that the Federal Reserve will raise the current 3.5% to 3.75% interest rate range by 25 basis points.

The key point of contention is whether it's a single interest rate hike or the start of a new cycle.

Investors are currently more concerned not with the interest rate hike itself, but with whether this action signals the start of a new tightening cycle.

Levine stated, "If the Fed signals that 'we still have work to do,' it won't be good news for the market. " She pointed out that if rate hikes are characterized as cyclical measures rather than isolated operations, the market impact will be far greater than a single correction.

JP Coviello, head of portfolio strategy at Citi Wealth, characterized the meeting as a test of Warsh's credibility in combating inflation. He stated that "the market still has some concerns about the Fed's independence," a factor that had already drawn market attention after the new chairman's first press conference in July.

Rising yields impact the stock market, putting pressure on small-cap stocks and valuations.

The transmission path of persistently rising yields to the stock market is becoming increasingly clear. Higher government bond yields mean that bonds are more attractive to funds, directly suppressing stock valuations and pushing up financing costs for businesses and consumers.

Coviello believes the current rise in yields is driven by "justifiable reasons," namely improved economic growth expectations, while strong corporate earnings provide fundamental support for the stock market. He stated, "Looking at the magnitude of changes in corporate earnings growth, we believe this is sufficient to offset the negative impact of rising real yields on equity investments."

However, market divergence is intensifying. Interest rate-sensitive sectors face greater pressure, especially small and mid-cap companies reliant on debt financing. The S&P 500 has risen approximately 11% year-to-date, primarily driven by corporate earnings growth fueled by large-scale investment in AI infrastructure, but has recently shown clear signs of a correction.

CPI report to be a key variable next week

Ahead of the Federal Reserve meeting, the market will also see a key inflation data release tonight – the Consumer Price Index (CPI) report. The results could directly influence the Fed's final decision and have an immediate impact on yield trends.

Meanwhile, tensions between the US and Iran pushed oil prices above $100 a barrel this week, further exacerbating market concerns about the inflation outlook and adding new variables to the Federal Reserve's policy decisions.

Whether the 5% yield mark will be breached depends on upcoming inflation data and the Federal Reserve's policy stance. For investors, this figure is not only a psychological technical barrier but also a crucial reference point for reassessing the relative attractiveness of stocks and bonds.

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