The Clock Ticks On: How Long Can Markets Absorb the Squeeze?

The 10-year Treasury yield has breached 5%, a milestone that’s often associated with financial market turmoil. However, experts caution against reading too much into this single number and instead focus on what happens next – specifically, how long rates stay high.

Markets may be able to absorb the initial shock of rising yields, but prolonged periods of elevated borrowing costs could expose vulnerabilities in some unexpected areas. One of the first places to feel the pinch will likely be housing, as mortgage rates approach levels that further erode affordability. Existing homeowners with mortgages at 3% are unlikely to sell, creating a freeze on transactions and impacting various sectors, including homebuilders, mortgage originators, title insurers, brokerages, and home-improvement retailers.

The problem is not a wave of defaults but rather a deepening freeze in housing activity. Banks may feel the pressure later as prolonged high borrowing costs lead to deterioration among property or corporate borrowers. However, over the short term, a steeper yield curve can initially support lenders’ margins as banks fund themselves at shorter-term rates and lend at higher rates further out the curve.

This temporary reprieve will ultimately give way to more serious credit stress. Companies and property owners who took on debt when interest rates were far lower are now facing refinancing challenges. Debt raised at 2%-3% now needs to be refinanced closer to 6%-8%, creating pressure on cash flows, asset values, and credit quality.

Markets can typically absorb a temporary move above 5%, but a sustained period of six to twelve months or longer becomes much harder to ignore. Duration matters more than the exact yield level. The real danger lies in the prolonged effects of high borrowing costs on vulnerable sectors.

The vulnerability in commercial real estate is particularly acute, with office properties already showing signs of strain and multifamily properties financed with floating-rate bridge loans in 2021 and 2022 facing significant risks. Rising borrowing costs increase the expense of financing a property, compounding existing problems.

While a 5% yield may not be catastrophic on its own, sustained periods of high rates will eventually lead to difficult choices – and potentially some unexpected casualties. The margin for error is narrowing, and investors would do well to pay attention to warning signs.

The clock is ticking, but it’s not just the markets that need to worry – it’s also policymakers who have yet to fully grasp the implications of this shift in borrowing costs. The next few months will be crucial in determining whether the market can absorb the squeeze or if we’re headed for a more serious credit crisis.