Normal Rates, Abnormal Markets

For much of the past 15 years, investors operated in a world of exceptionally low interest rates. With bond yields pinned near historic lows, many took on more risk in search of return. Stocks, real estate, private investments, and other assets benefited from an environment of relatively inexpensive capital.

The effects were widespread. Stock valuations rose as investors increased equity allocations and companies increased profit margins by issuing cheap debt. Housing prices surged as mortgage rates fell to record lows. Meanwhile, the federal government dramatically expanded borrowing without experiencing an immediate increase in interest expense of the same magnitude.

Then in 2022, the party ended.

As inflation accelerated following the pandemic, the Federal Reserve embarked on a rapid tightening cycle. The era of ultra-low interest rates was over. Today, Treasury yields have largely returned to levels that were common for much of modern financial history. This August, the average yield on the 10-year U.S. Treasury was 4.68% compared with an average of 5.5% over the full series beginning in 1953. Investors waiting for yields to go back down may be disappointed. From 1967 to 1998—31 years—bond yields remained above 5%.¹ Investors have spent so long in an unusually low-rate environment that today’s yields can feel uncomfortably high despite being historically ordinary.

Yet while the bond market has largely adjusted to higher rates, other markets and economic factors still appear to reflect the conditions of the previous era. As those areas adjust, investors should brace themselves for turbulence (and opportunity) ahead.

Despite Higher Rates, the Party Continues

The stock market appears reluctant to leave the low-rate era behind. Valuations remain elevated. As of September 18, 2026, the S&P 500 Index traded at 26 times trailing reported earnings, compared with a 20-year average of 19.6.² In theory, higher interest rates should pressure valuations as higher borrowing costs push earnings lower and as higher rates encourage investors to allocate more heavily towards bonds. Instead, the rapid buildout of artificial intelligence infrastructure has supported strong corporate earnings growth that in turn has supported higher stock prices. In the second quarter, for example, earnings from the S&P 500 grew more than 30% from the same period one year ago, over four times the index’s historical average.³ The denominator effect of higher earnings has lowered the forward price-to-earnings ratio to 18.3.⁴ However, it remains to be seen if this exceptional earnings growth can continue. For now, at least, earnings growth has more than offset any pressure from higher interest rates.

The housing market tells a similar story. When mortgage rates began rising, many expected home prices to fall as homes became less affordable. Instead, transactions slowed while prices remained resilient. The FHFA House Price Index rose 18% from the beginning of 2022 through the end of June 2026.⁵ Mortgage rates more than doubled during that same period, from 3.22% to 6.49%.⁶ Why did home prices rise rather than fall? The mortgage-rate lock-in effect has played a key role: As of Q1, 2026, the average mortgage rate held by existing homeowners is 4.4%,⁷ giving many homeowners a strong financial incentive to stay put. Additionally, during the Great Financial Crisis, new housing starts declined as builders pulled back, resulting in limited housing supply. The housing market has therefore adjusted more to lower housing supply than to lower housing demand.

Nowhere is the legacy of the low-rate era more visible, however, than the continued growth of U.S. government debt. Federal deficits ballooned during the COVID-19 pandemic as the government sought to support the economy with stimulus. Today, despite a relatively healthy economy, deficits remain historically large. The Congressional Budget Office projects a $1.9 trillion federal deficit in fiscal year 2026, equal to 5.8% of GDP, and growing to $3.1 trillion by 2036, equal to 6.7% of GDP.⁸ This compares to a 50-year average deficit of 3.8% of GDP. During the pandemic, low interest rates meant that adding debt did not result in adding interest expense of the same magnitude. Today, however, higher interest rates create outsized interest expense, an expense that now makes up over half of the total deficit. Higher deficits also create more debt. The CBO projects debt held by the public to be 101% of GDP in 2026, rising to 120% by 2036.⁹ This cycle in turn requires more issuance of U.S. debt.

As the supply of U.S. Treasuries continues to grow, investors may demand even higher yields to absorb that supply. Higher Treasury yields would raise the benchmark cost of capital across the economy, putting further pressure on these parts of the financial system to adjust.

What Happens When the Lights Come On?

For stocks, higher discount rates generally reduce the present value of future earnings. The effect may be most pronounced for companies whose valuations rely heavily on earnings expected far into the future, such as some AI companies. In addition, higher financing costs could eventually affect the pace at which companies build data centers, power capacity, and other infrastructure needed to support that growth.

The housing market would face its own challenges. Higher mortgage rates reduce affordability and shrink the pool of potential buyers. To date, limited supply and the lock-in effect have offset much of that pressure. However, if rates rise materially from current levels, weaker demand could place more downward pressure on home prices.

Private markets may produce more mixed results. Floating-rate private credit may benefit from higher rates through increased income, although higher borrowing costs can also strain weaker borrowers. Private equity and real estate could face headwinds if financing becomes more expensive or transaction activity slows.

For bond investors, however, higher yields represent opportunity. Unlike much of the post-Financial Crisis period, fixed-income portfolios once again offer meaningful income potential. Bonds can contribute not only diversification but also returns that are increasingly attractive on a stand-alone basis. And with higher starting yields, the income bonds generate today will help offset losses that fixed income investors may experience if rates continue to rise.

Investing in a Higher-cost World

Markets spent much of the past decade adapting to unusually low interest rates. Those forces helped push asset prices higher, borrowing costs lower, and fiscal deficits further into the background. While bond markets now appear to be operating on more historically familiar terms, other parts of the financial system have been slower to leave the assumptions of the previous era behind. As capital becomes more expensive and investors demand more compensation for risk, the coming years may be defined by how markets adjust to a world in which capital once again carries a meaningful cost.

¹ Federal Reserve Bank of St. Louis, FRED, Market Yield on U.S. Treasury Securities at 10-Year Constant Maturity (GS10), monthly data, April 1953-August 2026. August 2026 observation: 4.68%. The approximately 5.5% long-run average is calculated from the monthly observations in this series. fred.stlouisfed.org/series/GS10.

² The 20-year trailing P/E average (~19.6x) is likely upward-biased relative to very long-run history because the sample period (approximately 2006–2026) is dominated by the post-2009 low interest rate environment. That environment structurally supported higher equity valuations by compressing discount rates and expanding multiples. A longer-run historical average of 15.3x is more representative of the full range of rate regimes. See Deutsche Bank, World Outlook: Navigating Trump 2.025, December 2, 2024.

³ Bloomberg. Bloomberg Intelligence, as of September 28, 2026.

⁴ Bloomberg, as of September 30, 2026, estimated price-to-earnings ratio for the following year (IN113).

⁵ Federal Housing Finance Agency, U.S. House Price Index, July 2026 quarterly data. U.S. house prices rose 18.0% from Q1 2022 to Q2 2026. fhfa.gov/data/hpi/datasets?tab=quarterly-data.

⁶ Freddie Mac, Primary Mortgage Market Survey. The average 30-year fixed-rate mortgage was 3.22% for the week ended 1/6/2022 and 6.49% for the week ended 6/25/2026. freddiemac.com/pmms.

⁷ Federal Housing Finance Agency, National Mortgage Database Outstanding Residential Mortgage Statistics Summary, United States All Mortgages Outstanding at the End of Q1 2026, fhfa.gov/data/dashboard/nmdb-outstanding-residential-mortgage-statistics.

⁸ Congressional Budget Office, The Budget and Economic Outlook: 2026 to 2036, February 11, 2026. Fiscal year 2026 deficit: $1.9 trillion, or 5.8% of GDP, of which 3.3% is net interest outlays; projected 2036 deficit: $3.1 trillion, or 6.7% of GDP, of which 4.6% is net interest outlays; 50-year average deficit: 3.8% of GDP; debt held by the public: 101% of GDP in 2026 and 120% in 2036. cbo.gov/publication/61882.

⁹ Id.

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