Rising Treasury Yields Challenge AI’s Narrow Market Leadership

Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company.

A frequently asked question in recent weeks is whether the market is simply ignoring the risks stemming from the current geopolitical conflict, especially given the spike in oil prices that has pushed inflation pressures higher. Our answer is yes—but only at the index level. When you look beneath the surface, the message from the market is much more nuanced. It fits with a broader theme we have been highlighting for some time: the economy and markets have continued to move forward over the past few years, but not in a broad or an even fashion.

Instead, the U.S. economy remains highly bifurcated, with the dividing line still largely determined by sensitivity to higher interest rates. We continue to see that split across households, sectors, and industries. As we noted last week, higher-income consumers have generally remained in better shape than lower-income households, benefiting from the wealth effect of higher stock prices and a lack of variable-rate debt. The same divide is evident in housing, manufacturing, and even smaller companies that have been impacted by higher borrowing costs. This bifurcation was starkly illustrated by the preliminary May University of Michigan consumer sentiment report published earlier this month. While overall consumer sentiment hit a record low of 48.2—driven by everyday anxieties over gas prices and tariffs—the median stock market investment for respondents reached a record high of $311,218. It is a clear picture of an economy where everyday consumers feel the pinch of immediate costs, while invested wealth continues to grow.

Economic data released last week continued to paint a picture of the impacts of higher rates, as well as the risks emanating from the current conflict in Iran. April's existing home sales, at a seasonally adjusted annual rate of 4.02 million, are significantly lower than the 6.43 million recorded in January 2022 before the Federal Reserve increased rates. Over that stretch, the 30-year fixed mortgage rate moved from 3.7 percent to a peak of 8.09 percent in October 2023, before easing to 6.10 percent by early March. Since then, it has risen back to 6.46 percent.

Likewise, an index of U.S. manufacturing output released this past week remains below its March 2022 level despite a recent improvement. Lastly, the National Federation of Independent Business (NFIB) index of small business optimism—a subset of American businesses that is highly rate-sensitive—held steady for the second straight month (below its 52-year average of 98) after spending much of the period since November 2024 above it.

Despite these pockets of weakness, the economy has been held up by two important supports: resilient spending from higher-income households and a powerful wave of capital spending tied to artificial intelligence (AI). That same dynamic has shaped equity market returns. Leadership within the S&P 500 has been unusually narrow over the past several years, concentrated in many of the companies most closely linked to the AI buildout and least sensitive to economic slowing or higher rates. In each of the past three years, only 29 percent, 28 percent, and 31 percent of companies in the index outperformed the benchmark itself versus a historical average of 48 percent dating back to 1973. Periods of market leadership this narrow have been rare, with the late 1990s standing out as one of the clearest historical parallels.

In past cycles, unusually narrow markets have eventually broadened as the benefits of major innovations spread beyond the early winners. We continue to believe AI will follow a similar path over time. More recently, that potential broadening had started to emerge as falling interest rates offered relief to parts of the economy that had been under pressure.

Following the latest round of Fed cuts that began in September 2025, Treasury yields moved lower across the curve. With lower rates and hopes for further cuts, market leadership broadened starting in late October through February 27. During that time, Small- and Mid-Cap stocks each rose nearly 10 percent, while the market-cap-weighted S&P 500 index rose a mere 0.24 percent, weighed down by losses in the Magnificent Seven and technology stocks. However, with a healthy 68 percent of stocks outperforming the S&P 500 index, the equal-weighted S&P 500 rose by 9.4 percent during the same period. Put simply, the market broadened away from the AI trade as the dominant theme, anticipating an economic broadening on the back of lower rates and fiscal stimulus.

However, since the start of the Middle East conflict on February 28, the S&P 500 has kept pushing higher, rising 8.16 percent. This has led many to conclude that investors are simply ignoring the risks. We would frame it differently. The index is higher, but the advance has become narrow again, increasingly tied to the view that AI-related companies are relatively insulated from both economic slowing and higher interest rates. Only 24 percent of companies in the index have outperformed the S&P 500 since the conflict began, while roughly 60 percent actually posted negative returns. In our view, this is a market that is reflecting growing worries about the economy, but rather than running away from equity markets, it is reconcentrating in a theme that most believe will continue unabated despite growing risks.

That leaves the market in a familiar but still uncomfortable position. So long as AI spending remains strong, narrow leadership can continue for a time. But the bigger question is whether inflation and interest rates will allow that dynamic to persist. Last week underscored the challenge, especially on Friday, when equity markets finally pulled back across the board as long-term interest rates—including Treasury yields and mortgage rates—rose last week.

The 10-year Treasury yield moved above 4.5 percent for the first time since June 2025, ending the week at 4.59 percent versus a pre-conflict low of 3.94 percent. The two-year yield rose to 4.08 percent, up sharply from 3.37 percent on February 27, while the 30-year Treasury closed at 5.127 percent, its highest level since mid-2007. This is not solely a U.S. story, as bond yields in U.K., and Japan pushed toward multi-year highs, with the Japanese 10-year posting its highest close last week since 1997.

Against that backdrop, the arrival of new Fed Chair Kevin Warsh adds another layer of uncertainty, as hopes for immediate rate cuts appear to be on hold following recent inflation data. While risks remain in the nearer term, we continue to believe they are best managed through adherence to a thoughtful financial plan and a diversified asset allocation aligned with your intermediate- and longer-term goals. History suggests that narrow markets eventually broaden and that leadership changes as economic cycles evolve. We continue to see opportunities in areas of the market that remain cheaper and out of favor today, even if the path toward broader participation includes setbacks along the way.

Wall Street wrap

Small business owners remain cautious despite increasing signs of stability

The latest NFIB Small Business Optimism Report indicates a steady but cautious economic environment for small business owners. The optimism index held at 95.9, a slight stabilization from the previous month’s 95.8. This marks the second consecutive month below the 52-year historical average of 98 and represents the lowest level since April 2025. As a highly interest-rate-sensitive segment of the economy, small businesses continue to adapt to fluctuating borrowing costs. Prior to recent Federal Reserve rate hikes, rates hovered around 5 percent, eventually peaking at 10.1 percent in September 2024. Although a recent decline in rates had previously bolstered optimism, the latest data shows a slight increase to 8.3 percent, up from 7.9 percent. Furthermore, a net 2 percent of owners reported paying a higher interest rate on their most recent loan in April.

A net negative 8 percent of owners reported higher nominal sales, and only 3 percent expected higher sales in the upcoming quarter—the lowest reading in 12 months. Despite these top-line pressures, there is an encouraging sign in profitability: Positive profits rose by six points. Although the net reading remains low at negative 19, this improvement suggests that many businesses are successfully finding ways to protect their earnings and maintain financial stability in a challenging environment. However, expectations for future business conditions have softened, declining for the fourth consecutive month to reach their lowest point since October 2024, alongside a similar drop in the belief that it is a favorable time to expand.

Workforce dynamics also present ongoing considerations for business leaders. The Employment Index experienced a slight cooling, falling to 100.4 from 101.6. While this is the second consecutive month of decline and sits below the 2025 average, it remains above the historical average of 100. Hiring intentions remain relatively stable, with a net 13 percent of owners planning to create new jobs in the next three months. However, securing the right talent continues to be a primary hurdle, as 18 percent of owners cited labor quality as their most significant problem, well above the historical average.

Finally, inflationary pressures require continued attention, as both actual and planned price increases rose in April. A net 30 percent of owners raised their average selling prices, and 27 percent plan to implement increases in the next three months.

Inflation remains stubborn as higher costs leak into services

Consumer Price Index (CPI) and Producer Price Index (PPI) data for April indicate a continued, albeit shifting, inflationary environment, providing important context for broader economic trends. Overall CPI rose 0.6 percent month-over-month, a slight deceleration from the previous month’s 0.9 percent increase, which pushed the year-over-year rate to 3.8 percent, up from 3.3 percent. This surge was primarily driven by the energy sector, which climbed 3.8 percent for the month and a significant 17.9 percent year-over-year. Food prices also contributed to the increase, rising 0.5 percent month over month and 3.2 percent annually.

Core CPI, which excludes the more volatile food and energy sectors, rose 0.4 percent, slightly above the 0.3 percent estimate. This pushed the year-over-year core rate to 2.8 percent from 2.6 percent. Despite some nuances, the three- and six-month annualized rates are 3.2 percent and 3.1 percent, indicating a steady rise, though still below the Fed’s preferred PCE indicator.

Breaking this down further, goods increased 0.4 percent for the month (1.1 percent year-over-year), while services rose 0.5 percent (3.3 percent year-over-year). Notably, supercore services—which exclude shelter—advanced 0.45 percent for the month, reaching 3.38 percent year-over-year, with both the three- and six-month paces running at 4 percent. Additionally, alternative measures, such as the Cleveland Fed’s median CPI and trimmed mean CPI, rose 0.4 percent and 0.425 percent, respectively, bringing both to a 2.8 percent annual rate.

On the wholesale front, the Producer Price Index (PPI) for final demand demonstrated robust growth, rising a notable 1.4 percent following an upwardly revised 0.7 percent in March. This represents the sharpest monthly gain since 2022 and elevates the year-over-year wholesale inflation rate to 6 percent, its highest level since December 2022.

Core PPI, which excludes food and energy, experienced a notable increase of 1 percent over the prior month's modest rise of 0.2 percent, elevating its annual rate to 5.2 percent, the highest level observed since late 2022.

Retail sales figures reflect consumer fatigue

The latest U.S. retail sales data indicates a complex economic landscape, with headline numbers masking underlying consumer fatigue. Overall retail sales rose by 0.5 percent, following a slight downward revision of the previous month’s growth from 1.7 percent to 1.6 percent. When excluding automobiles, retail sales increased by 0.7 percent, compared to a 1.9 percent gain in the prior month. However, a deeper look reveals that gasoline sales accounted for more than 40 percent of this overall gain; when excluding gas, sales increased by a modest 0.3 percent. Although nine of the 13 retail categories experienced growth, these figures are not adjusted for price changes.

With inflation running hot, these nominal increases point to tepid, if any, real sales gains. Supporting this view, the Chicago Fed Advance Retail Trade Summary—released just ahead of the retail sales data—projected that while ex-auto sales would rise by 0.8 percent nominally, this would translate to zero real growth after adjusting for inflation. Furthermore, the Chicago Fed updated the previous month’s ex-auto data, which showed a nominal 1.9 percent increase, to reflect a 0.1 percent decline on a real, inflation-adjusted basis. Ultimately, these underlying metrics suggest that the consumer is beginning to show clear signs of economic fatigue.

Inflation and a ‘K-shaped’ economy weigh on mortgage expectations

The U.S. housing market remains locked in a lackluster pattern during what is traditionally its busiest spring homebuying season. High-earning households, bolstered by a surging stock market, are driving transactions for luxury homes priced at $1 million and above, while first-time homebuyers saw their market share slip down to 33 percent (from 34 percent last year) as standard wage growth fails to offset elevated mortgage rates and high list prices—underlining the increasing economic bifurcation we have often discussed in recent quarters.

The latest existing home sales data reveals a slight uptick in market activity, with sales rising 0.2 percent to a seasonally adjusted annual rate of 4.05 million, up from 4.01 million in the previous month. Housing inventories also saw a modest increase, climbing to 1.47 million from 1.39 million. Meanwhile, the median home price continued its upward trajectory, reaching $417,700. This represents an increase from last month’s $409,100 and a 0.9 percent rise from last year’s $414,000, remaining significantly higher than the 2020 pandemic-era level of $286,800.

Consequently, the combination of rising home prices and elevated mortgage rates has driven the National Association of Realtors’ affordability index to its lowest levels since the 2006–2008 housing bust.

The week ahead

Wednesday: The Federal Open Market Committee minutes from the April 28–29 meeting are scheduled to be published at 2:00 p.m. EST. The April policy meeting saw a historic number of voting dissents against holding interest rates steady. We will be analyzing the minutes to further understand these divisions and how they may influence future rate decisions.

Thursday: S&P Global will release its Flash U.S. PMI (Purchasing Managers Index) data for May at 9:45 a.m. EST, offering the first concrete look at economic health and inflation dynamics for May.

Separately, the U.S. Census Bureau will publish U.S. housing starts and building permits data for April at 8:30 a.m. EST. These metrics tie directly into shelter inflation, a sticky component of consumer prices. We will be watching to see whether April’s construction pipelines slowed or accelerated under the weight of higher-for-longer interest rates.

Friday: The University of Michigan will release the final results for its May Surveys of Consumers at 10:00 a.m. EST. As discussed earlier this month, the preliminary May reading plunged to a record low of 48.2, down from April’s final reading of 49.8. We will be watching to see if this historically weak consumer mood is revised upward or cemented even lower.

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