The interest rate threat

Equity markets continue to swing in reaction to US President Donald Trump’s latest social media post or interview - going one way if the news is of positive progress in negotiations (albeit denied by Iran), or the other when an escalation of the conflict seems imminent. The risk assets outlook remains unchanged insofar as further declines or a rebound from here depend on which path the war takes. 

There has been a change in market dynamics, however. Oil-sensitive industries continue to move alongside the price of oil, but for the technology sector, the key factors have evolved.

Technology stocks are particularly sensitive to interest rates due to the long duration of their earnings relative to companies in other sectors. This link was starkly apparent in 2022 when economies reopened after Covid lockdowns. Inflation resurged and central bank policy rates rose in response. The 10-year US Treasury yield jumped from 1.6% to 4.2% while the Nasdaq fell by some 35% over the year.

This correlation weakened in February, however, as other factors began driving returns. Hardware technology companies saw their share prices rise thanks to big increases in artificial intelligence-related capital expenditure, while software stocks declined due to perceived threats to business models from artificial intelligence tools.

The outbreak of the Iran war led to the unwind of very long and short positions in these sectors (as well as in gold and bitcoin). This overwhelmed the impact from the large jump in Treasury yields after 27 February and the net change in the Nasdaq index was limited.

Now that positions have been reduced, interest rate sensitivity has returned. As Treasury yields have risen further, the index has fallen (see Exhibit 1). We have also seen the return of the positive correlation between hardware and software stocks, which had broken down earlier this year.

This new equity market dynamic suggests the outlook for tech stocks is arguably more positive than it is for other sectors. The risk is that if the war escalates and oil prices rise further, Treasury yields could continue to climb. But a significant jump in oil prices might instead lead markets to begin pricing in a recession, which would likely point to lower interest rates. 

In this scenario, technology stocks could return to their “defensive” role within equities as demand is comparatively resilient and tech companies would likely continue their AI infrastructure investments. 

If negotiations to end the conflict do succeed, lower interest rates would likely spur a market rally. In our view the Federal Reserve’s relatively patient tone about the impact of higher oil prices on inflation, in contrast to a more reactive European Central Bank, provides further support for US equities.