Since mid-April, equity markets have rebounded strongly, thanks to the easing of the trade war and fairly solid corporate results. This rally has been accompanied by a rise in long-term interest rates. The US 10-year yield rose above 4.5% again at the beginning of the week, before easing back to 4.40% thanks to the latest economic data.

Equities and bonds: the group is doing well

For about a month now, we have been in a situation in which rising rates are not hindering the rise in equities. In principle, higher rates drag equity prices down, since equity valuations are based on discounting future earnings. Therefore, the higher the rates, the lower the present value of future earnings, which normally tends to weigh on equity prices.

It always depends on the narrative accompanying the rise in rates. Rates and equities move in tandem if growth expectations rise. However, when the rise in rates is driven more by expectations of higher inflation, this is generally negative for equities. This was the pattern we saw in 2022, at the peak of the inflationary wave. This positive correlation between equities and bonds – given the inverse relationship between bond prices and interest rates, where a rise in rates leads to a fall in bond prices – is the worst-case scenario for investors because, in this case, diversification does not pay off.

Another important factor for equities is the speed at which rates rise. When there is a shock that causes interest rates to rise sharply, that is when equity markets suffer the most. One of the most recent examples is the crisis in UK bonds in 2022, when the shortlived PM Liz Truss presented a mini-budget that included significant tax cuts. Long-term rates rose sharply, forcing the Bank of England to intervene.

Ever-increasing deficits

This is a precedent that all investors are bearing in mind as budget debates are taking place in the US Congress. Long-term interest rates also move in line with deficit projections and, therefore, with a country's long-term ability to meet its commitments.

And the least we can say is that the United States has a "small issue" with its public finances. The starting point is a deficit of over 6% in 2023 and 2024. And Congress is currently working on a tax cut plan, which was one of Trump's main campaign pledges. A plan that he has dubbed the "big, beautiful bill."

The plan essentially aims to extend the tax cuts passed in 2017, many of which are set to expire in 2025. It also includes additional measures: a partial tax cut for around 4 million workers who receive tips, increased deductions for the elderly, and relief for overtime.

According to CBO estimates, the version presented earlier this week in the House of Representatives would increase the deficit by $4.9 trillion over 10 years. This is a preliminary estimate, as debates are ongoing in the House and the Senate will then take up the bill.

One of the most hotly debated issues is the SALT deduction, which allows taxpayers to deduct local taxes from their federal tax bill. Some Republicans want to raise the cap, while others are calling for deeper cuts to Medicaid, the health insurance program for low-income Americans, in return.

Bonds vigilantes

While some issues are still to be debated, the central scenario remains that a deal will be reached by the summer and that the plan will significantly increase the deficit without improving growth prospects, as most of the measures are simply an extension of existing policies. There is hence very little additional fiscal stimulus, contrary to what House Speaker Mike Johnson said on Tuesday: "We think this is going to be fuel for the economy."

Indeed, the traditional Republican line is that tax cuts increase the tax base and ultimately raise more revenue. However, as the Committee for a Responsible Federal Budget pointed out in March: "Tax cuts generally do not pay for themselves."

Investors are therefore faced with a tax cut plan that increases the deficit without boosting growth. All this at a time when Donald Trump's policies are raising questions about the status of Treasuries as a safe haven, and when many central banks are seeking to diversify their reserves and therefore reduce their holdings of dollars.

Upward pressure on rates is therefore likely to continue. The 30-year yield touched 5% again this week. There is some good news, however: the sequence of tariffs has shown that Donald Trump is closely monitoring the bond market and is willing to shift his position. The bond vigilantes therefore still have work to do.