The US bond market is facing a critical test as the selloff that began with the war with Iran pushes the 10-year Treasury yield closer to the 5% mark, a level it has not sustained for an extended period in nearly two decades. The move is raising questions about how much higher yields could affect stocks, corporate borrowing, dealmaking and the broader economy.

According to Reuters, the impact of a 5% 10-year yield is not necessarily straightforward. Higher borrowing costs can weigh on consumers and businesses, but rising yields can also reflect strong economic growth and robust demand for capital.

Read more: Global Market: South Korean shares surge as Samsung, SK Hynix rally on AI optimism

At the centre of the debate is the artificial intelligence investment boom. Companies are committing billions of dollars to AI infrastructure and data centres, potentially supporting economic growth even as financing costs rise. However, another concern is gaining traction: growing government deficits and rising debt loads in the US and other developed economies could put further upward pressure on long-term bond yields, Reuters reported.

With the S&P 500 close to another record high, investors are assessing several factors that could determine the direction of markets following the Labor Day holiday.

Read more: Global Market: Japan bond yields ease as yen strength tempers BOJ tightening bets

Corporate borrowing costs come under pressure

A sustained rise in the 10-year Treasury yield would increase corporate borrowing costs, making it more expensive for companies to refinance existing debt and finance acquisitions and capital expenditure.

This could become particularly important as businesses increase spending on AI infrastructure and data centres. Higher financing costs could eventually put pressure on corporate earnings if companies rely more heavily on debt to fund their expansion plans.

At the same time, higher Treasury yields could make bonds and other fixed-income assets more attractive to investors. Investment-grade credit spreads remain historically tight, reflecting confidence in large companies and the investment outlook. However, narrow spreads also leave investors with less protection if credit conditions deteriorate, Reuters reported.

Higher yields could challenge stock valuations

Stocks could face greater competition from bonds if Treasury yields continue to climb. The increase in risk-free returns can make highly valued equities less attractive, particularly when valuations are already elevated.

Reuters noted that Societe Generale strategist Albert Edwards has highlighted the widening gap between long-term Treasury yields and stock dividend yields. The relationship has reached levels not seen since the dot-com boom around 2000, raising concerns about the durability of equity gains.

High valuations do not automatically signal the start of a bear market, but they can make stocks more vulnerable to negative economic or corporate news. The risk could become more pronounced if bond yields continue rising while earnings expectations fail to keep pace.

Another important indicator is the relationship between Treasury yields and nominal GDP growth.

The 10-year Treasury yield touched 4.8% on Friday and earlier in the week reached its highest level since October 2023. Yet nominal US GDP growth remained higher, at 6.07% year-on-year in the first quarter and 6.56% in the second quarter.

According to Reuters, economists argue that this gap provides the US economy with some cushion because economic growth is currently outpacing government borrowing costs.

The situation could become more challenging if Treasury yields eventually move above nominal economic growth. In such a scenario, the government debt burden could become increasingly difficult to manage as interest expenses grow faster than revenues.

With fiscal deficits remaining wide and yields moving higher, the margin for error is narrowing.

Real rates point to stronger growth

Inflation remains a concern for investors, but rising inflation expectations are not the primary driver of this year's increase in long-term Treasury yields.

The US Treasury's long-term real rate average has climbed to 2.92% this week from 2.55% at the end of last year. Real yields strip out inflation expectations and therefore provide a clearer indication of the underlying cost of capital.

Reuters reported that Gennadiy Goldberg, head of US Rates Strategy at TD Securities USA, sees the recent rise in long-term Treasury yields as being driven predominantly by real rates.

Higher real yields can be consistent with expectations for stronger economic growth. That dynamic could support the argument that the bond selloff is partly a reflection of a resilient economy rather than solely a deterioration in fiscal conditions.

Deal activity faces a tougher environment

Higher borrowing costs are also threatening to disrupt the wave of large corporate deals that had made this year a strong one for mergers and acquisitions.

According to Reuters, investors have detected a significant shift in sentiment as financing costs have increased. Some market participants are now preparing for deal activity to slow, potentially delaying transactions by several months.

Companies and dealmakers can attempt to offset higher financing costs through lower purchase prices or changes in deal structures. However, investors are already seeing buyers become less willing to pay high valuations.

A sustained increase in Treasury yields could therefore affect not only financing conditions but also the broader appetite for acquisitions.

What investors will watch next

The approach of the 5% threshold for the 10-year Treasury yield puts the focus firmly on whether rising borrowing costs remain a reflection of strong economic growth or become a sign of growing fiscal stress.

For equities, the key question will be whether earnings and the AI-led investment cycle can continue to justify elevated valuations as bond yields rise. For the government, the more important issue is whether economic growth can continue to outpace the cost of servicing its growing debt.

If growth remains strong, markets may be able to absorb higher yields. But if yields continue rising while economic growth or corporate earnings weaken, the combination could create a much more difficult environment for stocks, credit markets and dealmaking, Reuters said.