Higher bond yields creating a headwind for equities

Investors still look to strong earnings to support valuations

According to the latest reading,¹ the core Personal Consumption Expenditures (PCE) Index, a key inflation gauge for the U.S. Federal Reserve, rose 3% year-over-year in August 2026, down from 3.3% in July. While this figure might appear to be a positive sign that inflation is easing, core PCE does not tell the full story.

Energy is an important part of the broader inflation picture right now, but it is excluded from the core measure. In fact, the Fed is paying close attention to energy because its effects extend well beyond the sector itself, affecting transportation, data centres, and other energy-intensive areas. And until it is clear whether those inflationary pressures are transitory or longer lasting, the Fed cannot ignore them.

On one hand, rates could rise if inflation remains around these levels or moves higher. On the other hand, we would need to see a significant and sustained decline in inflation before the Fed would consider cutting rates. So far, the probability of a hike in October has fallen to around 40% following recent comments from Fed governors, but remains as high as 90% for December, suggesting a hike is still likely this year. At the same time, other parts of an economy remain strong, including spending, employment, GDP, earnings and productivity.

Bottom line: While core PCE eased in August, inflation remains elevated enough to keep rate hikes on the table.

Bonds

Bond yields are moving higher as inflation remains above target, alongside an increase in bond issuance. The velocity of that movement is quite extreme as well, putting more focus on bonds. This reflects a combination of higher Treasury issuance, greater borrowing needs among corporations, and stronger productivity, all of which are contributing to higher yields.

This trend has raised the stakes for equity markets. Typically, the equity risk premium comes down as bond yields rise, since investors can earn more income with less risk. However, this time, equity investors are looking through those risks and focusing on earnings, which remain strong enough to overshadow the pressure from higher yields.

In other words, while the bond market is reflecting the broader risks in the environment, equity markets appear to believe that earnings can continue to support valuations despite those risks. So far, that focus on earnings has supported higher equity markets, leaving the bond and equity markets at odds in how they are interpreting the current environment.

Bottom line: While higher bond yields are creating a headwind for equities, strong earnings are giving investors reason to believe valuations can hold up despite those risks.

Europe

With shipping through the Strait of Hormuz restricted, Europe has struggled to rebuild its gas stockpiles as it normally does each summer, leaving reserves well below the seasonal average. This adds to an energy market already strained since the Russia-Ukraine conflict and continues to weigh on the economy that is heavily reliant on imported energy.

Higher oil prices could also feed through to sectors such as transportation and other energy-intensive industries, which is why we haven’t moved to overweight, or even neutral, on Europe within international markets. The region is facing other headwinds as well, with recent reports indicating that the Trump administration has warned Germany and France of a possible U.S. diesel export ban unless they release emergency diesel reserves to help ease soaring global fuel prices.²

Together, these pressures reinforce our negative view of the region. Looking ahead, there are some reasons for optimism. Alternative supply routes are emerging, with more oil flowing through pipelines such as Saudi Arabia’s East-West pipeline, while new infrastructure is also being developed, including potential expansion of Canadian ports that could serve European markets.

Over the long term, greater diversification of supply routes should help reduce reliance on any one supply or transportation corridor. In the short term, however, energy remains a major headwind for Europe, adding to the broader challenges we see across international markets. Finally, the Purchasing Managers’ Indices (PMIs) are improving, so if that momentum can continue, then perhaps there is some upside potential in Europe.

Bottom line: Europe’s ongoing energy challenges remain a significant headwind, although greater diversification of supply routes could provide some relief over time.

Positioning

For a detailed breakdown of our portfolio positioning, check out the latest BMO GAM House View Report, “The broadening summer rally confronts a higher-rate reality.” 

Sadiq Adatia, CFA, FSA, FCIA, is Chief Investment Officer, BMO Global Asset Management.

Visit the BMO ETF Market Insights Page for ETF trends, educational insights, and strategies.

Notes

1. Jeremy Bowman, “The Fed’s Preferred Inflation Metric Came in Cooler Than Expected. Here’s What That Means for Interest Rates This Year,” The Motley Fool, September 30, 2026.

2. Alex Daniel, “Britain in talks with European allies over release of emergency diesel stockpiles,” The Guardian, October 1, 2026.

Disclaimer

Contents copyright © 2026 by BMO Global Asset Management Inc. All rights reserved. Reproduction without permission is prohibited.

The viewpoints expressed by the author represents their assessment of the markets at the time of publication. Those views are subject to change without notice at any time without any kind of notice. The information provided herein does not constitute a solicitation of an offer to buy, or an offer to sell securities nor should the information be relied upon as investment advice. Past performance is no guarantee of future results. This communication is intended for informational purposes only.

Any statement that necessarily depends on future events may be a forward-looking statement. Forward-looking statements are not guarantees of performance. They involve risks, uncertainties and assumptions. Although such statements are based on assumptions that are believed to be reasonable, there can be no assurance that actual results will not differ materially from expectations. Investors are cautioned not to rely unduly on any forward-looking statements. In connection with any forward-looking statements, investors should carefully consider the areas of risk described in the most recent prospectus.

This article is for information purposes. The information contained herein is not, and should not be construed as, investment, tax or legal advice to any party. Particular Investments and/or trading strategies should be evaluated relative to the individual’s investment objectives and professional advice should be obtained with respect to any circumstance.

This article may contain links to other sites that BMO Global Asset Management does not own or operate. Also, links to sites that BMO Global Asset Management owns or operates may be featured on third party websites on which we advertise, or in instances that we have not endorsed. Links to other websites or references to products, services or publications other than those of BMO Global Asset Management on this article do not imply the endorsement or approval of such websites, products, services or publication by BMO global Asset Management. We do not manage, and we are not responsible for, the digital marketing and cookie practices of third parties. The linked websites have separate and independent privacy statements, notices and terms of use, which we recommend you read carefully.

Any content from or links to a third-party website are not reviewed or endorsed by us. You use any external websites or third-party content at your own risk. Accordingly, we disclaim any responsibility for them.

Commissions, management fees and expenses (if applicable) may be associated with investments in mutual funds and exchange traded funds (ETFs). Trailing commissions may be associated with investments in mutual funds. Please read the fund facts, ETF Facts or prospectus of the relevant mutual fund or ETF before investing. Mutual funds and ETFs are not guaranteed, their values change frequently and past performance may not be repeated.

For a summary of the risks of an investment in BMO Mutual Funds or BMO ETFs, please see the specific risks set out in the prospectus of the relevant mutual fund or ETF. BMO ETFs trade like stocks, fluctuate in market value and may trade at a discount to their net asset value, which may increase the risk of loss. Distributions are not guaranteed and are subject to change and/or elimination.

BMO Mutual Funds are offered by BMO Investments Inc., a financial services firm and separate entity from Bank of Montreal. BMO ETFs are managed and administered by BMO Asset Management Inc., an investment fund manager and portfolio manager and separate legal entity from Bank of Montreal.

“BMO (M-bar roundel symbol)” is a registered trademark of Bank of Montreal, used under licence.

Image: iStock.com/Lacheev