The sudden jump in the long bond yield on Feb. 25 made it official: Rising interest rates are now the top market story of 2021. In a 24-hour span, the yield on the benchmark 10-year Treasury surged from 1.39% to as high as 1.54% by early afternoon, matching its pre-pandemic level of last February. Wall Street had been pretty much ignoring the uptrend already underway. But the February 25 spike brought fears that this may be the start of something big, front, and center. By 2 p.m., the S&P 500 had shed 82 points or 2.1%, while the Nasdaq took a 3% hit.

The rise isn't terribly troubling—yet. But if the recent leap evolves into a durable trend, and it's looking more that way every day, the super-high valuations for U.S. big-caps, and especially Big Tech, will take a Big Hit. "The issue now is whether we've reached an inflection point," says Chris Brightman, chief investment officer at Research Affiliates, a firm that oversees strategies for $145 billion in mutual funds and ETFs. "Until recently, rates were going from below the Fed's target toward the target. Now they've reached that target [based on expected inflation], and we're still seeing strong upward momentum. If the momentum continues, yields could go well above the Fed's target."

That's the outcome most likely to puncture the current bull market.

From the close of 2019 to the depths of the COVID-driven recession in mid-April of last year, yields on the 10-year (or long bond) shrank from 1.88% to 0.58%. They climbed back steadily to reach a still extraordinarily low 0.93% at the end of 2020. It marched upward at a steady pace, then freaked investors by vaulting to over 1.5% on Feb. 25. (Since the bond’s rate is in flux, we'll base this analysis on a yield of 1.5%.) Of course, inflation's a major force to setting interest rates. Right now, the consumer price index is increasing at a 1.4% annual rate. But the long bond yield is forward-looking: It reflects not today's inflation, but expected inflation over the next decade.

The pivotal number is the 10-year breakeven inflation rate. The BEI shows the pace investors forecast the CPI to be setting, on average, over the next decade. It's the BEI's trajectory that's a potential cause for alarm: Since mid-May of last year, it has accelerated from 1.1% to 2.2%.

The 10-year Treasury's rise from around 0.60% last summer to 1.5%, like all shifts in the yield, came in two parts. The first is the change in the outlook for inflation, as reflected in the BEI. The second is the move in the "real" or inflation-adjusted rate. The course of both components strongly influences future stock prices. So let's examine the role each played in that 0.9% rise in 10-year Treasury yields, more than half of which arrived in the early weeks of 2021.

So far, the biggest factor has been a sharp uptick in projected inflation. Since July, the BEI has advanced from 1.6% to today's 2.2%. That 0.6% move accounts for two-thirds of the rise in the long bond yield of 0.9% (from 0.6% to today's 1.5%). The additional 0.3% comes from a lesser increase in the "real" rate. (As we'll see, from one negative number to a lesser minus number.)

Both a reset to much higher inflation and a return to the real rates of the recent past are bad news for stocks. Keep in mind that the CPI is today waxing at just 1.4%; the problem is the substantially higher inflation on the horizon. In congressional testimony on Feb. 24, Fed Chairman Jerome Powell predicted that inflation will remain at or below the central bank's target of 2% through 2023. But if the BEI forecasts are correct, price pressures will be building over that period, and if inflation averages 2.2% over the next decade and runs under 2% for the next three years, markets are predicting that it will hover well above 2.2% for the remainder of the decade.

The current 2.2% number also represents forecasts at a moment in time, and it's already 0.2% higher than two months ago. The trend is toward much higher inflation than markets were anticipating even late last year. Of course, experts have been warning for years of a looming price spiral that hasn't materialized. But that doesn't mean it can't happen. Prices running hot at over 3% would begin to spell danger for stocks, and anything from 4% to 5% would prove an absolute disaster. "History demonstrates that a high and volatile inflation regime is associated with very low price/earnings multiples," says Brightman. "High inflation is an unambiguous negative for stock prices." Fast-rising prices would force the Fed to throttle the economic engine by raising rates, a move that would hammer corporate profits.

For Brightman, the best outcome would be for the BEI to "flatline at 2.2%." The problem now isn't the 2.2% that already exceeds the Fed's long-run ideal; it's the powerful uptrend, that if it persists, would push inflation into the red zone for equities.

Real rates

The second potential peril is a significant rise in real rates. That outcome carries higher odds than a big spike in inflation, for a basic reason: The real rate on the 10-year remains stuck in deep, minus territory. "People have been rationalizing the high multiples in the U.S. market by comparing the earnings yield on stock [the inverse of the extremely high P/Es] with real rates," says Brightman. If real rates return to anything like their historic norm, valuations are almost certain suffer a big shrink. Right now, the real rate on the long bond stands at –0.7%. That's the difference between 1.5% yield and the 2.2% BEI figure for expected inflation. The upshot is that because supersafe bonds don't even match inflation, investors are willing to pay super-high prices for their riskier rivals, U.S. big-cap stocks.

But as recently as January 2019, the 10-year inflation-adjusted rate was a positive 1.36% (BEI at 1.7% and long bond at 3.06%). That's over two points higher than today. A return back to those levels would likely crush P/Es.

Moderate inflation doesn’t much affect valuations. As labor and materials costs rise, companies simply generally increase their prices by about the same amount. Hence, their revenues for each car or can of paint they sell pretty much track with inflation—in fact, the ebb and flow of their prices determine the CPI. But a big increase in real rates, all other things being equal, is a big negative for stocks. It drives up the “discount” rate and makes future earnings less valuable.

At its record close of 3934 on Feb. 12, the S&P 500 fetched a lofty P/E of 28.2, based on GAAP trailing net profits—that's the pre-pandemic figure at the end of 2019. By Fortune’s calculations, if multiples stay there, investors will be getting just 16% of projected future profits over the next five years. Eighty-four percent will come in the future, and most of that after 2031. Unsurprisingly, the glamour tech names are especially dependent on great expectations, and hence most vulnerable to shifts in the real rate. For the 10 with the biggest market caps, ranging from Apple at the top to PayPal at the bottom, investors are paying a multiple of 46. By my reckoning, they expect almost 90% of their profits to materialize five years or more into the future.

The non-FAANG-plus part of the market isn't cheap either at a 24 P/E. Those other 240 odd stocks are expected to deliver 77% of their profits in more than five years. Let's assume the current outlook for a slow recovery remains about the same. Getting to a real rate of zero, which would be 0.7 points higher than today's, but far less than the positive 1.36% in early 2019, would hammer the S&P by over 18%, pushing the index to 3150. A real rate that waxes to just 0.5% could hammer the index by 25%.

Of course, we don't know if real rates will return to anything like their historic averages. Over long periods, they tend to track GDP growth, and they were getting back on that track before the Fed took emergency action in late 2019, when the Trump tariffs threatened a recession. The bulls insist it can't happen. This is why the Fed's role is so crucial. "The Fed could see inflation going to 3%, but decides it doesn't want borrowing rates to go to 3%," says Brightman. "So it buys bonds at longer maturities to hold the 10-year Treasury at 1.5% or 2.0%." That policy would keep real rates near where they are now, in the minus zone, and keep multiples rich.

For my money, the recent rise in real rates is likely to continue as the U.S. exits the lockdown and the economy expands. In a report from early February, the Congressional Budget Office was predicting that the inflation-adjusted yield will go from minus 0.7% to zero around 2024, and hit 1.0% and rising in the years that follow. The long bond is already yielding more than when the Fed issued the forecast. The rub is that rates don't have to return to "normal" for U.S. big-caps to suffer a significant decline. The S&P 500 is so pricey that it will just take a modest rise to do significant damage. When returning to a new normal that looks a lot better than the old normal is still destined to send stocks reeling, investor beware!