The cushion protecting US stocks from the impact of rising interest rates has worn thin, as the excess return offered by equities over bonds has shrunk to historic lows.

According to the latest research report from JPMorgan, the equity risk premium (ERP) on the S&P 500 has fallen to approximately 2.1%. This level is not only more than 100 basis points below the historical average but also marks the lowest reading since 2002. This trend is particularly noteworthy against the backdrop of recent increases in real bond yields. JPMorgan's global market strategy team warns that in this low-risk-premium environment, the stock market's sensitivity to interest rate movements will rise significantly, potentially making the impact of any shock more severe than what investors have experienced over the past two decades.

Analysts point to three knock-on effects: first, the stock market's sensitivity to bond yields will systematically increase; second, long-term investors will have a stronger incentive to rebalance their portfolios away from stocks and into bonds; and third, the positive correlation between stocks and bonds that has been in place since the 2022 inflation shock will be further entrenched. For risk parity strategies that rely on bond duration to hedge against equity risk, these changes constitute a persistent headwind.

Risk premium at 2.1%, a two-decade low

JPMorgan employs a dividend discount model (DDM) framework to derive an estimate of the equity risk premium. This is done by inputting the current S&P 500 price into a discounted cash flow equation to solve for the implied equity discount rate, then subtracting the real yield on the 10-year US Treasury note.

Strategists led by Nikolaos Panigirtzoglou calculate that the S&P 500's equity risk premium now stands at around 2.1%, roughly 100 basis points below its historical average. The metric has already broken below the 2.4% cyclical low seen in the third quarter of 2007; continued equity market gains coupled with further increases in real bond yields have since pushed the premium down to new lows.

Historical data reveals that the equity risk premium was similarly depressed between 1974 and 1998, a period that included both high inflation and the subsequent disinflation phase. JPMorgan notes that during that era, stock returns showed a markedly higher sensitivity to bond yields, with the two sometimes moving almost in lockstep. With the current risk premium back in a comparable range, similar dynamics could reemerge.

Growing pressure for stock-to-bond rebalancing as equity overweight hits highest since 2002

The second implication of the narrowing risk premium concerns asset allocation. JPMorgan's estimates of implied positioning among global non-bank investors show that the current overweight in stocks relative to bonds is the highest since 2002; a separate analysis of G4 pension funds and insurers, covering the US, UK, Eurozone, and Japan, reaches the same conclusion.

The report notes that the current low-risk-premium configuration could theoretically persist—if AI-related productivity gains continue to drive earnings growth, then a lower premium would have fundamental support. However, should real interest rates rise further from current levels, the compression in the expected return gap between stocks and bonds would give multi-asset investors more reason to increase bond allocations. The resulting rebalancing flows from equities into fixed income could exceed what has been seen in recent years.

Strengthened stock-bond correlation puts risk parity under pressure

JPMorgan points to a third implication of the shrinking risk premium: its effect on the stock-bond correlation.

Following the 2022 inflation shock, the daily return correlation between global stocks and bonds has turned positive from negative. The bank believes the current low-risk-premium environment will further reinforce this positive correlation through two channels: first, the valuation channel, where equities become more sensitive to bond yields; and second, the macro-mechanism channel, where if inflation volatility remains relatively elevated, the probability of stocks and bonds moving in the same direction will stay high.

These changes pose a systemic challenge to risk parity trades. The strategy depends on bond duration serving as a hedge for equity risk, but the positive stock-bond correlation weakens that hedging effectiveness. JPMorgan anticipates that multi-asset investors' demand for direct hedging instruments, such as equity options, may correspondingly increase.

Rising real rates: growth optimism or term premium?

The recent increase in real bond yields has also sparked debate over what is driving the move. JPMorgan believes the current rise cannot be easily attributed to a single factor.

The bank cites the decomposition of the 10-year real Treasury yield using the Federal Reserve's D'Amico, Kim and Wei (DKW) model. The data shows that the sharp repricing of real rates in 2022 was largely driven by expectations of real short-term rates, consistent with the significant monetary policy tightening at the time. However, since late February, the rise in real yields has been roughly evenly split between expected real short-term rates and the term premium.

JPMorgan points out that this decomposition is consistent with a modest upward revision in market expectations for long-run potential growth, potentially fueled by optimism surrounding the AI investment cycle. At the same time, persistently high fiscal deficits and the continued quantitative tightening (QT) by other developed market central banks are also contributing factors that cannot be overlooked. Data from Consensus Economics shows that long-term real growth expectations have begun to improve since the end of 2023, but compared to the downward trend seen between the 2008 financial crisis and the COVID-19 pandemic, the current increase in real rates is still noticeably larger than the improvement in growth expectations.