Nicholas Colas doesn't see 5% Treasury yields as a stock market spoiler. Instead, the co-founder of DataTrek Research sees them as a healthy reset of interest rates that could pave the way for more sustainable growth.

Barron's spoke with the Wall Street veteran about yields on the 10-year Treasury note, which just hit a 19-year high, why he doesn't expect stock market fallout and what sectors he favors. An edited version of our discussion follows.

Barron's: Why is there so much focus on the 5% level for 10-year bond yields? Colas: Last time we were around similar levels was October 2023 and that was one of the swoons in the stock market. [The fixation] is tied to recent memory of being here before and it not feeling good.

You don't know where the top is. When you get to a high, it trades on momentum so you don't want to see this upside, especially on historical levels near critical boundaries.

But it's real rates that is the driver of this move. The high for real yields in 2023 was 2.52%; Thursday's close hit 2.55%-a high since the depths of the global financial crisis. We hit 3.06% in Nov. 20, 2008. That was when we were worried about the U.S. economy and global financial crisis.

The economy is in much better shape now so isn't this a concerning move?

The economy is healthy. We have withstood a crazy amount of shocks since 2020. But there is no way to argue the current fed-funds rate is zero, not with the amount of fiscal spending. As you spend 5% to 6% of GDP on the deficit, you are stimulating the economy in a way that will ultimately be unsustainable. The tax coverage isn't there for that spending. Straight up credit quality is an issue.

The 10-year is the risk-free rate. It's not going to stop being that because it's too deep and liquid as a default for the financial system. This is not a cliff where people flee to the Chinese yuan. But people have options. The Treasury market says I'd like something over 5% to take on all this risk as the Fed has to keep rates at 4% and credit quality is not what it was 10 years ago. The market is resetting the rates.

What do higher rates mean for the stock market?

I'm not worried about 5% yields. The discount rate for cash flow and stocks is a combination of the risk-free rate, market premium and the growth rate. Right now we have very health growth rates, offsetting the reset in risk-free rates so we don't need multiple contraction. For the moment, growth is buttressed by most profitable companies not handing money back to shareholders [but instead investing it].

The market is doing the work of the Fed by slowing the economy and reducing inflation pressures. It's not a death sentence for the stock market but a path to more sustainable slower growth.

What about calls to slow down AI? People want to slow the pace of model development but the real issue for the economy is not the speed of model growth but AI data center growth and none of the [AI heads] are saying to slow the pace of that.

What should people look to own now? Software is still solid. It's deeply oversold versus semiconductors. Energy is still great and financials, which got hit because people were worried the long-end of the bond curve would be capped by Treasury Secretary Scott Bessent. But that has not happened and earnings revisions are good for the quarter.

Thanks, Nicholas.