Falling Treasury Yields May Be Hiding Deeper Concerns About the AI Boom's Financing

What happened

US Treasury yields have fallen sharply this week, with the 10-year yield slipping back below the 5% threshold. This decline occurs against a backdrop of rising oil prices, with Brent crude hitting $114, driven by geopolitical tensions between the US and Iran. Traditionally, higher oil prices tend to increase inflationary pressures and, consequently, bond yields. However, the inverse movement observed suggests other factors are at play. Concurrently, the stock market, particularly AI-related companies, has been battered this week, despite the apparent 'relief' that falling Treasury yields should provide.

The analysis points to growing concerns about the financing of the AI boom. The cost of insuring against defaults (CDS spreads) for companies in the AI sector has surged significantly over the past year. CoreWeave, for instance, saw its five-year CDS spread skyrocket to over 1,000 basis points, implying an annual cost of $100,000 to insure $1 million of debt. Other companies, such as Oracle, Meta, and Nvidia, also experienced increases in their CDS, albeit to a lesser extent, indicating broader investor apprehension about lending money to companies involved in the AI sector.

Why it matters

The drop in Treasury yields, amidst rising oil prices, is a warning sign. Instead of reflecting an expectation of controlled inflation, it may indicate that investors are pricing in higher risk for economic growth or, more specifically, for the sustainability of financing high-growth sectors. The increase in CDS for AI companies suggests that the market is questioning these companies' ability to generate sufficient returns to cover massive investments in infrastructure and data centers, many of which are debt-financed. If financing costs become prohibitive or the pace of AI investment slows, the consequences could be significant for the sector and the broader economy.

Market impact

• Interest rates and bonds: The fall in Treasury yields can be interpreted as a 'flight to quality' move or a pricing in of lower growth and higher risk. This tends to benefit higher-quality debt securities in the short term, but the sustainability of this trend will depend on the evolution of concerns about AI financing and global growth.
• Dollar and exchange rates: In a scenario of risk aversion and uncertainty about growth, the dollar tends to strengthen as a safe-haven currency. The real, in turn, may depreciate against the dollar, especially if capital flows to emerging markets are impacted by global caution.
• Equities: Stocks, particularly technology and AI names, tend to suffer from the perception of higher credit risk and the possibility of more expensive financing. Companies with weaker balance sheets and high reliance on debt for expansion may be the most affected. The Ibovespa, while less directly exposed to the AI sector, may feel the impact of global risk aversion and an economic slowdown.
• Commodities: Oil, already boosted by geopolitical tensions, may remain at elevated levels. However, if concerns about global growth intensify due to the AI financing scenario, demand for other commodities may be pressured.

What to watch

Investors should closely monitor the following indicators:

• AI company CDS spreads: Track the evolution of default insurance costs for CoreWeave, Oracle, Meta, Nvidia, and other AI sector companies. A continuous increase would signal deepening concerns.
• Earnings reports and investment projections: Observe the balance sheets and capital expenditure projections of major tech and AI companies, looking for signs of investment slowdowns or financing difficulties.
• Credit data and financial conditions: Monitor overall credit conditions and the availability of financing in the market, especially for high-growth sectors.

Scenarios

Base case: Concerns about AI financing persist, leading to a slowdown in sector investments and a correction in the valuations of the most exposed companies. Treasury yields may remain under downward pressure, while global risk aversion is maintained. Risk scenario: Concerns about AI financing spread to other sectors of the economy, triggering a broader credit crunch and negatively impacting global growth, with more severe consequences for financial markets.

Original source: ForexLive (InvestingLive). For information only, not investment advice.