The sudden spike in US bond yields over the past week to near 20-year highs raises a multi-trillion dollar question: Will those higher debt returns crash the sharemarket, and in the process derail the boom in artificial intelligence-related investment?
Having edged up for most of the year – since the war in the Middle East caused oil prices to soar – the yield on US 10-year Treasury bonds has jumped from 4.95 per cent to 5.16 per cent in the space of a week, with similar moves across the yield curve.
That’s the highest yield on the 10-year bond – the global reference point for most interest-bearing securities – since 2007, when it rallied in the lead-up to the global financial crisis.
Bond yields and sharemarkets generally (there are exceptions) have an inverse correlation.
Bonds are “risk-free” assets. If you can get more than 5 per cent from investing in bonds, the dividend yield on the US stock market –currently about 1 per cent – starts to look unappealing when the risks of a sharemarket inflated by the hype around artificial intelligence stocks and trading at near-record levels are factored into decision-making.
Higher yields push up borrowing costs, lowering company profits and dampening economic activity.
They also lift the discount rates used to calculate the value of companies’ forecast future cashflows in today’s dollars, which is a particular threat to an AI sector increasingly reliant on access to the debt market to fund the extraordinary levels of investment in chips and data centres, and the energy and water infrastructure to support those centres.
There’s a lot riding on a continuation of the AI investment binge and the promises of transformative productivity gains being realised – for investors, and the global economy.
The scale of the AI investments being made – in the US, it is more than $US700 billion ($990 billion) this year and could top a trillion dollars next year – and the mind-boggling rates of revenue growth that would be required to justify the investments make the AI sector and the “hyperscalers” dominating the digital infrastructure and accounting for about 35 per cent of the US market’s value exceptionally vulnerable to an increase in discount rates.
So far, there’s been no material impact on the sharemarket from the spikes in yields and, apart from a brief sell-off when the US and Israel launched their attack on Iran in February, it has traded largely unaffected by the surge in oil prices above $US100 a barrel, the stubbornly high inflation rate and the US Federal Reserve’s decision this month to raise its policy rate for the first time in more than three years.
That may be because of the continuing conviction that AI will change the world, and those companies leading the revolution will profit immeasurably.
It may also be because the US economy is growing strongly, buoyed by the investment in AI, by fiscal stimulus – the US government deficit is running at almost 6 per cent of GDP – and the strength of spending by higher income households, and by booming corporate profitability.
The AI investment boom may, however, taper or burst.
The resort to debt by even the hyperscalers – companies like Amazon and Alphabet – is an indication of the stresses even the biggest and most profitable companies are experiencing in funding their ever-escalating AI investments. Spending on AI has absorbed their vast legacy cashflows and is stretching the equity market’s capacity to support them with new equity.
The rise in yields makes the cost of AI debt – which already has a risk premium – more expensive, while the rise in interest rates being driven by the bond market and the Fed will start to squeeze consumers’ finances. The spending by wealthier households has been held up, so far, by the Republicans’ tax cuts and by the wealth effects of the sharemarket boom.
The rise in yields makes the cost of AI debt more expensive, while the rise in interest rates being driven by the bond market and the Fed will start to squeeze consumers’ finances.
Corporate earnings growth has been exceptionally strong. Third-quarter earnings estimates put it at about 25 per cent of the same period last year.
The earnings numbers are, however, inflated to some degree by the hundreds of billions of profits AI companies are reporting that flow from the markups in the value of their holdings in each other in what’s been described as the “circular” AI economy. There’s a lot of paper profit and revenue within the sector.
At a macro level, the current US settings – the 6 per cent government deficit and more than $US40 trillion of government debt – are unsustainable in a rising interest rate environment.
With the Fed having just started a rate-rising cycle, with the market pricing in at least three more 25 basis point increases over the next year, the threat posed to government and corporate finances posed by a significant increase in interest costs will only intensify.
The US could grow its way out of the looming debt trap as low-cost debt issued in the post-financial crisis and pandemic eras continues to mature and be refinanced with higher-cost debt. But, more likely, it will have to try to inflate its way out, which will probably agitate the bond vigilantes even more.
The risk to the sharemarket is heightened because today’s bond market is not what it once was.
Donald Trump’s trade wars and US sanctions have made the foreign central banks and institutions that were once the major buyers of US bonds more wary. They’ve been diversifying away from the US, into gold and other assets.
The market is now peopled by hedge funds and other traders, pursuing carry trades by either borrowing cheaply in other markets (Japan used to be the primary source of low-cost funding) or by running leveraged arbitrages between US physical bonds and their policing in futures markets.
That makes the market more volatile and potentially vulnerable if an “event” causes the funds to suddenly unwind their trades.
The bond market’s equivalent of the VIX index (often referred to as the “fear” index), which measures volatility in the sharemarket, is the MOVE (Merrill Option Volatility Estimate) index. It leapt over the past week from 78.56, which is roughly its average level of the past decade, to 96. Presumably some of those leveraged bondholders became spooked by the pace of the run-up in yields.
With stocks trading at pricey levels – the cyclically adjusted profit-to-earnings or CAPE ratio is at levels last seen in 1999, in the lead-up to the bursting of the dot-com bubble – a sustained rise in interest rates is an obvious threat.
It’s also a threat to both the real economy and the financial sector, where there’s been massive increases in non-bank, or “shadow banking” activity since the regulatory response to the 2008 crisis forced regulated institutions out of a lot of financial market activities.
There is perceived increased risk to the corporate sector and the economy being priced into markets, with the credit default swaps for investment trade companies blowing out and the yield curve in the bond market flattening.
An index for insuring against defaults on US investment grade debt started the year at 51 basis points and is now at 58 basis points – where it would have cost $US510,000 to buy insurance against a default on $US100 million of loans, it now costs $US580,000. For some of the hyperscalers, the cost is above 90 basis points, or more than $US900,00 per $US100 million.
The flattening of the yield curve – the difference between the yields on two and 10-year bonds has shrunk from about 85 basis points at the start of the year to about 30 basis points – points to an expectation that the US economy will slow as the Fed, and the market, respond to the risk of sustained high inflation levels.
It is, of course, conceivable that a sharemarket that has shrugged off Trump’s tariffs, the war in the Middle East and $US100-a-barrel-plus oil prices, $US40 trillion of government debt and the administration’s erratic policymaking can ignore the myriad of latent threats, buoyed by the transformative potential of AI.
There’s a lot riding on a continuation of the AI investment binge and the promises of transformative productivity gains being realised – for investors, and the global economy.
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