Liquidity Squeeze Puts the AI Trade on Notice

Executive Summary

Skeptics of the AI-fueled stock rally have long warned of a bubble, and last Thursday gave them their strongest evidence yet. Whether AI is a bubble or a richly valued growth story is still an open question. What’s clear is that the technology is already reshaping industries, and the hard part is deciding what that transformation is worth. From a fixed income perspective, the more pressing issue is that the liquidity tide that lifted AI stocks is now going out.

How the Curve Flattens Matters

The recent equity sell-off does puts weight on a question the bond market can help answer: Is financing getting tighter just as the industry needs more of it? A flatter Treasury curve, persistent inflation and heavy infrastructure spending make semiconductor earnings and corporate credit spreads more useful tests than a rebound in the headline stock indexes.

The technology can transform industries and still disappoint investors who pay too much for the companies supplying it. From a fixed-income perspective, the distinction matters because companies must finance data centers, chips and power capacity before they know whether those investments will earn an adequate return.

The spread between 10-year Treasury yields and three-month bills has narrowed by more than 40 basis points since early October. Stocks have underperformed bonds over the period. The two moves are consistent with a pullback in risk appetite.

The Liquidity Signal

Excess liquidity, the gap between real M1 money growth and economic growth, has been shrinking for more than three months. Its impact is only now reaching full force.

When excess liquidity is plentiful and rising, money not needed to support the real economy or keep up with inflation tends to flow into stocks and other risk assets. Rising prices draw in still more money, creating a self-reinforcing cycle. That cycle breaks when stronger growth and inflation start soaking up more cash and the Fed begins to tighten. Both of those conditions are now in place: GDP grew at a 3.4% annual rate in the third quarter, core PCE inflation is running at 3.1% and the Fed raised rates in September.

As excess liquidity declines, investors typically shift from stocks toward longer-term bonds. Equities lag, and the yield curve flattens. Historically, turns in excess liquidity have preceded turns in the yield curve by six to nine months, with the main exception being the quantitative easing years of the 2010s. Last week’s Treasury quarterly refunding announcement, which hinted at less long-term debt issuance, adds weight to the case for a flatter curve.

Why Semis are Most Exposed

Semiconductors are the sector with the strongest positive sensitivity to the yield curve, followed by energy. That leaves chipmakers with the most to lose as the curve flattens. The sensitivity is modest on its own, but semis are also the most crowded trade in the market. That makes them especially vulnerable to a politically driven shift in sentiment about data center construction.

The midterms add a policy variable, but election results do not translate directly into canceled data centers. The more immediate questions are whether developers can secure grid connections, win local approvals and agree on who pays for power upgrades. Delays can shift equipment orders into later quarters even when long-term demand remains intact.

A flatter curve should keep favoring smaller companies in the S&P 500. The equal-weight index has been outperforming its market-cap-weighted counterpart, and its correlation with the yield curve is turning negative faster. That’s a sign broader market breadth may benefit as mega-cap tech cools.

Positioning for What Comes Next

Most mega-cap tech companies have already reported, and their results broadly supported the AI growth story. The concern is not demand but whether profits can justify capital spending that keeps climbing. Three of the four largest hyperscalers reported negative free cash flow last quarter.

The key question is whether stocks can find a floor. There’s a reasonable case they can. For bond investors, the clearest sign of strain would be AI borrowers paying wider spreads even as Treasury yields fall.

We want to hear your views.

What would make you reconsider the AI trade: weaker demand, lower margins, construction delays or tighter financing?

Please share your comments below and click here for prior editions of “Treasury & Rates.”

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