The U.S. stock market is currently caught in a fascinating tug-of-war, according to Bank of America analyst Michael Hartnett.
On one side, two powerful forces are pulling the market higher. The first is expansionary fiscal policy. The U.S. government is running a large budget deficit, projected to be around $1.9 trillion in 2026. This means the government is spending much more than it collects in taxes, injecting a significant amount of money into the economy, which supports corporate earnings and overall growth.
The second force is a historic AI capital expenditure (capex) boom. Major tech companies, often called 'hyperscalers,' are investing unprecedented sums into building out their AI infrastructure. In 2026 alone, this spending is expected to surpass $700 billion. This investment directly boosts the revenues of tech companies and has ripple effects across other sectors like energy, which must supply the power for all the new data centers.
However, there's a catch. These two growth drivers are also creating the biggest risk for the market: rising long-term interest rates. The government's large deficits require issuing more Treasury bonds, and this increased supply can push interest rates up. Similarly, the massive energy demand from the AI boom can contribute to inflationary pressures, which also leads to higher rates.
This brings us to the critical threshold: a 5% yield on the 10-year Treasury bond. Why is this number so important? Higher long-term interest rates act like gravity on stock valuations. When the 'risk-free' rate of return on a government bond is higher, the future profits of companies become less valuable in today's dollars. A simple valuation model suggests that a move from a 4.5% to a 5% yield could shrink the market's price-to-earnings (P/E) multiple by over 6%, causing stock prices to fall even if company earnings remain strong.
In essence, the market is walking a tightrope. The powerful narratives of fiscal stimulus and the AI revolution are providing strong support, but the bond market holds a veto. If long-term yields remain below 5%, the rally can continue. But if that 5% line is breached and holds, the math quickly turns against stocks, posing a significant challenge to the current bull market.
- Capex: Short for capital expenditure, which are funds used by a company to acquire, upgrade, and maintain physical assets such as property, plants, buildings, technology, or equipment.
- Fiscal Policy: The use of government spending and taxation to influence the economy. Expansionary fiscal policy, involving higher spending or lower taxes, aims to stimulate economic growth.
- 10-year Treasury yield: The interest rate the U.S. government pays to borrow money for 10 years. It is a benchmark for many other interest rates and is often used as a proxy for 'risk-free' return.