The AI House of Cards, The Term Premium Threat, and Midterm Paralysis

Increasing debt, assuming increasing revenue, is dangerous. Right now, it appears markets are deeply concerned about the massive growth in AI infrastructure being funded by increasing debt. How high can this house of cards rise before there are real consequences for valuations—especially when the risk-free rate of return for 10-year Treasuries is hovering over 5%?

Underneath the AI investment explosion, there are serious reasons for concern. In addition to mounting corporate debt, with interest rates increasing, the cost of all debt is rising quickly. Much of today's corporate and junk debt is priced at variable rates, so as macroeconomic rates rise, corporate interest costs increase right alongside them.

The Hidden Risk of the Term Premium

Beyond standard interest rate hikes, there is also the cost of the term premium, which is a component of the yield curve. It is the cost of debt based on the maturity of the bond.

In order for investors to purchase long-term debt, they have to consider the risks of inflation that erodes the purchasing power of money. One of the biggest factors in regard to inflation is inflation expectations. Currently, inflation expectations are translating into an increasing term premium.

For a deeper dive into how this specific yield curve component is threatening the broader market, CNN published an excellent breakdown this week on the hidden economic risk of the term premium.

Of course, as interest rates increase, not only do corporate interest costs rise, but so does the cost of servicing the increasing federal debt, which recently crossed $40 trillion.

Is "Buy the Dip" Over?

Last week saw a retreat in market prices. Is "buy the dip" over? How will the midterms affect markets and interest rates?

Even if the Democrats take both the House and Senate, the President can veto legislation. As I said last week, markets like paralysis, and these midterm results are likely to result in paralysis, except for investigations.

As we navigate this house of cards, securing guaranteed 5% yields while the political and corporate debt dust settles remains an exceptionally prudent strategy.