The 10-year US Treasury yield approaches 5.4%, with the AI halo unable to hide the "inflated" risks of the S&P 500

While the US stock market appears calm on the surface, there are strong undercurrents beneath. This week, the yield on 10-year US Treasuries approached 5.4%, hitting the highest level since 2002, while Brent crude hovers above $100 per barrel. Financial markets are experiencing a broad retreat hidden by the halo of tech giants.

The S&P 500 Index reached a new all-time high this week, but this record conceals an extremely fragile market foundation—only about 30% of constituent stocks are trading above their 50-day moving average, marking the lowest market participation among all record-setting days since Bloomberg began collecting data in 1990.

Meanwhile, the Russell 2000 Small Cap Index has declined for five consecutive weeks, down roughly 8.5% from its peak, approaching the threshold for a technical correction.

The impact of rising interest rates is spreading to broader asset classes. Junk bond ETFs have fallen to levels near their lowest point since the spring’s trade war-driven sell-off. US high-yield corporate credit spreads continue to widen, and yields for the weakest credit borrowers have surged to around 15%. Lynn Martin, President of the New York Stock Exchange Group, has directly attributed the recent postponement of several high-profile IPOs to rising interest rates.

Record Highs in Indices Conceal Record-Low Breadth

The S&P 500 hit new all-time highs this week, but the significance of this record is under severe scrutiny.

According to Bloomberg data, only about 30% of S&P 500 constituents are trading above their 50-day moving average at the time of the record high. The 50-day moving average is an important measure of market breadth; the lower the value, the more the index is reliant on a few heavyweights to propel gains, and the lower the overall market participation.

Small caps are in an even more precarious position. In the rate-sensitive Russell 2000, only 27% of components are above their 50-day moving averages. The index has now fallen for five straight weeks, down roughly 8.5% from its peak and approaching the typical 10% threshold for a technical correction. Real estate stocks have also seen ongoing declines.

James St. Aubin, Chief Investment Officer at Ocean Park Asset Management, commented:

“The market-cap-weighted S&P 500 is masking significant underlying damage. Even before the Federal Reserve acts, the bond market has effectively tightened financial conditions. The risk is that the initial energy shock could ultimately turn into an earnings problem, a possibility the equity market has yet to fully price in.”

Interest Rate Shock Spreads Globally, Borrowing Costs Rise Across the Board

This Wednesday, the 10-year US Treasury yield briefly neared 5.4%, the highest since 2002, and the impact of rising rates is spreading well beyond US borders around the world.

Meanwhile, Brent crude prices continue to hover above $100 per barrel, deepening concerns about persistently high inflation. Borrowing costs in the UK have hit a 19-year high, and France is facing simultaneous increases in government debt pressure.

Signals of stress are even more direct in the credit markets. Yields for the weakest-quality borrowers have surged to about 15%, creating an extremely high hurdle for companies needing to refinance. US high-yield corporate credit spreads have continued to widen recently, and junk bond ETFs are now near their lowest levels since the trade war-driven selloff earlier this spring.

St. Aubin calls sub-investment grade credit spreads the "true panic barometer," and notes that the persistent widening since mid-September is concerning. He says his firm’s internal models have flagged downtrends in several rate-sensitive investments, leading the team to reduce exposures to credit-sensitive assets, including high yield bonds.

Extreme Scenario Assessment: S&P 500 May Fall Over 20% Next Year

Strategists at Société Générale have quantified the market’s trajectory under extreme scenarios, with pessimistic conclusions.

Société Générale strategists Manish Kabra, Charles de Boissezon, and Kawtar Mamouni noted in a recent report that if the 10-year US Treasury yield rises to 6%, Brent crude climbs to $150 per barrel, and cash flow pressure on tech giants persists, the S&P 500 could fall by more than 20% next year.

Conversely, if yields fall back to 4%, oil prices retreat to $80 per barrel, and fundamentals for the major tech firms improve, there is still room for the market to rise further. Kabra added:

“A 5% yield creates valuation headwinds, but a 6% yield would trigger credit events, which are more likely to occur in assets outside the private sector with the highest leverage on their balance sheets. Right now, all concerns are focused on the fiscal stability and debt sustainability of sovereigns.”

AI Trades Are Not Unshakeable, Capital Is Quietly Withdrawing

It’s worth noting that the sharp sell-off in chip stocks Thursday indicates that even the AI theme is not invincible.

The S&P 500 and Nasdaq 100 posted overall gains for the week, but Thursday’s collective drop in chip stocks signals wavering confidence in AI demand. Whether the major indices can continue to withstand pressure largely depends on the future direction of oil prices and the bond market.

Some investors have begun to actively exit. Jeff Muhlenkamp, who oversees a $270 million fund that has outperformed the S&P 500 this year, revealed he has significantly increased his energy holdings and almost completely exited all AI-related positions.

"I’m happy to leave the party while it’s still going on," he said of the AI boom. "Financing is still available right now. But once that condition is gone, the game is over."

Currently, rising rates are prompting investors to reallocate their portfolios, rather than causing a full-scale sell-off of risk assets. Investors are reducing exposures sensitive to bond yield volatility and high borrowing costs, from speculative credit to currency carry trades. But as rate pressures continue to build, this underlying structural divergence beneath a calm surface is testing the limits of the market’s ability to withstand stress.