Bank of America: "AI trading" is the "last line of defense" in the current US Treasury market

Bank of America warns that the AI narrative is currently acting as a "buffer" for macro risks, and once this narrative starts to crack, all suppressed macro risks will be simultaneously amplified, putting the stock market under real shock.

Bank of America's equity derivatives team pointed out in its latest report that in a market environment where attention is relatively scarce, macro risks "struggle to compete with the AI growth narrative for market attention."

The fear of missing out (FOMO) triggered by AI has prompted investors to aggressively buy the dip on each pullback, creating the so-called "AI put option" effect which has effectively suppressed market volatility.

Meanwhile, Meta's AI assistant Muse made a strong debut last week, driving the Nasdaq to surge over 3%. The VIX index remains at a relatively mild level, which stands in sharp contrast to the intense fluctuations in the bond market.

(Interest rate market volatility significantly exceeds that of US equities)

Bank of America believes that the real tail risk is if the AI narrative "malfunctions," a repricing of growth prospects could turn the current bond market issues into a full-blown market crisis. After the AI put option fails, all other risks could be "substantially amplified."

Bond market pressure continues to mount, yields hit multi-decade highs

The US bond market is currently undergoing the most concentrated selling pressure since February last year.

Tuesday's five-year US Treasury auction was priced at a yield of 5.033%, the first "5-handle" since 2007, with the bid-cover ratio at its lowest since 2018. That day, the bond market experienced its worst single-day performance since last year's so-called "reciprocal tariff" episode.

The next day, Treasury yields rose along the entire curve to multi-decade highs and continued to climb. The MOVE Index, which measures Treasury volatility, exceeded 100—a level typically associated with equity market turbulence.

(US Treasury rate volatility diverges from US stock market trends)

The Bank of America Global Financial Stress Indicator (GFSI) also confirmed the tense state of the bond market, rising from -0.10 to -0.05 last week. Stress in implied interest rate volatility in the Eurozone and US dollar rates led all sub-indices, with changes sitting at the 97th and 95th historical percentiles, respectively.

Interest rate volatility is currently the highest cross-asset volatility stress indicator since March, replacing commodity volatility, which had dominated since November last year. Signs of resonance have begun to appear in the credit market as well, with the Eurozone 3yr/5yr credit curve, USD investment-grade CDS, and Eurozone high-yield CDS all seeing stress gains in their respective historical top decile.

The stock-bond divergence puzzle: AI narrative provides "macro hedge"

The equity market has remained almost indifferent to these signals. Bank of America's explanation is: in a market with "relatively fixed attention supply," macro risks are competing with the AI growth narrative for dominance, and the latter currently holds an absolute advantage.

Last week's obvious catalyst was the launch of Meta's AI agent Muse, which quickly became popular on major app stores, driving the Nasdaq to post over a 3% weekly gain.

Bank of America also cited historical precedent to refute the assertion that "5% yields necessarily end the bull market." During the 1990s internet bubble, long-term rates rose by 200 basis points and the Federal Reserve hiked rates by 100 basis points, but the equity bubble continued to inflate.

In another report titled "Trapped in a 5% World," Bank of America's equity strategists similarly stated:

We do not believe that a 5% yield is necessarily a death knell for the stock market.

The bank believes that fundamental changes to the current landscape would require a significant further increase in yields, or a sharp spike in rate volatility, and this "may require policymakers to step aside from intervention."

The real risk of AI "put option" failure

What Bank of America truly worries about is not "the bond market crushing the stock market," but the reverse: if the AI narrative falters, a repricing of growth prospects could turn a bond market crisis into a market-wide crisis.

The original report states:

The long-term growth and productivity potentials spurred by the AI boom act somewhat like an "AI put option," serving as a buffer for various macro risks at present. Therefore, if the AI narrative starts to slide and growth expectations are revised downward, this could further intensify macro pressures and deliver a tangible shock to US equities.

This logic also matches market bets on US fiscal sustainability. Both Trump and Musk have publicly stated that the US can "grow its way out of $40 trillion in debt." The AI productivity narrative is the core support for this hope.

If this support wavers, concerns over fiscal sustainability will lose their hedge, and all other risks may then be "substantially amplified."

However, Bank of America also points out that fundamentals remain resilient for now, valuations are in a "de-bubbling" state, and thus this extreme risk scenario "is still further away on the timeline."

Bubble risk indicators: Heat is concentrated but not widespread

Bank of America has started releasing its Bubble Risk Indicator (BRI) every week.

Following the rally triggered by Muse, BRI readings for both US technology and the Nasdaq have jumped again—Tech sector BRI is about 0.72, second only to Healthcare (around 0.76) and approaching the danger threshold of 0.8.

The semiconductor sector posted the largest weekly BRI increase among all hot themes; Bank of America’s US cybersecurity basket (0.91) and US healthcare momentum basket (0.85) are the only two themes that have already entered the "clear bubble zone."

(Weekly BRI comparison of popular US equity sectors)

Even so, Bank of America highlights an essential difference from 1999. Currently, only 18 S&P 500 components have a BRI above 0.8, compared to 50-100 stocks at the peak of the internet bubble; these 18 account for only 3.2% of the index weight, while at that time the proportion was as high as 20% to 40%.

(BoA research shows that, compared to the late 1990s internet bubble period where 50–100 S&P 500 constituents were in bubble territory (BRI>0.8), today’s bubble is focused only on a handful of leading stocks)

The stocks with the highest BRI are Moderna (MRNA), CrowdStrike (CRWD), Hewlett Packard Enterprise (HPE), and Revvity (RVTY)—far from the iconic tech giants of 2000. For now, bubble risk remains localized, but Bank of America stresses that this status "rarely persists for long."

Strategy recommendations: Go with the trend

On the strategy front, Bank of America suggests investors follow this paradoxical logic. The bank’s derivatives team remains constructive on Nasdaq 100 calls linked to scenarios of "higher yields but range-bound," seeing them as a low-cost tool to capture this year's "stocks and bonds rally together" trend.

To hedge the risk of further yield rises, Bank of America recommends a put spread on long-term US Treasury ETFs (TLT), using the historically steep put skew to partially offset the extra cost from rate volatility spikes.

In terms of equity hedging, Bank of America synthesizes sector rate sensitivity and protection costs, arguing that put spreads on Materials (XLB), Small Caps (IWM), and Consumer Discretionary (XLY) offer the best value for money.

The bank notes that small caps "may face added pressure from further CTA selling." This trend has persisted for months as yields continue to climb, and small caps have been repeatedly hammered.