Several widely watched market indicators are approaching levels that historically precede stress for risk assets as investors wrestle simultaneously with an elevated oil price backdrop, Middle East conflict and a slowing in the AI-fueled stock advance.
A temporary pause in attacks in the Gulf has provided some breathing room and helped push oil down from the $100 mark, but prices remain high enough to pose a renewed risk for inflation. That situation is keeping long-term government borrowing costs at elevated levels - a dynamic that can be problematic for equities and other risk-taking investments.
On a knife edge
Technology firms continue to post strong earnings, yet investors are seeking evidence that future revenue and profit streams will justify the sizable investments companies are making into AI infrastructure. Financial markets are pricing in additional U.S. rate increases this year, and that expectation is showing up in credit markets: yields on bonds issued by AI hyperscalers are rising faster than those on U.S. Treasuries, and the cost of hedging a deterioration in creditworthiness has surged.
These credit-market strains are emerging even as the torrid rally in semiconductor stocks begins to lose momentum - an outcome that feeds worries about the sustainability of recent gains in tech. At the same time, positioning in futures markets points to an important behavioral dynamic: the ratio of bullish to bearish positions on Nasdaq futures has dropped to a 17-year low as investors have rotated away from tech, which could leave room for capital to flow back into the sector if sentiment reverses.
Underlying the equity market advance is record leverage. Margin debt reached a record $1.5 trillion in June, according to the Financial Industry Regulatory Authority, and investors' net balances with brokers sit at a $1 trillion deficit for the first time. That means a substantial cohort of investors owes more to brokers than they hold in cash, a condition that historically makes those investors more likely to sell into market declines rather than add to positions.
The 5% test
U.S. 30-year Treasury yields have remained above 5% for the longest stretch since the early days of the 2007 financial crisis. While the level itself does not automatically trigger a market selloff, higher long-term yields can lift borrowing costs across the economy - from mortgages to corporate loans - potentially squeezing consumers and weighing on demand.
Higher yields on long-duration government debt, if sustained, can also push up borrowing costs for corporations. Raymond James Chief Investment Officer Larry Adam highlights that spreads on some of the riskiest corporate bonds have reached a 15-month high, indicating that markets are requiring greater compensation to hold weaker credit. "Investors are increasingly more discerning as markets price in tighter Fed policy and a more challenging environment for the weakest borrowers," he said.
The cost of oil
Although oil has eased from the $100 handle, it remains 27% higher in dollar terms year-to-date - a tailwind for U.S. producers but a significant headwind for importers. Euro zone and UK buyers are paying nearly 30% more than a year ago, and the burden is amplified where importers' currencies have weakened.
Japan illustrates that dynamic: the value of its imports is at a record high. Indian refiners are paying roughly 40% more for Brent-linked crude, despite having been large purchasers of discounted Russian grades in recent years. Refiners in Argentina and Turkey face an even steeper increase, paying nearly 50% more. Shipping costs have surged as well: with navigational risks in the Strait of Hormuz and the Red Sea, tanker rates for key routes from the Middle East to Asia are about 600% higher year-on-year.
Funding currency pressure - the yen
The Japanese yen, trading near 164 per U.S. dollar, has weakened to four-decade lows and investors are closely watching for the possibility of official intervention to support the currency. Reports that the Bank of Japan is weighing a faster pace of rate hikes and a string of warnings from Finance Minister Satsuki Katayama have so far failed to stabilize the yen, which has been pressured by relatively low Japanese interest rates, the energy shock and Prime Minister Sanae Takaichi's expansive fiscal plans.
Historically low Japanese interest rates and subdued volatility have made the yen a popular funding currency for carry trades - borrowing in yen and investing in higher-yielding assets such as U.S. stocks and bonds. If authorities were to engineer a rapid appreciation, investors could be forced into swift unwinds of those positions, amplifying market moves - a dynamic that played out in August 2024.
Where fragility shows up
The confluence of elevated energy prices, rising long-term yields, stretched investor leverage and strains in AI-related issuers points to multiple channels through which stress could surface: tighter consumer finances from higher mortgage and loan rates; increased cost pressures for import-dependent economies and companies; higher funding costs for marginal corporate borrowers; and renewed volatility in technology and semiconductor markets as profitability and cash-burn questions take center stage.
For now, a pause in Gulf attacks has eased a near-term source of risk and oil is off its peaks, but the persistence of higher prices and the broader interplay of rates, credit spreads and crowded positioning leave markets sensitive to further shocks.