William Peets

I've been spending a lot of time thinking about and analyzing why the AI trades have been selling off. The easy answer is to say "A lot of things" and move on, but I think there is one major proximate cause that I hadn't considered. In the first chart below you can see that the Nasdaq topped the day of Warsh's first FOMC meeting. I had noticed this previously, but I wasn't sure how Warsh's previous meeting would flow through so directly to the AI trade. In the second chart you will see "real rates" measured by the 10y treasury - the 10y inflation breakeven number. Long term inflation expectations haven't moved up much, but treasury rates have. This leads to a tightening of financial conditions, and in this case ~50bps higher real rates. And Warsh is signaling more hawkish measures ahead. The committee has begun to indicate hikes (even as long term inflation breakevens haven't moved), and, perhaps more critically, Warsh is an ardent balance sheet hawk. What this means is that Warsh plans to shrink the balance sheet, probably by letting things like MBS and long duration treasuries roll off over time. Removing a buyer/holder of longer duration assets from the market also has the effect of raising real rates and tightening financial conditions. This all comes at a time when the hyperscalers are doing more capex than ever, and the entire AI complex is dependent on that capex for their own EPS targets. To fund this capex the hyperscalers are issuing more debt than ever by wide margins (see chart 3). This debt needs to be absorbed amongst tighter financial conditions more broadly, and potentially at the same time as Warsh is plotting to remove one of the major holders of duration from the market. Of course the hyperscaler fundraising is miniscule in comparison to treasury issuance, but the increased supply of treasuries raises their cost of capital. The AI buildout is also one of the longest duration trades in the market. So real rates rising has a big impact on the value of the future cash flows from the data centers being built. This would probably all be fine if the hyperscalers were rolling in free cash flow like they once were (and thus didn't need the debt to fuel the buildout), but they've already largely tapped that (chart 4). And thus the market is punishing them for this spend rather than rewarding it. AMZN/GOOG are flat on the year and META/MSFT are down 10% and 20% respectively, even as NDX is +10%. All of this has the net effect of constricting the AI trade. All of this added pressure on the hyperscalers leads to lower capex expectations farther out, which flows through directly to EPS expects. While analysts haven't begun to move semis EPS expects down yet, it's possible that the market is sniffing out this dynamic before the analysts. None of this is helped by all the AI-specific news like efficiency breakthroughs, Chinese hardware entrants, etc. And if I'm right about this then the worst part of it is that it's actually surprisingly difficult to trade on from here. Hyperscalers might begin to get rewarded if they cut capex, but that's difficult for them to do when they mostly seem to feel that AI is existential to their business. Semis have verifiably high backlogs, but they remain vulnerable to this whole dynamic. With Warsh this week maybe we will get some color and clarity, but I doubt it. He's been very clear about wanting to remove forward guidance from his mandate. I'm not a great rates trader, but maybe the opportunity is somewhere in there. Have a good trade idea for this dynamic? Let me know.