Wall Street's infatuation with artificial intelligence has become so intense that it is overshadowing virtually every other risk—including surging interest rates—as investors continue pouring money into the market's largest technology stocks, driving key indexes toward record highs.

Even as sentiment remains exuberant, however, the dangers lurking ahead are growing sharper, particularly with long-term U.S. Treasury yields approaching their highest levels in decades. Just last week, the 30-year Treasury yield touched 5.69%, while the 10-year Treasury yield broke above 5.3%—both reaching those levels for the first time since 2002.

Yet technology shares have held onto their gains. The Nasdaq 100 hit a fresh record on Friday and is up 22% year-to-date, while the S&P 500 sits less than 1% below its all-time high set in August. Over the past three months, the biggest contributors to gains in the S&P 500 and the tech-heavy Nasdaq 100 have been technology giants including Microsoft Corp (NASDAQ: MSFT), NVIDIA Corp (NASDAQ: NVDA), and Apple Inc (NASDAQ: AAPL).

Investors' confidence that this rally can continue rests largely on extremely high expectations for the earnings these technology giants are about to report. Over the past several years, it is precisely these companies that have delivered the bulk of growth. Wall Street currently expects third-quarter earnings per share for the technology sector to grow more than 65%, the second-fastest pace among all sectors behind energy. That would help drive overall EPS growth for S&P 500 constituents above 24%. If that forecast materializes, it would mark the third consecutive quarter of more than 20% EPS growth for the index.

Rob Conzo, chief executive of Wealth Alliance, said: "It's hard to even understand this through a normal lens. This is historic."

For the past three years, AI has been the primary engine of stock market gains, especially in technology shares. Companies have invested hundreds of billions of dollars building the infrastructure needed to support this emerging technology. That capital spending has created a virtuous cycle for investors: the giants making the massive outlays see their share prices rise as their AI businesses make progress, while the companies receiving those funds—from chipmakers to data center builders—also rally in tandem as their revenues begin to take off.

Greed and Fear

Over the past few months, however, market sentiment around AI has swung repeatedly between excitement and anxiety. Wall Street professionals are questioning when—and whether—they will see returns on these enormous investments. At the same time, they are also pondering whether those returns even matter, given the risks this technology may pose to humanity.

On top of that, the market is still grappling with the Middle East war, stubborn inflation driven by surging oil prices, and the possibility that the Federal Reserve could raise rates again this year. This back-and-forth has pushed money rotating between software and hardware stocks, before flowing back into the "Magnificent Seven"—the giants that lagged in the first half of the year but have outperformed since late July.

Together, all of this has created a complicated trading environment. Investors cannot ignore the remarkable momentum driving AI-related shares higher, but the threat of a stock market selloff is real—especially with interest rates at extremely high levels and AI capital spenders needing to borrow ever-larger sums to finance their ambitious plans.

Ken Mahoney, chief executive of Mahoney Asset Management, said: "As rates move higher, all of us are on pins and needles. At this rate level, rate-sensitive stocks are already feeling the pressure. I think if rates keep grinding higher, eventually every stock will feel that pressure."

For now, at least, the market appears to have accepted the reality that rates will stay higher for longer. But given the strong profitability of technology companies, it remains unclear how long this can last, or at what rate level the pain would begin to materially affect technology shares.

Matt Stucky, chief portfolio manager at Northwestern Mutual, said: "I would have said 5% was the ceiling, but you know, that level is now in the past. Historically, the 10-year Treasury yield needs to move about 100 basis points before it starts to affect valuations and earnings. So, simply put, I think it's just that rate levels are higher now."

With the benchmark 10-year Treasury yield at about 5.3%, there is not much room left to rise. Chris Galipeau, chief market strategist at the Franklin Templeton Institute, said: "If the 10-year yield rises to 6%, we will have to have a completely different discussion."

The last time the 10-year Treasury yield touched 5% was in 2023, and that level was only briefly reached. The S&P 500 rose 24% that year, kicking off a stretch of three consecutive years of double-digit percentage gains. The thinking at the time was that rising yields had not ended the rally because gains were led by the "Magnificent Seven," companies with enormous cash on their balance sheets and light debt burdens, giving them the capacity to withstand higher financing costs.

But the situation has changed this year. Massive AI infrastructure spending has prompted these companies to raise needed funds by selling stock and issuing bonds. Annual free cash flow at major AI capital spenders Alphabet Inc (NASDAQ: GOOGL), Amazon.com Inc (NASDAQ: AMZN), and Meta Platforms Inc (NASDAQ: META) has all turned negative.

Analyst Robert Schiffman said: "When these companies first entered the AI buildout phase, they had the greatest flexibility, maintaining very high-quality AA and AAA credit ratings—what we call the 'Mount Rushmore' of corporate credit. But now the funding needs of hyperscalers such as Meta, Amazon, Google, Microsoft, and Oracle Corp (NYSE: ORCL) have far exceeded internal cash sources, forcing them to turn to the bond market for financing, which will push leverage higher over the next two years."

Still, he added that even against this challenging backdrop, the companies' credit ratings have not yet been affected. He said: "This unique stability remains because soaring EBITDA growth expectations are still successfully offsetting the impact of rising leverage."

Of course, higher yields have already hit other parts of the market and led to compression in S&P 500 valuation multiples. The index's forward price-to-earnings ratio has now fallen below 19 times, down from more than 21 times in May.

Although the S&P 500 is less than 2% from its record high, nearly every sector has been battered—from rate-sensitive small caps to banks and utilities. And many of the market's most speculative areas—such as technology companies that have yet to turn a profit and businesses with the weakest balance sheets—have lagged the benchmark since the Fed raised rates last month for the first time in three years to curb inflation.

For U.S. stocks, this is a unique moment: the AI trade is propping up market performance at the index level, but at the same time the market is facing an environment that historically has often led to sharp swings—rising geopolitical risk, higher interest rates, and uncertainty surrounding the U.S. midterm elections.

Paddling Furiously Beneath the Surface

Given that technology shares have been the market's main engine over the past few years, investors' biggest concern now is this: if these stocks begin to lose momentum, will the broader market's strength be threatened?

Chris Galipeau said: "The S&P 500 at the index level is like a duck floating on the water. Everything looks fine, but beneath the surface its feet are paddling furiously."

Ken Mahoney said: "If tech stocks lose momentum and go into a correction, then more dominoes could fall." He noted that the market remains strong because investors expect oil prices to fall quickly once the war between the United States and Iran ends, easing the pressure inflation puts on the economy. If that happens, strong earnings are expected to drive large-cap technology shares even higher.

That, however, is far from certain. Meanwhile, the war continues, and experts question whether oil prices would fall immediately even if it ended. Beyond stubborn inflation and high interest rates, a host of risks could just as easily derail this rally.

Magdalena Ocampo, market strategist at Principal Asset Management, said: "Growth is still strong and is being supported and driven by technology-related activity. What has changed now is that the market increasingly believes there are more upside risks to inflation and more downside risks to growth. That may be exactly what the market is telling us beneath the surface."