Bank of America is warning that the AI narrative is currently serving as a buffer against macroeconomic risks. Once that narrative shows cracks, all the suppressed macro risks will be magnified simultaneously, and stocks will face a genuine shock.

In its latest report, Bank of America's equity derivatives team noted that in a market environment where attention resources are relatively limited, macro risks struggle to compete with the AI growth narrative for market attention.

The fear of missing out (FOMO) generated by AI is pushing investors to aggressively buy the dip on every pullback, creating what is known as the "AI put option" effect, which has effectively suppressed stock market volatility.

At the same time, the strong debut of Meta's AI assistant Muse last week drove the Nasdaq up more than 3%, while the VIX index remains at relatively moderate levels, forming a sharp contrast with the violent swings in the bond market.

(Volatility in the rates market is notably greater than in US stocks)

Bank of America believes the real tail risk is that if the AI narrative experiences a breakdown, the repricing of growth prospects will turn the bond market problem into a market-wide crisis. After the AI put option fails, all other risks could be substantially amplified.

Treasury Market Pressure Continues to Escalate, Yields Hit Multi-Decade Highs

The US Treasury market is under the most concentrated selling pressure since February of last year.

Last Tuesday's 5-year Treasury auction was priced at a yield of 5.033%, marking the first time since 2007 that it has reached the "5-handle," with the bid-to-cover ratio hitting its lowest since 2018. That day, the bond market recorded its worst single-day performance since last year's so-called "reciprocal tariffs."

The following day, Treasury yields rose to multi-decade highs across the entire curve and have continued to climb since. The MOVE index, which measures Treasury volatility, broke above 100, a level typically associated with stock market turbulence.

(Treasury rate volatility diverges from US stock market performance)

Bank of America's Global Financial Stress Indicator (GFSI) also confirms the tense situation in the bond market, rising from -0.10 to -0.05 last week. Stress increases in implied volatility for eurozone and dollar rates ranked at the top among all sub-indicators, with changes at the 97th and 95th historical percentiles, respectively.

Rate volatility is currently the cross-asset volatility indicator with the highest stress level since March, displacing commodity volatility, which had held the top spot almost continuously since last November. Credit markets are also beginning to show signs of resonance, with stress increases in the eurozone 3-year/5-year credit curve, dollar investment-grade CDS, and eurozone high-yield CDS all ranking in the top decile of their respective histories.

The Mystery of the Stock-Bond Divergence: The AI Narrative Provides a "Macro Hedge"

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

The specific catalyst last week was Meta's launch of its AI agent assistant Muse, which quickly went viral across major app stores, driving the Nasdaq to gain more than 3% for the week.

Bank of America also cited historical precedent to refute the argument that a 5% yield必然ly ends a bull market. During the internet bubble of the 1990s, long-end rates rose by a cumulative 200 basis points and the Fed hiked rates by 100 basis points, yet the stock market bubble continued to inflate.

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

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

The bank believes that fundamentally changing the current situation would require either a significant further rise in yields or a sharp spike in rate volatility, which "may require policymakers to abandon intervention."

The Real Risk of the AI "Put Option" Failing

Bank of America's real concern is not that the bond market will crush the stock market, but rather the reverse transmission: if the AI narrative suffers a setback, the repricing of growth prospects will turn the bond market crisis into a market-wide crisis.

The original report stated:

The long-term growth and productivity potential brought by the AI boom functions somewhat like an "AI put option," serving as a buffer against various current macro risks. Therefore, if the AI narrative falters, the downward revision of related growth expectations could further intensify macro pressures and deliver a substantial shock to US stocks.

This logic also aligns with market bets on US fiscal sustainability. Both Trump and Musk have publicly stated that the US can "grow its way out of a $40 trillion debt trap" through economic growth. The AI productivity narrative is the core pillar supporting that hope.

Once this pillar is shaken, concerns about fiscal sustainability will lose their hedge, and at that point all other risks could be "substantially amplified."

However, Bank of America also noted that fundamentals remain resilient and valuations are in a "de-bubbling" state, so this extreme risk scenario "remains relatively far off on the timeline."

Bubble Risk Indicator: Heat Is Concentrated but Not Spreading

Bank of America has begun publishing a weekly Bubble Risk Indicator (BRI).

Following the rally triggered by Muse, the BRI for the US tech sector and the Nasdaq jumped again — the tech sector reading is about 0.72, second only to healthcare (about 0.76) and approaching the dangerous threshold of 0.8.

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

(Comparison of weekly BRI across popular US stock sectors)

Nevertheless, Bank of America cautions that this differs fundamentally from the situation in 1999. Currently, only 18 stocks in the S&P 500 have a BRI above 0.8, compared with 50 to 100 at the peak of the internet bubble; these 18 stocks account for only 3.2% of the index weight, versus 20% to 40% at that time.

(Bank of America research shows that compared with 50-100 S&P 500 constituents being in bubble territory (BRI>0.8) during the late-1990s internet bubble, today's bubble is concentrated in only a handful of leading stocks)

The stocks with the highest BRI are Moderna (MRNA), CrowdStrike (CRWD), Hewlett Packard Enterprise (HPE), and Revvity (RVTY), far removed from the iconic tech leaders around 2000. Bubble risk remains a localized phenomenon for now, but Bank of America cautions that this state "rarely persists for long."

Strategy Recommendation: Go With the Flow

At the strategy level, Bank of America advises investors to follow this paradoxical logic. The bank's derivatives team continues to favor Nasdaq 100 call options tied to a "higher but range-bound yields" scenario, viewing them as a low-cost tool to capture this year's "stocks and bonds rising together" trend.

To hedge against the risk of further yield increases, Bank of America recommends a put spread on the long-duration Treasury ETF (TLT), using the option's historically steeper put skew to partially offset the extra cost from a jump in rate volatility.

On the equity hedging side, after comprehensively considering the rate sensitivity and protection cost of various sectors, Bank of America believes put spreads on materials (XLB), small caps (IWM), and consumer discretionary (XLY) offer the best value.

The bank noted that small caps "may face additional pressure from further CTA selling." This trend has persisted for months as yields have continued to rise, with small caps remaining under heavy pressure.