The Fed Hikes, and the AI Trade Faces a New Question

The Fed Hikes, and the AI Trade Faces a New Question

Stocks were mixed last week as the Federal Reserve unanimously raised the federal funds rate. The S&P 500 slipped just 0.06% to 7,651, the Dow fell 1.65%, and small caps lagged with the Russell 2000 down 1.47%, while the Nasdaq Composite bucked the trend, up 0.73%. All three major indexes remain solidly positive for the year, with the S&P 500 up 12.71% and the Nasdaq up 14.61% year-to-date.

Yields Rise, Sales Surge

Treasury yields moved higher following the hike, with the 2-year yield rising to 4.76% and the 10-year to 5.01%, both up from the prior week, while the 30-year held roughly steady near 5.34%. Retail sales came in well ahead of expectations, surging 1.2% in August, while import prices climbed 0.7% month-over-month.

Tech Pulls Back

Technology was the week’s weakest sector, down roughly 3.0%, while more defensive areas held up better: Health Care led at +1.9%, followed by Consumer Staples and Energy. Energy remains the standout performer for the year, up 45.6%, with Technology still a strong second at 25.0% year-to-date, even after last week’s pullback.

Fed Signals Gradual Path

Looking beyond this single meeting, the Fed’s own projections show a further step up to 4.125% before a gradual path lower, settling near a 3.2% longer-run rate. That path suggests policymakers see this week’s move as part of a brief tightening phase rather than the start of a sustained hiking cycle.

AI Funding Faces Pressure

A notable debate emerged last week as several leading AI executives called for a slowdown in development, citing risks if increasingly powerful models are left unchecked. With the Fed’s hike raising corporate borrowing costs across the board, the more pressing question for markets may not be whether companies will keep building AI, but whether they can keep funding it at the current pace.

Mega-Caps Absorb Higher Rates

On that question, the data are reassuring for now: the largest technology companies (the “Magnificent 7”) carry interest coverage ratios of roughly 32 times EBIT to interest expense, far above the S&P 493, mid-caps, and especially small caps, which have far less cushion to absorb higher financing costs. That gap suggests higher rates are likely to weigh more heavily on rate-sensitive areas of the broader market than on mega-cap technology.

Looking Ahead

Looking ahead, this week’s flash PMI readings and consumer sentiment data will offer the next read on how the economy and consumers are absorbing higher borrowing costs following the Fed’s move.

As Always

I’d like to leave you with the final line we’ve used since we started these commentaries back at the very height of market volatility in March 2020. Always remember that we create financial/investment plans not for the easy times, but to prepare for the tough ones.