Rising yields and market volatility are creating headwinds for AI infrastructure funding rounds despite underlying demand.

Wall Street's artificial intelligence fixation is so powerful that it is overwhelming major risks, including soaring interest rates. Investors continue to pour money into the market's largest technology stocks, pushing equity indexes toward record highs even as yields on long-term Treasuries trade near their highest levels in decades.

"With these higher rates, all of us are on edge," said Ken Mahoney, chief executive officer of Mahoney Asset Management.

Last week, the long bond yield reached 5.69% and the 10-year rate topped 5.3%—levels neither has reached since 2002. Yet tech stocks have held onto their gains. The Nasdaq 100 Index hit a fresh record on Friday and is up 22% this year. The S&P 500 Index is less than 1% from its all-time high reached in August. Microsoft Corp., Nvidia Corp., and Apple Inc. have been the largest point contributors to gains in both indexes over the last three months.

"I would've said 5% was the limit, but you know, that's kind of in the rearview mirror already," said Matt Stucky, chief portfolio manager at Northwestern Mutual.

Investors' confidence in the durability of this rally rests largely on sky-high expectations for upcoming tech earnings. Third-quarter earnings per share for the technology sector are expected to jump more than 65%, giving the group the second-fastest growth after energy. S&P 500 earnings per share are anticipated to rise more than 24%, which would mark the third straight quarter of gains exceeding 20%, according to Bloomberg Intelligence.

"It's hard to even put that in perspective," said Rob Conzo, chief executive officer of the Wealth Alliance. "It's historic."

Artificial intelligence has been the primary driver of market gains over the last three years. Companies are spending hundreds of billions of dollars to build the infrastructure needed for this nascent technology. These capital expenditures have created a virtuous circle: the behemoths spending on AI rally because they are making progress on the technology, while their suppliers—chipmakers and data center construction companies—also climb as their revenues take off.

Yet sentiment has oscillated between excitement and concern many times in recent months. Wall Street professionals question when and if they will see returns on all that capital being deployed, and whether returns will even matter given the risks the technology could pose. Simultaneously, the market is grappling with the war in Iran, sticky inflation led by surging oil prices, and the likelihood of another interest-rate hike from the Federal Reserve this year.

This back-and-forth has driven rotations from software to hardware and back to the Magnificent Seven tech giants, which lagged in the first half of the year but have outperformed the broader market since late July.

The environment is complicated. You cannot dismiss the incredible momentum driving artificial intelligence names higher, but the threat of a stock market selloff is real, especially with interest rates at elevated levels and AI spenders needing to borrow increasing amounts of capital to fund their ambitions.

"The interest-rate sensitive stocks are feeling it at this level," Mahoney said. "I think every stock would feel it if it keeps grinding higher."

The market appears to have accepted that rates will remain elevated for longer than previously expected. But it is unclear how long that will persist or at what level the pain would begin to weigh on tech stocks, given their earnings strength.

"Historically it takes roughly a hundred basis point move or so in the 10-year to kind of impact valuations and earnings," said Stucky. "So I guess it's just higher, simply put."

With 10-year Treasuries around 5.3%, there is not much room to go higher. "If 10-year yields go to 6%, we're going to have a different conversation," said Chris Galipeau, head market strategist at the Franklin Templeton Institute.

The last time the 10-year hit 5% was briefly in 2023. The S&P 500 rose 24% that year, kicking off a three-year run of double-digit percentage gains. The theory then was that rising yields did not kill the rally because gains were being led by the Magnificent Seven, which had enormous piles of cash on their balance sheets and light debt loads, giving them the ability to withstand higher borrowing costs.

That has changed this year. The massive artificial intelligence infrastructure spending has prompted these companies to sell stock and issue bonds to raise the capital they need. Alphabet Inc., Amazon.com Inc., and Meta Platforms Inc. have all seen free cash flow turn negative on an annual basis.

"These companies initially entered this AI build phase with maximum flexibility, holding pristine AA and AAA credit profiles, what we call the Mount Rushmore of corporate credits," said Bloomberg Intelligence analyst Robert Schiffman. "Today, however, hyperscalers like Meta, Amazon, Alphabet, Microsoft and Oracle have cash needs that far exceed internal cash sources, forcing a turn to debt markets that will drive leverage up over the next two years."

Despite this challenging backdrop, the firms' credit ratings have not been hurt yet.

"This unique stability persists because surging EBITDA growth expectations continue to successfully offset the increased leverage," Schiffman said.

Higher yields have hit other parts of the market, leading to multiple compression in the S&P 500. The index now trades at less than 19 times forward earnings, down from more than 21 in May.

"The S&P at the index level is like a duck on the surface of the water," Galipeau said. "It looks fine, but under the surface the feet are paddling like crazy."

Given how tech stocks have driven gains over the past few years, the biggest concern for investors is whether a loss of momentum in that sector would jeopardize the strength of the entire market. "If technology loses it and technology corrects, then a lot more chips may fall," Mahoney said.

For now, strength is continuing because investors expect that the end of the war with Iran will swiftly send oil prices lower, loosening inflation's grip on the economy. Should that happen, strong earnings would be expected to power Big Tech stocks higher.

However, that is hardly guaranteed. The war is dragging on, and experts question whether oil prices will immediately drop if it ends. Between that, stubborn inflation, and high interest rates, there are plenty of risks that could just as easily derail the rally.

"Growth is still strong and supported and elevated by tech-related activity," said Magdalena Ocampo, market strategist at Principal Asset Management. "What's changing now is this rising perception that there's potentially more upside risk to inflation and a bit more downside risk to growth. And that's perhaps what the markets are telling us underneath the surface."