The book " This Time Is Different: Eight Centuries of Financial Folly,"
by Carmen M. Reinhart and Kenneth S. Rogoff, warned that the economies of countries throughout history have collapsed after sovereign debt grew to 100% of GDP.
The U.S. has just exceeded that ominous milepost with worse predicted to come.
https://www.cbo.gov/publication/62105
Deficits
In CBO’s projections, the federal budget deficit in fiscal year 2026 is $1.9 trillion and grows to $3.1 trillion by 2036. Relative to the size of the economy, the deficit is 5.8 percent of gross domestic product (GDP) in 2026 and grows to 6.7 percent in 2036, which is greater than the 3.8 percent deficits averaged over the past 50 years. Rising net interest costs drive much of that increase. The primary deficit, which excludes those net interest costs, totals 2.6 percent of GDP this year and stays below that level through 2036, when it totals 2.1 percent.
Debt
From 2026 to 2036, large and growing deficits cause debt to increase. Federal debt held by the public rises from 101 percent of GDP this year to 120 percent in 2036, surpassing its previous high of 106 percent of GDP in 1946…
[end quote]
These are fiscal deficits that go directly to consumers and corporations. The rising fiscal stimulus will drive consumer price inflation if growth in demand exceeds growth in supply of goods and services. The rising deficits directly drive record corporate profits.
The bond market is very aware of the risk of rising inflation. Since the 2008 financial crisis, the Federal Reserve has bought massive amounts of long-term Treasuries and mortgage bonds (Quantitative Easing or QE) to suppress the long-term interest rates.
This week begins the inauguration of Kevin Warsh as the new Chairman of the Federal Reserve. Warsh has been outspoken about his criticism of QE. He strongly believes in the market discovering a true price level without Fed manipulation.
Taking him at his word, the Treasury yield curve melted up last week. In addition the 30 year TIPS yield (which is inflation-adjusted) rose to 2.8%. This is a real yield which shows that the bond market is concerned about the risk of rising yields above inflation over the next 30 years due to out-of-control government spending with no end to rising deficits.
President Trump will put immense pressure on Warsh to cut the fed funds rate. Trump doesn’t seem to understand that the long yield is more important than the fed funds rate but perhaps it’s because the political impact is key to a politician.
Warsh has cooked up a rationale for cutting the fed funds rate even though inflation is higher than the target and rising. Warsh’s rationale is supply-side - that the productivity gains from AI will reduce inflation. Of course, inflation is today while any productivity gains from AI are in the future but that’s Warsh’s cover for cutting the fed funds rate.
The bond market isn’t buying that. With the overnight rate pegged the Treasury yield curve will steepen as longer-term yields rise. This is called a “bear steepener” because it’s bearish for existing bonds. Bond prices drop when yields rise, especially long-term bonds.
Rising bond yields will have a potentially dramatic impact on the stock market.
I discussed this at length with Gemini. Here is Gemini’s summary.
1. The AI Monetization Gap
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The massive AI infrastructure buildout is largely running on an insular, circular economy where hyperscalers fund AI startups, who immediately return that capital to buy cloud compute.
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This capital deployment pace heavily outstrips genuine, organic enterprise end-user software sales outside the tech sector by a ratio of nearly 20-to-1.
2. The CAPE Ratio Divergence
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With the Shiller CAPE ratio hovering near 40x, the S&P 500’s performance is aggressively concentrated in a handful of mega-cap tech giants, leaving the non-tech sectors essentially stagnant.
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A systemic valuation reset to historical means would likely unfold via sharp multiple compression, an institutional capital rotation into neglected value sectors, or a multi-year, flat “lost decade” as realized corporate earnings slowly catch up to stock prices.
3. The Compounding Leverage Tower
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The equity market’s structural vulnerability is highly amplified by a record FINRA margin debt tower of over $1.3 trillion.
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With the Investor Net Credit Balance sitting deep in negative territory at roughly -$793 billion, the market has exhausted its internal cash cushions. It relies entirely on a continuous influx of new, marginal sideline buying volume to sustain current peak multiples.
4. The Gravity of Structurally High Long Rates
- Higher long-term nominal yields automatically compress stock valuations by increasing the mathematical discount rate in Discounted Cash Flow (DCF) models. This duration risk heavily penalizes back-loaded tech and growth assets whose promised cash flows sit far out on the time horizon.
- Concurrently, long-term real yields are matching this move, as demonstrated by secondary-market 30-year TIPS (maturities from 2050–2056) yielding 2.80% and slightly above . Because this represents a contractually guaranteed real return on top of inflation, it aggressively shrinks the Equity Risk Premium. It provides institutional asset allocators a highly compelling, risk-free alternative to overextended equities, prompting automated risk-management programs (like VaR models) to systematically trim equity exposure.
5. The Flaw in Front-End Insulation
- A structural bear steepener driven by public debt worries and a Warsh Fed may keep short-term borrowing costs low, but cheap front-end rates cannot protect the record margin tower.
- If the hollowing out of the Equity Risk Premium and rising long yields cause tech stock collateral to drop, automated broker liquidation algorithms will trigger involuntarily, executing mechanical market-order selling regardless of accommodating short-term policy.
6. The Sovereign Debt Trigger
- The recent yield curve melt-up reflects a permanent fiscal adjustment rather than a temporary headline blip. With U.S. public debt crossing 100% of GDP and net interest expenses consuming over $1.2 trillion annually, the lack of a price-insensitive buyer like the Fed means the private market will continue to demand a structural term premium to absorb the massive, weekly supply of long-term Treasuries. [end quote]
In a nutshell, rising bond yields threaten the stock market.
- Institutional buyers will sell risky stocks to buy safe bonds.
- Stock prices are strongly correlated with margin. The price of margin will rise. Since there’s more margin debt than cash in brokerage accounts there will be margin calls, forcing stock sales.
- Any investment that’s not a cash cow today is valued by discounting. The longer the horizon the steeper the devaluation when interest rates rise. This includes AI stocks, preferred stocks and long bonds.
The market has been playing musical chairs. Rising long-term yields may cause the music to stop. The optimistic scenario is a slow but steady transfer of assets from high-fliers to currently disfavored cash cows. But there is a real risk of a sudden market crash because leveraged speculators are driving the prices of the high fliers at the margin.
John Mauldin held his investment conference last week. He wrote an essay called “Shootout at the Inflation Corral.”
Mauldin’s guest economists disagreed about whether inflation will continue or whether inflation will be quelled by an upcoming recession. Never once did he mention the likeliest outcome - stagflation - with both high inflation and economic stagnation. I remember this so clearly from the 1970s. It’s sticky and hard to overcome. Take a look at the the inflation adjusted SPX between 1970 and its nadir in 1982. Remember Volcker’s recession of 1980-82 induced by raising the fed funds rate to 19%.
The stock indexes continue to rise. The trade is risk-on. The Fear & Greed Index is in Greed. USD, gold, silver, copper, oil and natgas are moving in their channels.
The Chicago Fed’s National Financial Conditions Index (NFCI), which provides a comprehensive weekly update on U.S. financial conditions in money markets, debt and equity markets, and the traditional and “shadow” banking systems, shows looser financial conditions.
Inflation is rising.
The Atlanta Fed’s Latest GDPNow Estimate for 2026:Q2, Updated: May 14, 2026, is 4.0%. That’s very high.
The options market sees no change in the fed funds rate for the next 3 meetings of the FOMC and a 30% probability of a raise in October 2026 and about 50-50 of a raise in November 2026. If Fed Chair Warsh presses for a cut with inflation and economic growth so strong he will only undermine his own credibility.
The METAR for next week is sunny. But the season is changing. Might be a good time to patch those holes in the roof.
Wendy
https://www.cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html
