The economic alarm bells are ringing

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US bond and stock markets are nearly the same size, but to most people financial markets are all about stocks. Only specialists tend to pay very close attention to bonds. This is unfortunate, because bond markets pack a punch and usually end up dominating stock markets whenever the two price in contradictory scenarios.

Right now, bonds and stocks are sharply at odds with one another. Bond markets have been selling off, which is pushing up long-term yields sharply, while stocks are rallying and apparently completely oblivious to what is happening with interest rates. This price action implies completely conflicting narratives about the US economic outlook - stocks are super-positive, while bonds are ringing the alarm bells. Both markets cannot be right, so a reckoning appears imminent. The purpose of this article is to explain what such a reckoning might look like and why it matters to all of us.

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Before getting into the latest market developments, let me briefly explain why bond markets should never be under-estimated. Bond markets are orders of magnitude more powerful than stock markets. While stock markets strongly affect short-term sentiment, this effect can be as fickle as a candle blowing in the wind. By contrast, bond markets literally set the level of interest rates for the entire economy. As such, bond markets directly influence the level of aggregate demand. Via its impact on interest rates, the bond market determines what you pay for consumer credit, your education and car loans, and the funds you borrow to pay for durables or a holiday.

Housing, of course, is particularly sensitive to movements in bond markets, because so many people borrow a lot of money to buy a house. Flexible rate mortgages are directly linked to market interest rates, which, when they rise, can quickly depress housing demand. Consumers, who already own a house, are not immune either, because lower house prices have devastating negative wealth effects as we saw in the Global Financial Crisis of 2008/2009.

Bond markets also impact the future economy. Higher term yields will, all else even, depress the willingness to invest, which translates into lower growth tomorrow. Moreover, bond market volatility can be as bad, if not worse, than rising interest rates, because financial markets absolutely hate uncertainty. Interest rate volatility directly attributable to instability in bond markets is a concern right now, rooted in a sharp decline in the quality of nearly all aspects of US macroeconomic policy management.

Nor should stock market investors feel immune to what happens in the bond market. At a time of record high stock market valuations, the recent rise in bond yields is a serious worry. Stock markets can only ignore bond markets for so long before higher yields undermine the earnings potential upon which all equity market valuations are based.

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In my humble opinion, the US stock market faces a very serious, clear, and present danger from the US bond market. US long-term bond yields began to rise on 28 February, when US President Donald J. Trump launched his war with Iran. Bond yields soon began to rise in other countries too due to the stupid market convention that US bonds are the safest in the world, wherefore bond yields in other countries must rise always be higher than yields in the US.

Hence, as I type these words the US 10-year Treasury yield is up nearly 70bps since February, but 10-year borrowing rates are up 80bps in OECD and even more in heavily indebted and fiscally challenged economies like the UK and Japan. Needless to say, sovereign bond yields have also risen sharply in Emerging Markets, which, equally stupidly, are always deemed to be the riskiest of all.

Remarkably, the rising yields in global bond markets have been completely ignored in the US stock market, which is currently on a major Artificial Intelligence (AI) bender. Stock market investors only have eye for one thing, namely a very bright future of unprecedented productivity gains due to AI.

Bond markets on the other hand are telling us that the US government is in the process of committing a clusterfuck of policy mistakes, which could crash the entire economy. Bond investors worry about the inflation shock from Trump's war with Iran, which, by the way, appears to have no obvious resolution. They also worry about a serious loss of credibility of both fiscal and monetary policy in the United States. And, of course, bond markets see real prospects that the whole AI thing is a bubble about to burst.

So, which market is right? Bonds or stocks? If you don't have a clue and therefore implicitly assign 50-50 odds to each scenario, it is still prudent to give much greater weight to the view expressed in the bond market than that expressed in the stock market. This is because the pay-offs in the two scenarios are radically different; if stocks are right, you will ultimately be fine, but if bonds are right then you, me, everyone & their dog will be up the creek. I will get into what ‘creek’ means shortly, but first we need to look at where bond yields are heading next. To do this, we have to ask what got them up here in the first place.

The immediate driver of term yields was higher oil prices. The price of West Texas Intermediate (WTI), the most traded crude oil contract in the world, went up by USD 30 per barrel after Trump started his myopic and poorly thought-out war with Iran. At the same time, the war significantly increased uncertainty about global oil supplies and raised the prices of many other goods that use oil as an input in their manufacture.

The rise in oil prices has given rise to what bond traders call 'bear steepening', which is where long-term yields rise faster than short-term yields. At first sight, this is odd. Ordinarily, one would expect higher inflation to give rise to expectations of interest rate hikes by the Federal Reserve, which push up short-term bond yields more than long-term yields. Indeed, long-term bond yields may even fall as markets price in expectations of a return to stable, non-inflationary growth in the future.  

But this is not what we are seeing now. While the 2-year US Treasury yield has gone up a bit, long-term bond yields in the US have gone up more. This tells us that bond markets do not think that the Federal Reserve will raise rates as much as required to stamp out inflation - in other words, the market is pricing in a Fed policy mistake.

The expectation of a policy mistake on the part of the Fed can be attributed to Trump's appointment of Kevin Warsh as Fed Chairman. Warsh is a political operator, who made dovish utterances to curry favour with Trump before his appointment. He is not regarded as a credible technocratic Fed chairman. The prospect of a Trump mouth piece at the Fed pushes up long-term yields, because markets believe that long-term outlook is now far more uncertain. If inflation not brought under control, everyone has to pay more to borrow long-term, because lenders rightly demand compensation for lending into a much riskier future.

Now, let us take a closer look at the possible downside scenario I alluded to earlier if bond markets are right and stock markets are wrong. Specifically, let us, for prudence's sake, suppose that Warsh does fall behind the curve on inflation and Trump really fails to extricate himself from his Iranian quagmire. In this scenario, inflation remains high and may rise further, which in turn keeps long-term bond yields high and may even push them higher.

What will this do to the US economy?

First, higher term yields will undermine the business case for stocks, especially AI stocks, where valuations are sky high and the so-called Mag-7 companies have over-invested significantly due to their winner-takes-all mentality. While a lot of the funding in AI comes from retained earnings rather than outright borrowing, the opportunity cost capital increases with every basis point rise in bond yields, so money will leave the sector. To make matters worse, Mag-7 stocks currently trade at valuations far in excess of the Dotcom Bubble, so when the adjustment comes - courtesy of rising bond yields - the pain will be considerable.

Second, rising rates will inflict even more damage on the huge number of companies up and down the supply chain in the AI sector, which, unlike the monopolistic Mag-7 giants, do not have big fat cash cushions. They are naturally credit-dependent and therefore more vulnerable to rising rates.

Third, higher term yields will of course also have their conventional negative impact on the wider economy outside the AI sector, notably through the cost of mortgages. House prices will stagnate and may eventually fall, which will seriously depress consumption. Consumption makes up nearly 70% of GDP in the United States and most other developed economies, so this is no trivial matter.

To make matters worse, should recession arrive in the US the government will not be able to rely on its traditional painkiller of fiscal policy, because US government debt just broke through 100% of GDP due to Trump's tax cut give-aways to the rich and the cost of his war with Iran.

At these elevated levels of public debt, there is a non-negligible risk that bond investors suddenly refuse to fund the US government as they did in the United Kingdom during the Liz Truss debacle. If this happens, the US government could be forced to raise taxes and cut spending into a recession, which would dramatically deepen the economic rout. Bear in mind that at current yields the annual debt service cost for the US government is already several percentage points of GDP.

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In the face of some ch unpleasant downside risks, there ought to be significant pressure on Trump & Co to change direction on economic policy. However, the single most important step Trump can take right now is to stop the war in Iran. But how? If I was the Iranian leader, I would demand a pound of flesh from Trump knowing that every day that passes without a resolution further undermines the Republicans' prospects in November's midterm election.

Personally, I do not see how Trump can achieve a deal with Iran, which is anywhere as good as Obama's 2015 Joint Comprehensive Plan of Action (JCPOA). Will Trump's racist ego allow him to accept terms that are inferior to those achieved by a black man? I doubt it, unless he comes up with a major distraction, such as a Cuban invasion or some other crazy scheme.

Even if Trump strikes a deal with Iran right now, however, there may still be considerable pain ahead for the US economy due to the time it takes to normalise oil markets. As I explained in a recent blog post, the real oil supply shock is imminent. Remember the world has continued to consume oil the same pace as before the closure of the Strait of Hormuz, but this has only been possible due to draw-downs in oil inventories. Inventories of crude are falling at a rather alarming rate of 4 million barrels per day, or 1.5 billion barrels annually.

To put this inventory declining into perspective, there are only 800 million litres of available commercial inventories left in addition to government strategic reserves of some 800 million barrels. The world therefore runs completely out of inventories in about a year. In reality, however, there is far less time. Oil markets are not just going to sit around and wait for the last barrel of oil to disappear. Long before we get there, there will be frantic hoarding of crude. Exactly when the panic starts is anyone's guess, but it is certain to happen well before inventories are depleted.

When the panic starts, the price of oil immediately jumps to the level that brings global demand into line with global supply less Iranian crude and the oil still sitting on ships in Hormuz. How high is this clearing price? The answer is beyond my pay grade, but I have seen estimates by credible analysts well in excess of USD 175 per barrel.

There is one silver-lining on this cloud, however. As far as inflation is concerned, we are looking at a supply shock, meaning a reduction in output rather than excess demand (when people buy beyond their means). The higher prices caused by the supply shock undermine real incomes and therefore naturally lead to lower demand, which brings us closer to equilibrium. While the process of adjusting to supply shocks can be painful, at least central banks can take a back seat as far as hiking rates is concerned, because markets are doing most of the work.

There is only one important exception to the rule that central banks can take a backseat in supply-side shocks, which is when central banks are low on credibility. If markets do not have faith in central banks, then inflation expectations rise in response to supply shocks.

Unfortunately, as of May 2026, US short-term inflation expectations have risen to their highest in a year, reaching 3.6% for the one-year-ahead horizon. This is due to Warsh's appointment as Fed chairman. The Fed may ultimately have to raise interest rates further and for longer than a credible central banks would have to in order to achieve the same amount of disinflation. The Warsh Fed may even have to hike into an economic downturn in order to restore some semblance of credibility.

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Even if the Iran disaster is brought under control - which is a big if - the Trump Administration will still be left with a major fiscal hangover from the ill-advised Iran war. There is obviously zero chance of fiscal adjustment ahead of the upcoming mid-term election, but US public debt is clearly far too high. When the election is over, the real legacy of high term yields will therefore be to place the US in a fiscal strait jacket just as happened in the United Kingdom following Liz Truss. This, perhaps, will be the biggest challenge for American lawmakers going forward. They will simply no longer be able to approve another fiscal stimulus to keep the economy going. Nor will they be able to borrow and spend at will if a recession looms.

In other words, economic reality has caught up with the United States, courtesy of Trump.

The End