Stiff headwind: higher oil, rates, and Mighty Dollar…
Executive Summary:
Equity Headwinds & The AI Reality Check: The S&P 500 is experiencing technical deterioration amid a toxic macroeconomic cocktail of high oil prices, elevated interest rates, and a strong U.S. dollar. Additionally, equities are digesting a sudden "gut check" in the AI revolution, as industry leaders propose slowing development—a pause that could threaten the AI capex boom responsible for nearly half of recent U.S. economic growth.
The Dual-Chokepoint Energy Shock: Diesel and gasoline prices are surging as geopolitical risks expand to two critical global shipping chokepoints: the Strait of Hormuz and the Bab al-Mandeb Strait. With the IEA slashing supply forecasts and the global refining system stretched to its absolute limit, this energy spike acts as a massive tax shock on consumers, directly compressing real wages and corporate margins.
Financial Repression & The Fixed Income Opportunity: Real yields on 10-year and 30-year Treasuries have surged to post-GFC highs of 2.55% and 3.0%, respectively. Sustaining a 3.0% real yield against today's massive federal debt stack mathematically guarantees a sovereign debt spiral; therefore, policymakers will ultimately be forced to cap yields, making the long end of the bond market a highly compelling asymmetric opportunity for patient capital.
Full Commentary
While trimming losses for the week with Friday’s relief bounce, the S&P 500 has been trending lower for the better part of a month, and both the Dow and Russell 2000 remain trapped below their key 50-day moving averages. If the S&P 500 closes below the 7,600 level—which has recently acted as support—odds favor a move down to the 7,300–7,200 range in the coming weeks based on seasonal, sentiment, and momentum conditions. Breadth metrics remain dismal: barely 20% of S&P 500 stocks are trading above their 20-day moving averages, and more than 35% are sitting at new 4-week lows.
It should come as no surprise that the equity market is stumbling. Investors are facing a toxic cocktail: oil prices breaking out to multi-year highs above $100/bbl, interest rates nearing multi-decade highs (more on this below), and a U.S. dollar hovering just 1% off its 52-week high. Add to this a Federal Reserve forced into a renewed rate-hiking cycle by supply shocks outside its control, and you have a formidable wall of resistance – even against the strong tailwind of consensus estimates calling for +25% S&P 500 earnings growth in 2026. It is these headwinds, along with a growing recognition that those earnings estimates might be artificially inflated, that have caused the forward 12-month P/E multiple to contract from 22.5x to 19x this year. While 19x matches the 10-year average, a higher cost of capital demands a lower multiple.
Over the weekend, the market's "wall of worry" grew taller as the AI revolution received a sudden gut check. Facing mounting public and political backlash—sparked by the resignation of an Anthropic executive over AI’s existential threats—leaders of the biggest AI firms have proposed slowing model development to assess the risks. OpenAI has walked back plans to go public this year, while Meta and Google have suddenly elevated their warnings regarding AI's potential damages, ranging from a loss of personal security to rogue states developing bioweapons. Bumpy evolutions are standard when life-changing technology integrates into the commercial fabric, but this unified pause is rightfully catching markets' attention.
President Trump has strongly opposed any throttling of development, citing the great power competition with China. Furthermore, tapping the brakes on AI capital expenditures would deal a heavy blow to the U.S. economy. Over the past year, nearly half of our economic growth has come directly from the AI capital spending boom, with the other half driven by the equity "wealth effect" propping up high-end consumer spending.
I do not believe these recent developments are a reason for investors to panic, nor should they be brushed aside as a ‘nothingburger.’ A significant loss of momentum in AI capex would represent a material hit to GDP. The rest of the economy currently ranges from modest strength (job growth, manufacturing, consumer spending) to outright weak (housing, government spending, net exports). To prevent a recession if AI spending stalls, we would need a significantly lower cost of capital—a highly unlikely scenario with the Fed poised to hike rates again this week in response to an Iran-driven supply shock in global oil transit.
Nevertheless, the most realistic outcome of this latest AI hysteria is tighter safety gates and independent oversight, not a draconian halt to capex. Those closest to the technology are effectively saying it is advancing so rapidly that it requires structural speed limits. Think through that claim for a moment: the warning itself contains the bull case. This stuff really works.
Moving on to oil prices, the product markets – diesel in particular – are reaching levels guaranteed to hurt everyone and everything outside of the energy sector. Let me be clear: if sustained at current levels, oil prices and ongoing supply disruptions are a severe problem for the global economy.
Markets have spent most of 2026 obsessing over the Strait of Hormuz. Now, there is a second strait to worry about. The Houthi land offensive has pushed toward Bab al-Mandeb, the narrow entrance connecting the Red Sea with the Gulf of Aden. Control of the surrounding coastline dramatically increases the group's ability to threaten shipping through one of the world's most critical trade routes. As the map below illustrates, we now have two major global shipping chokepoints directly impacted by the U.S./Iran conflict. The result has been highly predictable: Brent crude surged through $100/bbl as markets began pricing in the possibility of a second front in this global energy shock.
While average retail gasoline prices in the U.S. are hovering around a painful $4 a gallon, diesel—where the rubber literally meets the road for the industrial economy—has skyrocketed to a record $6 a gallon. This massive divergence in "crack spreads" tells us that the world's refining system is stretched to its absolute limit; the bottleneck isn't just getting crude out of the ground, it's refining it into usable middle distillates.
Relief does not appear to be on the horizon. The IEA recently warned that Middle East oil flows will remain constrained well into next year, subsequently slashing its global supply forecast by a staggering 5.7 million barrels per day. This comes as global oil supply fell by 1.6 million barrels per day last month alone, and global oil stockpiles are now down 2.8 million barrels per day on average since the start of the war.
Until recently, the rapid drawdown of those global reserve stockpiles was a main contributor to keeping prices in check. With those buffers now drained and the refining system maxed out, the market is exposed. We are seeing zero diplomatic progress in Iran or Ukraine, Saudi Arabia is being forced to shutter key pipelines (with crude exports slumping to about 3 million barrels per day, the lowest since early 2017), the Houthis are escalating in Yemen, and China has returned as a large-scale importer. From my vantage point, consumers almost everywhere are facing a very painful winter.
While this all carries a distinct stagflationary feel, there is a critical difference between today and 2022. Today, the labor market is cooling off rather than heating up. This means the current energy spike acts less like a source of durable, sticky inflation, and more like a massive tax shock on incomes. It directly compresses real wages and squeezes corporate margins. When you layer an interest rate shock on top of that reality, recession risks become a very real conversation – even with the economic buffer of the AI spending binge. However, as noted above, with the narrative rapidly shifting from "grow and conquer at any cost" to "safety and regulation," even that AI buffer may begin to thin.
As for interest rates, the run-up in bond yields toward 5.0% on the 10-year Treasury note is clearly causing indigestion across equity markets—particularly with policy friction mounting between Donald Trump and the Federal Reserve leadership. Simultaneously, if the market's reassessment of the AI spending binge slows the breakneck pace of corporate debt issuance, that alone should relieve some supply pressure on benchmark Treasury yields.
The fed funds futures market is pricing an 86% probability of a rate hike this week; at this stage, holding steady would deliver a genuine shock to markets. Furthermore, another hike is almost fully discounted by year-end, with the futures strip drifting above 4.5% (pricing in nearly four cumulative hikes through the end of 2027, up from a peak of 4.375% back in June). The bond market has aggressively priced in a renewed tightening cycle. While I remain skeptical this full cycle comes to fruition, risk assets have shown remarkable resilience in absorbing such a violent repricing.
Despite the headwinds, I find myself becoming distinctly more constructive on the long end of the yield curve, with the 10-year yield touching 5.0% and the 30-year sitting at 5.35%. Sentiment and positioning in fixed income are overwhelmingly negative. Almost no one wants to own long duration—a natural psychological reaction after the brutal total return performance of the past decade. Last week, Jim Bianco shared a striking historical chart plotting the rolling 10-year annualized total return of the U.S. bond market going back to 1793. At -1.85% through the end of August, it reached its worst rolling performance in nearly 235 years.
Extreme pessimism alone does not make an asset class a buy, but the underlying valuation metrics reveal an extraordinary opportunity: real yields.
Real yield – nominal yield minus expected inflation – is the true cost of money. Across both the 10-year and 30-year horizons, real yields have surged to their highest levels since the Global Financial Crisis (GFC). Ten-year real yields (TIPS) have climbed from 1.07% in April 2023 to 2.55% today, eclipsing the October 2023 peak of 2.52%. Outside of that brief spike, one must look back prior to 2009 to find 10-year real yields this elevated. During the acute panic of November 2008, they briefly touched 3.0% amid gridlock surrounding the general election and sluggish policy response. Prior to that, cycle peaks in June 2006 and 2007 topped out at 2.67% and 2.84%, respectively.
Those pre-GFC highs represent the practical ceiling for 10-year real rates. A decisive breakout above the 2.70%–2.85% corridor would signal either a profound structural regime shift or impending breakage within the financial plumbing. If real yields simply test those 2006/2007 cycle peaks, nominal rates would have another 12 to 28 basis points of upside—implying a near-term ceiling for nominal 10-year yields around 5.10%–5.25% (assuming inflation expectations remain anchored).
The setup is even more pronounced on 30-year Treasuries: nominal yields are at their highest levels since 2007, while 30-year real yields sit at a record 3.0%.
To find an environment where long-term real yields persisted between 2.5% and 3.0%, you have to look exclusively at the pre-GFC era. Throughout the early 2000s, 10-year TIPS routinely traded between 2.0% and 4.0%; demanding a 3% inflation-adjusted hurdle to hold long-dated paper was standard practice. After 2008, Zero Interest Rate Policy (ZIRP) and Quantitative Easing (QE) artificially compressed the curve, keeping real yields under 1.5% and pinning them in negative territory for much of the 2010s and early 2020s.
While today's real yields of 2.5% to 3.0% are not without historical precedent, they are mathematically incompatible with today’s sovereign balance sheet.
The critical difference between 2005 and today is the sheer scale of the debt stack. U.S. federal debt-to-GDP (debt held by the public, which excludes intra-government holdings) is near 100% today, compared to 33% in 2000 and 35% just before the GFC. Prior to the current era, the last time U.S. federal debt held by the public breached 100% of GDP was in the aftermath of World War II, peaking at roughly 106% in 1946. Back then, the government did not, and could not, pay a 3.0% real yield. Instead, policymakers executed the textbook playbook of financial repression.
From April 1942 until the Treasury-Fed Accord of 1951, the Federal Reserve surrendered its independence to cap borrowing costs: long-term yields were pegged at 2.5% and short-term bills at 0.375%. When wartime price controls lifted, inflation spiked to nearly 20% in 1947. Because nominal yields were artificially pinned, real interest rates collapsed deep into negative territory. As documented in landmark research by Reinhart & Sbrancia (2015), real interest rates remained negative roughly half the time between 1945 and 1980. This negative real rate served as a massive, invisible "liquidation tax" on bondholders, transferring wealth from savers to the sovereign to inflate away the WWII debt burden.
Financial gravity has not changed. The fundamental arithmetic of sovereign debt sustainability is dictated by the spread between the real interest rate ( r ) and the real economic growth rate ( g ):
When r < g: The economy expands faster than the debt compounds. The debt-to-GDP ratio can organically stabilize or contract even if the government runs modest primary deficits.
When r > g: Interest on the debt compounds faster than national output.
Trend real U.S. GDP growth ( g ) is projected at roughly 1.8% to 2.0%. If long-term real rates ( r ) remain anchored at 3.0% under an r > g regime, the only mathematical mechanism to prevent debt-to-GDP from spiraling exponentially is to run a large primary budget surplus (tax revenues exceeding non-interest spending). Given that the U.S. currently runs a structural primary deficit of 3% to 4% of GDP (total deficit of 5-6%), sustaining a 3.0% real yield would require brutal fiscal austerity, deep entitlement cuts, or severe tax hikes that are politically dead on arrival.
Therefore, sustained 3% real yields risk initiating a sovereign debt spiral. Because austerity is unviable, the path of least resistance remains clear: policymakers will ultimately intervene, cap nominal yields, and tolerate moderately higher inflation, forcing r back below g.
This is why I am becoming increasingly bullish on fixed income at these levels. Yields could drift marginally higher in the near term, but they cannot rise much further without triggering severe systemic stress. Treasury Secretary Bessent is acutely aware of these mechanics, which is why the Treasury is already utilizing targeted interventions – heavily tilting issuance toward short-term bills to spare the long end, alongside active Treasury buybacks. If initial operations do not calm the curve, expect more aggressive balance sheet measures.
The consensus has thoroughly abandoned fixed income; all I hear on bubblevision or read about in the financial periodicals is about how high the bond vigilantes are going to push yields. Yet mathematically, today’s elevated yields provide substantial cushion against future price volatility. For patient capital, locking in a 3.0% real return in TIPS or taking advantage of peak nominal yields on the long end before policy intervention forces yields lower, presents one of the most compelling risk/reward setups in the bond market we have seen in more than a decade.
Navigating this environment requires patience. This game is hard right now with a lot of cross currents at play. Without question, September, a month notorious for volatility, is living up to the billing. I guess we can take some relief that it's just been sideways chop rather than violently down, but it's frustrating nonetheless. The equity market is stuck in a tug-of-war between pain-inducing oil prices, a surge in interest rates, and the promise of AI dreams (perhaps at a slower pace now) underwritten by highly optimistic earnings growth. Looking across the pools of investment capital: retail investors are getting chopped up and exhausted, with participation starting to wane; discretionary active managers have cut risk going into a notoriously poor seasonal period, and systematic/algorithmic trading shops are close to fully invested with a lot of reflexive selling to come if the S&P 500 breaks below key technical levels.
With that said, I’m still of the view that we’re in a ‘bend, but don’t break’ environment. Risk assets could chop around and be weak into mid/late October, which sets up a strong rally up to 8,000 into the end of the year. Time will tell if this is the right view to have, and I reserve the right to change my mind if the facts change, but I remain of the view that we’re in a window where the signal-to-noise ratio is extremely low. So my advice is to understand that volatility is the price of admission to the higher return stream offered by equities and other risk assets. It’s a good environment to hold a diversified basket of stocks (both foreign and domestic), bonds, commodities, gold, and cash while understanding that they may not all be rowing in the same direction at every moment in time, but given today’s starting point, the collective should work out well over an intermediate to long-term holding period.
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