Convulsion in credit markets

The United States government just posted a $432.3 billion deficit for July, the largest monthly shortfall since March of 2021. That single burst of red ink pushed the yeartodate deficit to $1.8 trillion, with two months still remaining in fiscal 2026. At this pace, Washington will soon wax nostalgic for the “good old days” when annual deficits were only $2 trillion. The fiscal deterioration is no longer episodic—it is structural, relentless, and accelerating. 

The reason is simple: the U.S. financed its debt on the short end of the yield curve, choosing convenience over prudence. Instead of locking in longterm rates when they were historically low, Treasury saturated the market with Tbills. That means the entire debt stack must be rolled over constantly at today’s rates, whatever they may be. This is why the White House wants yields lower, and why Kevin Warsh—despite his hawkish reputation—is not raising the Fed Funds Rate. It is also why Secretary Bessent is now doing an operation Treasury Twist—where he is buying back 30-year bonds and issuing even more on the short-end of the yield curve. Washington is busy using smoke and mirrors to mask the daunting math. 

The nation is now paying $3 billion per day in interest on our debt, approaching $100 billion per month, and $1.2 trillion per year. Ten months into this fiscal year, net interest has already reached $963 billion, up 14% from the same period last year. Interest expense is now the fastestgrowing major component of federal outlays, and it is rising far faster than tax receipts or GDP. 

This leaves the Federal Reserve with a conundrum that borders on the absurd:

· Raise the Fed Funds Rate, which sends T-bill yields higher and increases interest payments even further into unaffordable territory. 

· Cut rates and unleash even higher inflation that sends the long-end of the yield curve soaring.

Neither path is viable. Therefore, the Fed will almost certainly attempt a third option next year: shrink the balance sheet while keeping the policy rate near current levels. Warsh has already hinted at this strategy. By selling longterm Treasuries and mortgagebacked securities, the Fed can attack assetprice inflation without directly crushing Main Street--at least initially. Wall Street loses while the middle class remains mostly unscathed. 

But make no mistake: this path is not at all painless. Every prior attempt to reduce the balance sheet has destabilized credit markets. Liquidity evaporates, spreads widen, and equities buckle. The fissures are already visible. The 30year Treasury yield is at its highest level since 2001, and bond yields across the curve are at quartercentury highs. This is occurring before any meaningful balancesheet reduction has begun. 

Warsh has already printed $55 billion since taking office in late May—hardly a tightening cycle. But his task force report, expected in early 2027, will provide the political cover he needs to begin selling assets. When that happens, the credit markets will not respond with polite disagreement. They will convulse. 

A crucial component of my model is credit spreads, because spreads reveal what insiders are doing long before equity markets notice. When spreads widen, it means the plutocrats—the bondmarket elite—are quietly selling economically sensitive corporate debt and fleeing to the perceived safety of Treasuries. The overall market appears calm for now, but the hyperscalers tell a different story. The spread between hyperscaler bonds and Treasuries is widening, and the cost of insuring against default for these companies is rising. This is the first tremor of the breaking of the credit bubble. 

AI related debt is only one segment of the gargantuan credit bubble, but it is a critical one. It accounts for roughly half of U.S. earnings and GDP growth. If these companies credit spreads continue to widen, the entire market narrative around AI, productivity, and earnings momentum will reverse violently. 

And AI debt is merely the tip of the spear. The broader credit bubble includes:

· $1.6 trillion in Private Credit

· $1.4 trillion in CLO debt

· $1.5 trillion in Junk Bonds

· $1.4 trillion in Margin Debt

· $40 trillion in National Debt

· $18.8 trillion of consumer debt, which is much more difficult to service because households have been ravaged by inflation.

This is not a bubble. It is a superstructure of leverage, built on the assumption that rates would remain near zero forever. That assumption has died, and the consequences have just started to become priced in. 

The most dangerous myth in markets today is the belief that the Fed and Treasury can easily bail out the next crisis. They cannot. Their balance sheets are already broken. The Treasury is issuing debt at a pace that rivals world-wartime financing, and the Fed is trapped between inflation and insolvency, with a balance sheet that is near $7 trillion—not the few hundred-billion-dollar level held during prior economic crises. The next crisis will not be immediately met with unlimited liquidity. It will be met with hesitation, political conflict, and delayed intervention. 

The bond market is beginning to understand this. Investors should too.

The fracturing of the massive credit bubble is not a distant risk—it is the next phase of this cycle. The data are clear, the math is unforgiving, and the policy options are narrowing. The implosion of asset prices will begin where it always begins: in credit. And once it starts, the unwind will be swift, disorderly, and intractable; with the tools that worked in the past ineffective. 

We monitor credit spreads and financial conditions obsessively and our model is positioned accordingly. We are allocated on the correct part of the Treasury curve, we own gold and the miners, domestic and international dividend payers. And, we have begun to put hedges in place (such as managed futures), which will increase and broaden these hedges as the credit market continues to fracture. The next economic and stock market downturn will not be a gardenvariety recession. It will be a repricing of leverage across the entire financial system.

The reckoning is no longer coming. It has already begun.