Over the past 150 years, US per capita economic growth has followed a remarkably steady trend line near 2% annually. That pace may look modest year to year, but its cumulative effect is powerful: it doubles living standards roughly every 35 years.

The striking feature of modern economic history is that major General Purpose Technologies have raised per capita GDP growth temporarily but have not permanently lifted the long-run growth rate.

Economically, a GPT is a technology broad enough to reorganize production across many sectors, generate complementary innovations, and reshape the economy over time. Yet no GPT has permanently bent the growth slope upward. That is why we should be cautious about assuming AI will break the pattern.

If GPTs are genuinely transformational, why does history not support the economic sunny uplands now being claimed for AI, especially when investment has reached the scale of a new Manhattan Project every year since 2023?

Lipsey-Carlaw Challenge

Economist Richard Lipsey sought to better understand GPT’s to counter Robert Gordon’s productivity and growth pessimism. Lipsey intuitively understood that Gordon’s argument argued for a return to the pre-industrial pattern of flat living standards that seemed to stand in the face of repeated technological advance that sustained economic growth.

IN the current context, AI’s pioneers argue that the technology will create a recursive feedback loop: machine intelligence will accelerate innovation, allow GDP growth to compound at unusually high rates. This impacts public policy: it would make difficult economic policy decisions less urgent.

Current optimism about AI’s potential to unlock exponential growth in abundance rests on the idea that AI acts as a force multiplier for both research and the automation of knowledge work. This argument implicitly assumes that AI can permanently raise total factor productivity (TFP) growth.

However, Lipsey and Carlaw while positive on the impact of GPT’s, nonetheless urge caution. They argue that GPTs sustain growth: they don’t permanently raise it. To see why, once the latest GPT has rendered its full transformational effects, and no more can be gained from the technology, stagnation sets in. New GPTs prevent GDP growth from converging toward zero when the gains from the old GPT has been exhausted.

Daron Acemoglu’s task-based modelling of AI’s economic effects supports this view. He estimates the likely boost to total factor productivity at well under 1% cumulatively over a decade.

Fed Chairman Warsh hit upon this point in his Jackson Hole speech contrasting today’s economic vitality with the secular stagnation malaise that had gripped economies following the 2008-2009 financial crisis.

The real growth contribution of a GPT then is that it sustains the growth process rather than accelerates it. According to Lipsey and Carlaw (2004) the focus should shift away from techno-optimism and toward a more modest role: prevention of stagnation.

That distinction matters because the AI debate is not only about technological possibility. It is also about whether governments, investors, and central banks can safely build expectations around a permanently higher growth path.

Why Do Returns from a GPT Eventually Fall Toward Zero?

AI models may be potent, but their ability to reorganize the economy and mobilize abundance remains a belief in the absence of proof.

Today’s AI driven exuberant growth expectations misread the historical impact of GPTs on growth. Classical economics shows there are diminishing returns to the capital because there is a predictable relationship between the rate of technological change and the rate of capital accumulation.

The introduction of a new technology raises the return on the existing capital stock, encouraging investment. If investment growth initially lags the rate of technological progress, the productivity of the existing capital stock rises.

Eventually, however, the capital stock expansion exceeds the rate of technological improvement so the return on capital declines.

A breakthrough technology can produce a wave of economic rejuvenation and efficiency, but history suggests that such waves are more likely to deliver only a one-time boost to per capita GDP because a new larger capital stock exceeds the opportunities to be put to good use.

In the current context, continued investment in the data centre infrastructure can be expected to deliver smaller gains in efficiency and output as it oversupplies tokens relative to demand.

More intuitively, before the AI boom, growth pessimism rested on familiar headwinds: ageing populations, constrained gains from globalisation, supply-chain bottlenecks, and an internet economy increasingly calibrated to transfer income from consumers to producers, thereby weakening disposable income growth. AI may offset these forces, but economic theory suggests that this may be its main contribution.

Some Examples from History

While today’s GPT is incomparable to steam power or electrification, it is not yet clear whether it will break from the historical pattern of eventual exhaustion. The efficiencies of the Victorian economy — an economy of physical fabrication, production, and infrastructure accumulation — were powered first by steam and then extended by electrification. But by the late 1950s, however, that economic model was on its last legs as both technologies approached the limits of innovation.

Advanced industrial economies hit the doldrums by the early 1970s, only to be carried forward by the fresh winds of the ICT revolution, which helped prevent growth from falling towards zero. The application of ICT birthed secondary inventions and new forms of economic activity that went all the way to the mid 2000s, but that wave too eventually ran out of steam.

This history puts a burden of proof on AI optimists: Demis Hassabis’s view that AI will propel us toward the singularity needs to be taken carefully. The safer assumption is that AI will preserve the growth trend rather than permanently raise it.

That matters for policy because the investment boom arrives before the productivity dividend. The result is a timing mismatch: demand pressures are visible now, while the promised supply-side relief remains uncertain.

Monetary Policy’s Timing Challenge

Current AI investment is exceeding the scale of all past GPT buildouts, which presents a genuine timing problem for monetary policymakers. The excess demand created by the AI buildout is happening now, while the supply boost has yet to come.

This creates a central bank dilemma: should policymakers raise interest rates now to constrain the inflationary impact of excess demand from the capex boom, or should they hold off in anticipation of AI’s promised supply-side benefits? The bet is that today’s boost to prices is temporary and will be absorbed by future productivity gains. That may be a reasonable observation, but the history of GPTs warns that it could go badly wrong.

Fiscal policy is also betting on a sustained increase in US per capita GDP growth to keep debt dynamics from overwhelming government finances. But if the expected growth surge does not arrive, fiscal retrenchment through lower spending and higher taxes becomes harder to avoid. More on this later.

Financial Markets vs. the Real Economy

Financial markets have already priced in much of the expected AI upside across both equities and fixed income. At the same time, recent pressure moves by Scott Bessent to cap long-term yields at politically tolerable levels suggests that investors are beginning to distinguish between the hype from the AI investment and some doubt about a durable productivity acceleration.

Evidence is creeping in that the AI hype has yet to be realized. A recent Federal Reserve research note indicates that measuring any positive impact of AI on productivity to date has proven difficult. A central challenge is determining whether labour cost savings from automating tasks are sufficient to offset the enormous costs of building the required infrastructure and the substantial demand that infrastructure places on energy systems. Are revenue expectations sensible at the current price of assets?

US Debt (Mis) Management

There are two main arms of macroeconomic policy for steering growth around trend: monetary policy and fiscal policy. Monetary policy is tasked with price stability, while fiscal policy is tasked with debt sustainability.

If fiscal policy fails to maintain debt stability, monetary policy cannot reliably deliver price stability, because fiscal disorder eventually constrains the central bank’s room to act.

Fiscal policy is clearly not under control, and capital markets cannot assume that the federal debt ratio will be stabilized while the United States remains in its current political state.

However, if AI is merely a structural defence against growth stagnation, then the hoped-for boost to revenues from higher growth is unlikely.

Capital markets will demand debt stabilization through thoughtful action that raises revenues and reduces expenditure. The farcical attempts at fiscal stabilization through DOGE didn’t cut the mustard. A negative US debt momentum is slowly building as debt is refinanced at much higher rates of interest. Long-end interest rates have reached the limit of political tolerance as the high cost of living and the falling labour share of GDP is biting hard.

Without a sustained structural increase in productivity growth toward 3%, it will be very difficult to blunt the gathering negative momentum in public debt. The Congressional Budget Office projects that public debt will reach 150% of GDP over the next three decades.

One has to weigh the optimistic view that the US can grow its way out of its deficit against the realistic alternative: genuine fiscal consolidation through higher taxes and reduced expenditure. Politically, the US currently appears incapable of pursuing that kind of sustained austerity and hoping that growth will deliver is making Scott Bessent and imprudent man.

Such incapacity is precisely what makes the other two options — financial repression and outright monetization of the debt — the more probable paths forward. Scott Bessent and Kevin Warsh are like two locomotives facing in opposite directions leaving the train at a standstill making no progress to either fiscal or price stability.

The United States, in its current chaotic administrative and political state, cannot be relied upon to deliver either fiscal or monetary stability. If AI preserves the old growth trend rather than raises it, an ever-steepening yield curve is the key risk

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The Fed’s policy decision to leave interest rates unchanged in late July was effortlessly absorbed by fixed income markets, which is just how it should be. Interest rate changes should be non-events and are so because the market knows both that central bank strategy is to deliver 2.0% inflation and how it achieves it. And we have arrived at this happy place because central banks long ago adopted transparency in their operations.

Transparency is saying what you do. Credibility comes from doing what you say. To judge any central bank’s credibility, we need to know how it achieves its goals.

While the policy decision was well received, Warsh’s stumbling press conference was met with a surge in long-term borrowing rates and his performance was largely panned. Warsh’s awkward performance can be traced to his Fed critique set out in prior writings and speeches. He has both dismissed forecasting as pointless and suggested that less communication is more, with the latter intended to restore a sense of risk balance in the fixed income market.

Prior to becoming Fed chair, Warsh had some harsh things to say about the day-to-day management of Fed interest rates but now he is Chair he finds himself boxed in by his preannounced position.

In a speech to the Group of 30 in April of last year he said, “I do not find the current Fed policy of ‘data dependence’ of much real value. We should care little about two numbers to the right of the decimal point in the latest government release.” It’s one thing to carp from the sidelines; it’s quite another to be in charge of Fed communications when forecasting is a necessary condition for meeting the inflation target.

How to Hit the Inflation Target

Delivering the inflation target of 2.0% demands a forecast of the interest rate path that the central bank believes has the highest probability of meeting 2.0% over its forecast horizon, roughly two years ahead.

How good an inflation targeter you are depends on how good an interest rate forecaster you are, and interest rate forecasting is essential because there are lags between changing interest rates and the impact on first demand (nine months) followed by inflation (eighteen months to two years later.)

The interest rate forecast is both a guide and an anchor that minimizes inflation drift from its target. Central banks do not have perfect foresight, and they will make forecast errors. But they react to those errors by revising their interest rate forecast, followed by an interest rate change – either up or down. Interest rate changes are contingent on the change in information, or surprises to your interest rate forecast.

When the market knows this operating model – or it knows the central bank’s reaction function – policy changes can be anticipated, and confidence in the inflation target maintained. The market should not be surprised when outcomes are different than forecast, but any change should be explained.

Communicating the contingent nature of policy is essential for the smooth functioning of capital markets. The smaller the magnitude of surprises, the smaller the market’s uncertainty about inflation remaining near 2.0% and the smaller the deadweight loss the economy must shoulder.

The Fed needs a forecast to do its job, but it does not need to share the details of the forecast with the market for fear of it becoming a commitment. This notion I share. But you can’t meet an inflation target if you don’t have a forecast to guide you. If you have no truck with changing interest rates in response to a changing interest rate forecast, then what is the alternative?

If instead policy is made in response to today’s inflation rate rather than the inflation forecast, then the interest rates necessary to bring inflation to target will be higher, stay higher for longer, and cause more volatility in both interest rates and the real economy.

You can see why the press conference quickly went off the rails and the bond market repriced.

Outsourcing Policy to the Market

The Fed Chair’s message was basically that after doing nothing there was nothing to say. More to the point, he seemed to say that the interest rate changes necessary to meet the inflation target had been outsourced to the market. One wonders if Kevin Warsh is the dog that caught the car.

Outsourcing inflation control to the bond market would be a serious error. The one thing that the central bank can deliver with confidence is inflation at a rate of its choosing, and it does so by moving demand around relative to supply. Too much demand? Raise rates and bring it down. Too little demand? Move rates down and give it a boost. The bond market cannot deliver low inflation with such precision, so it is not clear that the bond market is even qualified for the job.

While Warsh has definitely boxed himself in by his prior public record on communication and forecasting, one has to wonder if he understands the Fed’s reaction function. Moreover, he seemed doubtful that inflation can be controlled by moving interest rates (up in this case.) This is astonishing for a central bank governor; quite curious one might say.

Forward Guidance vs Saying What You Do and Why

Forward guidance emerged in the post-GFC world, where interest rates were constrained by the zero lower bound and the interest rate forecast was flat as far as the eye could see. Central banks wanted a flatter yield curve, and to get it they told the market that it should not price central bank tightening for some time – the next nine years, it turned out.

Forward guidance then was appropriate, but Warsh is entirely correct that its time has come and gone. But you still need to talk about the decisions you make and why you have made them when interest rates go up, go down, or do not change. If you leave a communications vacuum, someone else will fill it, often in ways that are unhelpful. Unanswered questions emerge like has the target changed, has the strategy has changed, is there is a new operating procedure?

Ending the sin of forward guidance does not demand an end to the communication of decisions.

Changes in the Distribution of Outcomes

Financial markets are important expectations processing and transmission mechanisms. So discerning the forces driving large movements in asset prices is important, especially when those forces are not driven by a change in underlying economic and financial forecasts.

The market’s reaction to the Fed decision last week was benign; it didn’t signal a change in the market’s modal or most likely forecast for growth and inflation over the Fed’s near-term policy horizon. Bond markets did react to the lack of information in the press conference by steepening the yield curve, signalling concern about how inflation is being managed.

Strangely, Warsh indicated he was comfortable with this outcome suggesting the market had stepped-in to do his job for him. This is folly because the bond market prices what the Fed is likely to do not what it should do.

Paul Samuelson suggested that a central bank looking to market prices to tell you something valuable is not useful. He called it the monkey in the mirror. When a monkey sees its reflection in the mirror, it sees another monkey, not its reflection. Warsh didn’t see a market asserting control over inflation in the mirror: he saw his performance in the mirror. And it has been a long time since inflation was at or below 2.0%

Only the central bank owns inflation control, and if the yield curve is steepening in response to a central bank governor’s comments, then the governor is in danger of losing the confidence of the market.

Growth & Inflation are the Two Big Asset Risk Drivers

Economic factors and the policies governing them are the drivers of the major trends in capital market asset prices. An emerging loss of confidence in the central bank is not a trivial issue. While it is too early to change the modal forecast in response to a difficult communications event, it is not too early to reprice the left tail in the expected return distribution.

The bigger impact on all asset prices comes when the modal forecast changes. This is now a risk that needs to be taken seriously, as beyond the communication challenge a three-person dissent in favour of higher interest rates is a big deal. This divergence of opinion should have been explained.

Interest rate decisions are still made on the weight of FOMC votes, but whenever interest-rate decisions are made they should be explained regardless of whether the decision is up, down, or no change.

Data lead words and words lead action. What data led the three dissenters to their vote? Why did others not share their concerns? Why were potential questions not anticipated, and why were responses not prepared? These are questions the Chair should have prepared for in his G30 speech he indicated indifference to changes in data.

In isolation, this monetary policy disturbance doesn’t change the most likely outcome; it merely shifts perceptions about both the probability and scale of a potential loss of inflation control priced in the tails. But it still matters.

Policy Slippage & Asset Repricing

Central bank independence has been a stabilizing force when the independence of other institutions has withered in the heat of politics. Chipping away at Fed independence threatens a sizeable repricing of a US economic regime or superstructure, one that would deliver a significant destabilizing repricing of the modal outlook well beyond tail repricing.

The dominant asset pricing risk factors are growth and inflation and are common to all asset prices. Just as successful central banks need to be good forecasters, successful investors also need to be good forecasters. They don’t need to be perfect, just good. This means that investors need to have a handle on what the next move in asset prices might be, and if the Fed isn’t doing its job well then the repricing could be big.

Before we position for a big modal forecast change, we have to determine whether Warsh’s awkward communication was by design or accident. Does it signal a major change in strategy and tactics, or was it a rookie mistake?

Diversify & Derisk

Given that long-run asset return correlations that underpin mean-variance optimization are unstable, and that asset return volatilities are unequal, the shaky ground underneath US inflation targeting in the context of stretched asset values suggests it’s time to diversify and potentially derisk as a way to recognize a fattening in the left tail of the return distribution.

Adding alternative inflation-protection assets helps compensate for one of the key risk factors – inflation – but it leaves you exposed to growth. Seeking returns to uncorrelated risk factors helps, and structuring downside protection is worth consideration if it can be done cheaply.

Emotional, chaotic, and extractive trade policy has shaken but not stirred the foundation of the US$, and US policy errors will continue to be transmitted globally limiting the diversification advantage of non-us asset markets.

Monetary Regimes fit the Moment

Global-macro investment opportunities come when investors get ahead of a change in consensus pricing. Price changes lead the changes in market forecasts because investors adjust to the change in their assessment of the probability distribution of outcomes by prepositioning to capture the coming change in the consensus. The central forecast thus changes in response to investor actions led by price action.

Monetary regimes come and go over time, and it is highly likely that inflation targeting will give way to a different regime at some point in the future as it may not meet the moment. The catalyst may well be failure to deliver inflation at target—and neither all-items CPI nor core CPI has been at or below 2% since March 2021, even if the Fed’s formal target is defined in terms of PCE inflation.

Inflation targeting continues to meet the economic moment but there is some doubt whether it meets the political moment. Some commentators ascribe Warsh’s rudderless press conference to his subordination of policy communication to the satisfaction of Donald Trump.

Faith is belief in the absence of evidence, but can one have faith in the Fed to deliver 2.0% in spite of the evidence? It would be reassuring if you believed the Chair misunderstood the appropriate reaction function and would soon learn. But if he doesn’t, then does he have a new regime in mind other than inflation targeting? In a world of creeping fiscal dominance, this is no trivial question.

The Here and Now

Any new central bank governor faces a challenge. Typically the question is whether in the policy transition the policy leaves with the man or woman. That challenge would easily have been put to bed by nudging interest rates higher to bring inflation back to target, with a clear message communicated afterwards.

Inflation at its 2.0% target is becoming an ever-smaller dot in the rear-view mirror and on current price trends, sustaining inflation credibility will demand action.

One swallow does not a spring make, but Warsh needs to understand the difference between forward guidance and his role in explaining management of the current conjuncture. If you aren’t crafting the narrative, then someone else is. And that can be costly.

Inflation is always and everywhere a monetary phenomenon. So argued Milton Friedman. But inflation does not proceed in an orderly way. The Irish-French economist Richard Cantillon showed that money injected into an economy does not raise all prices simultaneously; its effects flow unevenly through product markets over time at different rates.

Similarly, when a relative price shock is large and persistent, it affects other prices with a lag, sometimes long after the initial shock has faded. Wary of Friedman’s observation, central banks must manage the most recent energy price shock despite the uncertainty over the lag between the shock and its eventual impact on economy-wide prices. Their tardy response to delayed action in 2022 shows the necessity of acting on a forecast rather than waiting for confirmation.

The 2022 inflation process was complex, stemming from the combined COVID disruption to supply chains and the impact on energy prices from Russia’s invasion of Ukraine. We relearned that a price shock in tradable goods spills over to non-tradable service prices following a process that can extend for years after the initial shock dissipates.

Central banks have long known that the larger the negative supply shock, the more likely it is that they must raise interest rates to contain second-round effects. The more central banks do up front, the less monetary pain they inflict later. The longer they wait, the more they must hold rates above the level the real economy needs to prevent inflation expectations from rising. Once the pain starts, the more the pressure builds to ease-up before inflation is put back in its box.

There is unfinished business from the 2022 break-out from the 2.0% inflation era, especially since survey measures of inflation expectations remain about 0.5 percentage points above their pre-2020 level.

The Fed arguably eased interest rates too early in the fall of 2024, and here we go again. Investors must be alert to how the long tail of commodity-price inflation it works its way through to other prices with persistence.

What is the evidence for the long tail from commodity prices to broader inflation?

The disruption to oil and natural gas exports from the Persian Gulf has driven up not just energy prices — the worst of which has for now eased — but also related raw materials derived from oil and natural gas, including fertiliser, sulphur and helium, all of which are inputs to food production and manufacturing.

The AI boom has already lifted microchip prices, raising costs for consumer electronics and gaming hardware, while helium shortages have constrained chip production. Add to this disruption China’s reduced supply of tungsten, which has prompted a 300% surge in the price of tungsten hexafluoride a precursor gas in microchip production. Japanese gas producers are warning that they may suspend production, underscoring the breadth of supply-chain disruption across other regions and products.

As for the commodity price tail, CME Group’s Mark Shore shows a strong correlation of about 0.68 between changes in the Bloomberg Commodity Index and PCE inflation from July 2010 to November 2024. As the shock passes through distribution chains, the correlation rises to 0.78 against total PCE and 0.85 against core PCE non-durables after a lag of three to five months. The proof of the pudding will soon be in the eating.

A more interesting, and more alarming, finding from Lapo Bini at UC San Diego shows that supply-chain disruptions can add to pressures as they generate negative price dynamics of their own, extending and amplifying the initial commodity-price disturbance.

Using data provided by global shipping companies from 2014 to 2026, Bini shows that constraints along distribution chains — such as port stoppages and other obstructions, including China’s willingness to restrict the supply of rare earths and other commodities — compound the pressure from the initial energy shock.

Bini argues that these frictions accounted for 45% of the post-pandemic consumer price increase in 2021. Moreover, that effect had not fully dissipated before the Iran conflict began, so we should be wary of concluding too quickly that this inflation scare is over.

Central banks relied too heavily on stable inflation expectations to absorb the inflation shock after a long period of price quiescence. They underplayed the impact of supply-chain disruption and the lockdown-induced labour market disruption, treating inflation as transitory.

While price changes in the year before the 2026 energy shock were benign, all is not well in inflation management given higher average rates of inflation and unsettled inflation expectations.

The ECB has been the first to signal caution, which is hardly surprising given the hawkish German Bundesbank was its antecedent. The ECB is sensitive to the risk that, while tradable-goods prices absorb the initial shock first the shock to non-tradable goods, services and wages, is coming so they are following their forecast rather than waiting for confirmation.

Lags matter, will surface, and need management as non-tradable services can take up to a year to pass on. Commodity-price pressures may soon recede, but higher input costs likely already been paid by the non-tradable sector especially where domestic firms have no alternative suppliers.

Bad timing

Inflation remains well above the 2.0% target in most countries, sitting in the top half of the 1.0% to 3.0% target range that approximates a 95% confidence interval. Between 2000 and 2020 inflation in most inflation targeting countries tracked 2.0% closely so stabilizing inflation expectations at target. The inflation process was predictable, so inflation expectations were almost bang-on 2.0%. More precisely, US all-items inflation averaged 2.1% annually and 70% of all monthly changes lay between 0% and 0.4%.

After the start of 2021, however, 70% of all monthly changes were greater than the 0.2% consistent with the inflation target, as the price change distribution shifted to the right taking the average up to 3.9%.

Core inflation experienced an even larger shift, with 75% of the distribution showing monthly changes above 0.2%, lifting core inflation from an annual rate of 2.0% between 2000 and 2020 to 4.1% after the start of 2021.

Today’s data suggest that, while monthly price changes were easing and moving towards the pre-COVID average at the start of this year, the reversion of inflation to its pre-COVID stability was incomplete.

Inflation management was poorly positioned to absorb the current exogenous price shock and maintain confidence that inflation would return to the 2.0% target without intervention. Inflation has still not returned convincingly to the 2.0% rate needed to stabilise expectations, and consumers and producers are nervous, even if investors and savers are more confident.

We should be wary, as there is likely some unobservable price tension between tradable and non-tradable goods that is on the verge of spilling into the open. Holding benign expectations for future inflation and downplaying the need to lean into potential inflation is a big bet. The ECB has shown the way, and the Fed appears to be taking the risk more seriously.

There’s a new sheriff in town

Central bank independence is under pressure in more populist and emotional times, but investors have benefited from politicians outsourcing inflation control to central banks. The bargain is simple: the public grants central banks operational independence on the understanding that they will deliver price stability. For that outsourcing contract to be honoured, central banks must keep inflation on target.

Kevin Warsh has made clear how he wants to put an anti-inflation stamp on the Fed. Yet his dismissal and ridicule of economic forecasting suggest a misunderstanding of inflation management under an inflation-targeting regime.

To be a good inflation targeter, a central banker must be a good forecaster. To meet the target and minimise inflation variance, interest-rate decisions today must be based on a forecast of where inflation will be tomorrow, not merely where it is today. Lags in the inflation propagation mechanism demand the best possible forecast: the central bank cannot wait until inflation is visible before managing it.

Alternatively, Warsh may be signalling a quiet retreat from inflation targeting altogether in favour of something more amorphous, something less well defined. That would leave investors searching for the inflation picture in the speckled brushstrokes of Degas rather than the clean lines of Piet Mondrian.

Central banks, as the outsourced inflation manager, must manage inflation for us -- but if they fall short then we will have to manage it ourselves. And, if we do not know what Warsh’s target is, then we must build-in a margin of inflation protection for ourselves, redirecting return seeking assets to less efficient and potentially costly inflation protection.

Two Bald Men and a Comb

Argentine literary figure Jorge Luis Borges framed the Falklands War as a fight between two bald men over a comb. The image has aged well. The longer the United States and Iran contest the Persian Gulf, the more it will cost the rest of us — and the cost is already being measured not just in lives and matériel but in a variety of economic forces that are slowly building momentum to push core inflation higher.

There is some confusion about which price index is the central bank’s target: all items inflation or core inflation? The target is of course all items inflation, but frequent references to core inflation are made because core inflation is the better predictor of future inflation: if core remains well behaved then all items will converge to core. But at what level?

Since the outbreak of hostilities, oil prices have almost doubled, and while they have recently retreated, supplies are tight and, without the resumption of Gulf supplies, prices are likely to rise.

More consequential for inflation control than the initial oil price spike is the fact that oil prices remain elevated. Markets continue to believe that the shut-in supply of energy and related products will resume once rationality takes hold. But questions of sovereignty do not follow the logic of commercial profit maximisation: one side is focused on survival, the other on dominance. The priors of the trader are not the same as the priors of the politician.

The swing in inflation risk was priced from the very start of this conflict, and interest rates have not just unwound expectations of central bank easing but have swung to tightening. The interest rate market is sending central banks a message they have heard but not yet heeded.

This Is Not COVID

The inflation shock induced by COVID lockdowns and the resulting supply chain disruption saw stagflation concerns rise to become top of mind, a concern that proved to be misplaced. While supply chains have been disrupted again, we should be less certain that inflation can be easily tackled.

COVID inflation was the product of two forces operating simultaneously. The first was excess demand: governments paid people to stay at home, so they could still consume but had nothing to produce so creating excess demand. Second, supply chains could not keep pace with the surge in demand when lockdowns lifted, triggering a necessary relative price adjustment — prices spiked, signalling to producers to increase production to satisfy shortages.

Inflation required monetary tightening because short-term 2% inflation expectations were disturbed and threatened to push medium-term inflation higher as well. This had to be contained. Even though the major central banks were slow off the mark, they managed to contain inflation within the inflation range (usually 1% to 3%), but not at target.

The inflation-control balance today is both more complicated and more dangerous. Inflation has not returned to target, and the fiscal trajectory is simply out of control, with a deficit close to 7% of GDP at full employment. The fact that inflation is already above target cannot be ignored. And the new Fed chair, Kevin Warsh, is untested but is sure to be pressured to ease interest rates in the face of a negative supply shock of extended duration. The margin for error in inflation control is considerably narrower than it was in 2022, as inflation expectations are not as well anchored as they were four years ago.

From Auction Prices to Contract Prices

The risk of higher-than-expected inflation now depends on duration: the longer the energy supply disruption lasts, the more likely it is to feed into core prices and the harder it will be to reverse if inflation expectations become unanchored.

To see why, it helps to look at the flexible and sticky price indexes estimated by the Federal Reserve Bank of Atlanta. They show how a change in relative prices can spread into many other prices. Flexible prices have surged to 5.6%, while core sticky prices have not yet responded as much as one might expect, though they remain elevated at 3.0%. That is still nowhere near 2.0%.

Flexible prices are those repriced frequently, for example durable and semi-durable goods, commodities, and all inputs whose prices are set in auction markets, which respond rapidly to new information. Sticky prices are essentially service prices, such as consulting and transportation contracts, long-term energy supply agreements, insurance premiums, and eventually wages. Contract prices are negotiated at intervals and follow sustained increases in auction-market-determined prices with a lag.

Oil price swings have been highly sensitive to the stream of announcements, reversals, and strategic ambiguity emanating from Washington, and they will move sharply on any credible signal that the Strait of Hormuz will reopen. But an insurance underwriter at Lloyd’s of London, trying to price shipping risk through a contested waterway, cannot rely on that signal alone.

Cargo routes are being rerouted. Marine insurance rates are being renegotiated. Long-term transportation contracts whose terms were set before the Strait closed are now coming up for renewal in an uncertain environment — and uncertainty reliably commands a premium.

Auction prices filter into contract prices slowly. Even if a relative-price increase later reverses, the contract repricing it sets in motion can continue. That is why an oil price increase caused by a persistent negative supply shock tends to push core inflation higher with a lag.

Given that the supply potential of the Gulf has remained constrained for three months, it is now only a matter of time before the future becomes the present and core inflation begins to tick up. Some of the repricing now underway in shipping, other transportation alternatives, and insurance will remain with us six, nine, twelve, and twenty-four months from now — long after energy spot and futures markets have repriced as supply constraints ease.

It’s Inflation, Not the Vigilantes

The sell-off in the long end of the yield curve is widely advertised as the reprise of the bond vigilantes, out to slay wayward sovereigns. Or so the debt fanatics announce with glee.

Some weeks ago we outlined the dangerous state of play in sovereign debt dynamics: debt-to-GDP ratios are now very high across most industrialised countries. Most important is the narrowing gap between financing rates and nominal GDP growth. The long period of low policy rates kept that gap favourable for management of debt dynamics. For most countries other than the United States, the path to fiscal stability is steep but still navigable — though only with political pain.

The steepening yield curve is a welcome signal to sovereigns to find some fiscal discipline, but it is not deliberate. Rather, the long end is more likely pricing the uncertainty around when and by how much central banks will be forced to tighten. A new Fed chair of undemonstrated convictions, under political pressure to ease interest rates, and the sharp rise in consumer inflation expectations measured by survey data are all signaling unease about monetary management and whether it is free to react.

The longer central banks delay showing their hand, the more the yield curve will steepen — and the more likely it is that those hoping for the bond vigilantes to punish profligate sovereigns will be vindicated.

Understanding the signal and intent from the bond market is important. The debt fundamentalists consistently misunderstand or ignore the fact that sovereign debt is not household debt. They can’t go bankrupt. A sovereign can always print money to extinguish a nominal obligation — at which point investors exchange an interest-bearing government IOU for a non-interest-bearing one.

The real debt constraint is not insolvency but the political economy of rising interest expenses crowding out fiscal choice. Poor monetary management will embed an additional inflation premium in interest rates, compounding the rate of debt growth and stressing all asset markets.

The debt fanatics understand the effects of fiscal indiscipline even if they confuse cause with effect. Their language is dramatic, but their fear of what high debt can bring is well placed. We should take no comfort from today’s fiscal fragility and the vulnerabilities created by fiscal mismanagement. Default is not the threat; financial instability is. The risk of another financial crisis is growing.

The Equity Market’s Binary Future

Equity market values are eye-wateringly high, signaling eye-watering levels of risk, but investors buy into tech stocks on the grounds that both today’s and tomorrow’s earnings growth justify the risk. Maybe. If so, then value remains good and the risk of loss low. If future earnings don’t show, then value is bad and the risk of loss high. The CAPE is just 10% below its high of 44.2 in December1999, and the equity return after that was -3.7% over the ensuing ten years.

Moreover, additional vulnerabilities accompany the current moment, namely the troubling self-funding dynamics between the hyperscalers and the semiconductor manufacturers; some correction in that complex will surely come.

For now, the equity market is happy to blow away the froth and take that risk, but it is ignoring the signal coming from the bond market. As the 2008–2009 financial crisis unfolded, corporate bonds priced the risk earlier than the equity market. This time around, corporate bond spreads are near their lows even as the sovereign bond market signals trouble. If the inflation risk goes unmanaged as it did in early 2022, all assets priced to the sovereign will be in for a rough ride.

A Good Crisis Should Never Go to Waste

There is significant political pressure on the US administration to find a face-saving exit from the Persian Gulf conflict, necessary to restore the 20% of world oil supply flowing through the Strait. While we should remain alert to the risk that a supposedly transitory inflation shock becomes a stubborn inflation process, a clean end to the conflict will likely rein in the surge in long-term rates. But the danger is that this episode will be written off as a near miss, with no lesson learned. Yields may not pull back quickly to their pre-war levels.

The bond market is signaling that a fight is brewing between monetary and fiscal policy which could spill over to a painful and difficult struggle for dominance. The longer central banks wait to show their cards, the more expensive the inflation remedy becomes, and the more difficult will be the serious work of stabilising debt dynamics.

The bald men’s fight over the comb is a sideshow — the fight we should be having is over inflation control, and the bond

AI and the End of Work: Complement or Substitute?

The end of work is the policy question of our times. Every general-purpose technology in history has seen work not only survive technological change but thrive. But AI is unlike any new technology that has gone before it.

The question that matters — will work survive? — is one our institutions have yet to ask. If we don’t ask the question and prepare to manage the change already wrought, then the existing economic processes that distribute the economy’s income will cease to work. It is better that we continue to share the gains than fight over the losses, so we need to get ready.

We owe our current high living standards to technological change. And, and we would do well to remember how technological change hauled most of humanity out of poverty before we succumb entirely to AI anxiety.

Britain, the first industrial country, saw its economy grow 115-fold between 1700 and 2002[1]. Australia grew 4,000-fold. Canada — not ordinarily given to boasting — grew an astonishing 8,000-fold. Poverty-level subsistence for most of human history gave way, through successive waves of technological disruption, to the prosperity we now take entirely for granted.

But history also counsels patience. Electrification took seventy years to deliver its full economic promise. The ICT revolution took forty. Both created enormous dislocation along the way. The difference this time is speed. AI is being integrated into work processes before we have had time to absorb what it is, let alone what to do about it.

The Jevons Paradox

AI is a general-purpose technology, one that fundamentally changes every aspect of economic and social life, as the steam engine, railways, electrification, and information and communications technologies did before it. What distinguishes a GPT from a merely useful invention is its pervasiveness: it reaches into every corner of the economy and rewires how things get done.

English economist Stanley Jevons, born in 1835, showed us something that still holds: any technology that lowers the cost per unit of output, and becomes widely available, should produce more output at a lower price. Demand increases, and employment rises. This is the Jevons Paradox — the counterintuitive finding that efficiency gains tend to expand activity as demand rises rather than merely substitute labour for machine.

Lawyers are finding AI’s effects on hourly rates a challenge for law form partners as it disrupts the long standing sweatshop partnership model. Like educators, lawyers need to respond to an unstoppable technology and develop a new organizational model. We should anticipate lower-priced legal services will allow those currently excluded by price into the market for legal services. Even though prices fall, capturing lower priced volume could be a winner for those who grasp the Jevons Paradox.

Manufacturing unions were tamed in the 1980s are professional unions next? Don’t hold your breath when the regulators are primarily lawyers.

The fear of automation is nothing new. It has accompanied every major wave of technological change and has, so far, never been vindicated at the aggregate level. Technological change has created more jobs than it has destroyed, and new jobs that our predecessors could not have imagined. Total employment in existing job titles in the United States in 1940 was roughly 50 million. Many of those titles still exist and still employ around 50 million people — but another 100 million jobs now exist that no one in 1940, or even 1990, could have foreseen.

That is the record. But the record has its limits as a guide, and AI is testing them.

Two Forces, One Reckoning

The early inventions of the industrial revolution identified two effects that new technologies exert on the labour market. Economist Daniel Susskind calls them the complementing force and the substituting force, and the distinction is everything.

The Spinning Jenny, developed in 1760, transformed cottage-based yarn spinning into a factory industry, raising production, lowering prices, and stimulating demand. It was a complementing force — it made workers more productive, not redundant. The Jacquard loom of 1805 was something else entirely: a paper program fed into a loom that automated complex weaving patterns, allowing the unskilled to do the work of the skilled on a mass scale. The Jacquard loom was a substituting force.

The history of automation is a history of tension between these two forces and their effects on the labour market. Complementing tools — nail guns for carpenters, MRI machines for radiologists — augment the value of human expertise and raise the wages of those who use them.

Substituting tools — GPS for taxi drivers, to take a pointed example — commoditize expertise. The black cab drivers of London once spent years memorising the city’s maze of streets, sitting oral examinations to demonstrate they knew the most efficient route between any two points. That knowledge had market value. It no longer does.

We need to be honest about where we are. In the United States, wages in production occupations fell by almost 8% between 1960 and 2015 as manufacturing tasks were computerised and handed over to robots.

According to David Autor, general labourers saw wages decline by 6% per year as disruption took hold. Those subject to the complementing force — doctors, lawyers, financial professionals, technicians, executives, and managers — saw their wages rise between 2% and 6% annually. The labour market is not a neutral actor in the face of technological gains. It distributes the impact of change unevenly, and the net effect on both the quantity and quality of jobs, whether created or destroyed, is determined by which force dominates.

The AI reckoning is already underway. Recent research by Goldman Sachs shows that firms deploying AI as a substituting force — cutting costs, eliminating job postings — are doing exactly that. Firms pursuing the complementing force are capturing productivity gains and hiring. The Jevons Paradox is playing out in real time, but in two directions simultaneously. Old businesses need new people who can execute new tasks. Many companies are now hiring AI natives rather than investment bankers and CPAs, recognizing the future that the Jevons Paradox portends.

What Is Different This Time? The End of Polanyi’s Paradox.

Of the many tasks we execute, we do most of them effortlessly — and we cannot articulate how. We cannot define rules for how we tell a joke, what makes a good cook, and how a seasoned analyst smells a flawed argument before the numbers give it away. If we cannot specify the rules, we cannot program the task. Until now, Polanyi’s paradox has not been challenged.

However, AI is different because it learns autonomously from unstructured text. Large language models produce output that bears no resemblance to rules-based programming. AlphaFold determined the folding structure of proteins — a problem that had eluded structural biologists for decades — without being programmed with any rules for how to do it. Based on amino acid sequences previously beyond our ability to interpret, the implications for drug discovery are profound.

This phenomenon is genuinely new. AI can encroach on tasks that prior automation could not touch, across multiple occupations simultaneously. Economists call this task encroachment — the chipping away at processes within a given job, rather than the elimination of specific jobs altogether — and the breadth and depth of AI’s potential encroachment have no precedent.

The industry talks about “agentic AI,” a term designed to excite executives about substituting AI for headcount. But it is the wrong framing. A more accurate description is delegative AI: a tool that shortens the distance between intent and outcome, and one that will become as ubiquitous as Microsoft Office is today. With great respect for all who have helped me in the past, AI is the best research assistant in my career. An assistant that finds not just the source, but the paper, the paragraph, and the sentence containing that nugget of data and analysis to prove the hypothesis.

Whether it is truly intelligent is a separate question, and one worth contemplating. Give AI every piece of information available in the late eighteenth and early nineteenth centuries and it will not produce Einstein’s theory of relativity. It is, for now, a very sophisticated chauffeur: it will drive you to the data and the analysis, but it cannot create what is yet to be created.

The Policy Lag

Global polling by Ipsos finds that citizens in the United States, Canada, Britain, and Ireland are significantly more anxious about AI than their counterparts in Asia. Some observers suggest the anxiety is less about the technology itself than about what corporations will do with it — and with those whose jobs it displaces. That is the right question. It is also, conspicuously, the one that policymakers have yet to contemplate: the impact on the labour market at the macro level.

Labour markets are the mechanism through which national income is distributed. In aggregate, some 65% of national income flows to workers; 35% to capital. The labour market also determines what we contribute — through taxation — to the public services that underwrite our standard of living: health care, education, income support. If the substituting force dominates and labour income declines, those services may no longer be financed through conventional means. The fiscal arithmetic of a high-substitution AI transition is one that no government has yet attempted to model, let alone define a response to.

The answer is not to protect jobs, but to ensure the survival of work. Policy must guide AI so that work is preserved. We must have sustained investment in education and training, job transition income support, and a renewed commitment to competition policy that prevents the gains from AI from accruing exclusively to the hyperscalers and their shareholders.

Canada, which has observed what raw economic power can deliver when deployed without constraint, should understand better than most why that commitment matters.

And What of the Here and Now?

AI technology stocks are powering ahead. Unlike the internet crash of 1999 to 2000, equity prices are rising to capture earnings that have, so far, consistently outperformed expectations.

The AI infrastructure buildout is structurally similar to those faced by investors in late nineteenth-century railway expansion and the late twentieth-century internet infrastructure boom. The risk is that AI repeats the past and that revenues arrive too late to sustain the debt necessary to build it.

And there are markers of trouble, notably the self-funding dynamics between the hyperscalers and the AI hardware manufacturers. Some correction will come, leaving a capital overhang and debt that cannot be serviced. Much of the debt sits with investors rather than the banking system, which limits the risk of a financial crisis — but economic growth will take a hit as losses need to be distributed and taken.

The worst real economy outcome relative to expectations — observed by economic historian Adam Tooze — is that AI proves not to be a GPT but something more like the airline industry: a useful technology that builds a useful industry but on which investors find it difficult to make much money.

Expectations of the bounty from the universal adoption of AI are behind this year’s price momentum, but the muted market response to Nvidia’s recent upside earnings surprise suggests the bar to ever higher prices has been raised. Financial-market overshoots are common in momentum and carry trades, but they rarely end until expected gains give way to expected losses. The gap between them is likely narrowing.

Financial markets are discounting mechanisms, and they can offer a weighted wager on future economic outcomes. One signal that the market is placing more weight on the complementing effect than on the substituting effect as AI works its way through the economy would be a shift in the driving investment style — from momentum to value.

Stay tuned

Many sovereigns sit at the precipice between “manageable” and “precarious” debt balances —especially the United States and the United Kingdom. The debt-to-GDP ratio is the base upon which debt compounds, and GDP is the proxy for the sovereign’s ability to raise revenue.

A high debt ratio is bad enough, but if it is accompanied by a primary deficit – revenues less expenditures before debt interest costs – the combination can be deadly for fiscal sustainability. The US has a primary deficit of 4.0% of GDP and an expenditure gap between revenues and expenditures equal to 9% of GDP, by far the biggest in the G7. It has got away with it because it is the world’s reserve and payments currency, but this privilege is being eroded.

This is not comforting, as a joint adverse setting for these two variables primes the fiscal system for a shock. What ignites the powder is higher interest rates and lower growth. And today’s negative supply shock might spark the powder.

The debt ratio is less an indicator of future default, and more an indicator of future inflation because a sovereign can always print money to redeem its debt when in difficulty. Of course, as this exchange approaches, investors are aware they would be exchanging an interest-bearing government IOU for a non-interest-bearing IOU so they tend not to wait around. The speed at which a high and rising debt ratio can overwhelm fiscal and inflation management should not be underestimated.

Just because a sovereign won’t resort to default, doesn’t mean there are no constraints. When markets are quiescent, persistent primary deficits will drag the debt ratio up, but there is no market pressure to rein-in over-spending. Eventually a rapidly rising debt ratio and a primary deficit left unattended causes debt interest costs to crowd out other expenditures. Rising debt interest costs eventually force higher taxes, lower spending, or some combination of the two, and the primary deficit closes. But often in adverse circumstances.

The Nitty-Gritty: Four Variables That Matter

The rate at which the debt ratio changes is determined by the interaction of four variables: how fast the economy grows, the rate of interest paid on the debt, the prior year’s debt ratio, and the primary balance.

The intuition is straightforward. This year’s debt ratio rises (or falls) roughly by the difference between the financing rate and GDP growth, scaled by last year’s debt ratio. For example, if last year’s debt ratio is 100% of GDP, the financing rate is 4%, and GDP growth is 3%, then the debt ratio rises by about 1 percentage point. Reverse the gap— a financing rate of 3% and GDP growth of 4%—and the debt ratio falls by about 1 percentage point.

Primary balances matter because they add or subtract from the debt ratio directly. If debt momentum reduced the debt ratio by 1.0 percent ,and the primary deficit was 4.0%, then the debt ratio would rise by 3.0%. A favourable interest rate -growth is nice to have but it is negated if there is a persistent primary deficit.

Debt momentum is currently benign, but it can quickly turn malignant in difficult circumstances. If interest rates rise and GDP growth slows, debt momentum adds to the debt ratio, and this force is amplified by the primary deficit: the debt ratio can quickly soar.

As the debt ratio rises, interest rates will go up to absorb additional debt (which now goes to meet the interest rate bill) GDP will go down. A vicious circle takes hold of ever higher interest rates and ever lower growth. Investors demand still more compensation, and the compounding accelerates.

The rising interest premium is not a debt default premium, rather an inflation premium. The market assigns greater priority to the levying of an inflation tax rather than a rational fiscal consolidation through higher taxes and lower expenditure.

Adjustment in these circumstances is hard. Persistent primary deficits – that built the debt in the first place -- result from an inability to forge a political consensus around the need for sound fiscal management which cannot transcend political belief and priorities. It takes a crisis to find political consensus for austerity.

The Market’s Quiet Warning Signal

The risk that negative debt momentum may kick-in is currently a tail risk. Just look at the term premium – or the compensation demanded by investors for holding long-term bonds instead of rolling short-term debt.

Back in the early 1990s, when bond markets worried about, and priced protection against, inflation the term premium was substantial. The US is the world’s most important sovereign borrower, and in April 1992 the term premium was 252 bps, inflation was 3.2%, and the debt ratio was 48.3%. Today, the term premium is 65 bps, inflation is 3.3%, but the federal debt ratio is two-and-a-half times higher at 125%, and the US has imposed a negative supply shock on itself and the rest of the world.

While today’s term premium has risen from its -65 bps 2020 low, the market has not fully discounted the elevated inflation risk embedded in the precarious US debt and deficit position. Moreover, persecuting the Chair of the Federal Reserve at a time of economic instability, and the absence of a meaningful risk premium in US interest rates, is playing with fire.

Emerging Markets Are Also Vulnerable

Fiscal vulnerability is not limited to advanced economies. The IMF’s most recent blog flags the fiscal risk facing middle income and poor countries from a new food and energy price shock when the scars of the 2022 energy and food price shock remain unhealed.

The emerging world is vulnerable as the energy price shock becomes quantity scarcity. Much of Asia’s oil and LNG comes from the Persian Gulf. Thailand sources almost half of its energy needs from the Gulf; South Korea about a third; India and Vietnam about a quarter. In the first instance, incomes are first pinched by the rise in energy prices, immediately followed by a second hit as food prices rise.

Food is roughly one-third of the CPI basket in poor countries, about one-fifth in middle-income countries, and around one-tenth in advanced economies. Governments seek to contain the political instability that comes from food-and-energy price shock.

The 2022 shock damaged vulnerable county fiscal positions and shrank shock-absorbing buffers. They have not yet fully recovered. The Fund’s policy instinct now to advocate fiscal discipline is familiar, warning of the fiscal damage that may come from preserving social and political peace by sheltering households today at the expense of households tomorrow.

Em and low-middle incomes have lower debt ratios and smaller primary deficits yet the Fund fears the negative debt and currency management challenges for middle income countries that come from adverse terms-of-trade shocks (higher energy prices). Fiscal adjustment can be wrenching if shocks are large, real interest rates can soar and currencies depreciate catastrophically.

But like advanced economies this remains a tail risk. Many EM countries have built up large US$ reserves to provide self-insurance against interruptions to capital flows—but those reserves are finite, and poorer countries cannot outbid richer countries for long when global energy supplies become scarce.

Lucky Canada

The punishment from long neglected fiscal imbalances and devastating debt momentum in the advanced world comes from Canada’s 1990’s experience. At the end of the 1980s, Canada sought to head off a cyclical rise in inflation, running around 5%, and then lower average inflation to 2%. This ambitious objective was viewed with some scepticism by financial markets.

A trend tightening in interest rates began in 1987, with three-month interest rates rising from about 9% at the start of 1988 to a peak near 14% in early 1990. Then the trouble began.

Knowing that monetary policy works with a lag, and with its inflation objectives in sight, the Bank of Canada eased interest rates in 1990 as a mild recession loomed. But markets were not confident that cyclical inflation was truly tamed, or that the 2% objective would be met.

The market responded negatively and jarringly. The C$ dropped dramatically and interest rates surged undermining the Bank of Canada’s ability to manage inflation. The Bank backed off and held interest rates too high for too long to shelter the currency at the expense of growth.

This opened the Pandora’s Box of negative debt dynamics. Debt service costs surged: the interest rate on the debt rose to 10.3% while nominal GDP growth shrank to 3.6%, leaving a gap of 6.7 percentage points. The debt ratio took off. Even though Canada funded its expenditure from taxes and ran a primary deficit, debt interest costs overwhelmed any attempt to manage either fiscal or monetary policy.

As the market moves much faster than policy, stabilization demands a large reduction in expenditure to get the markets on side. While this eventually happened, it took almost five years to achieve. The chart shows that even a primary surplus of 2.0% of GDP could not stem the magnitude of debt momentum, which required huge primary surpluses to overcome.

As a small open economy Canada got lucky, and the fiscal adjustment was relatively painless compared to expectations. NAFTA gave Canada access to US demand, the C$ depreciated significantly, and real interest rates plummeted by 500 basis points. Export demand filled the demand gap created by fiscal contraction (which was about 5% of GDP) and growth resumed as interest rates fell so negative debt momentum was blunted.

You Wouldn’t Start from Here

The menace of potential negative debt momentum today comes not from today’s interest-growth differential, but high debt ratios and serially wide primary deficits. Markets understand how devastating debt momentum can be and how quickly it works against you. If GDP growth turns down, negligible debt momentum can quickly become significant. Debt compounding can become menacing with unsettling speed.

Large sovereigns do not enjoy the same escape route. Canada was lucky, the UK less so. The U.K.’s experience with austerity in the 2010s is a cautionary tale. As a much bigger economy, and being a relatively open economy, the UK could not rely on exports to offset the economic drag from fiscal austerity. And Brexit worsened Britain’s terms-of-trade making it even harder. The NBER estimates that Brexit cost the U.K. 8% of GDP, vital support that would have eased its fiscal austerity.

The United States retains the exorbitant privilege from reserve currency status and dollar dominance in international payments, but bullying and intimidating trading partners will surely undermine its privilege. US activity in the Persian Growth gives some evidence this is already the case. Some investors have moved away from US Treasuries and instead accumulated supranational dollar bonds that allows them access to US$’s but avoids exposure to the quixotic US government liability.

We Are Not Well Positioned

When debt momentum turns against sovereign issuers, markets can reprice sovereign risk much faster than sovereigns can respond, putting them on the back foot. Credibility takes years to build and lost in an instant. The world’s major sovereigns are not well positioned to absorb the pressures coming from the US, upending of thirty years or more of trade and security stability in the face of a second energy and food price shock just four years after the last.

The war in the Gulf is far from settled, and the market is already separating the weak from the strong sovereigns. The market now prefers supranational dollar borrowers to the US state, and the market has singed out the UK, France and Italy as Europe’s troubling sovereigns[1]. Emerging markets are not immune.

We have been warned, and if fiscal contraction is coming, no one will get off as easily as Canada did in the 1990s – including Canada itself.

[1] We have discussed the dangers of fiscal dominance in previous essays, and we are about to see how stressful this can be as illustrated by recent bond performance of the BIF’s: Britain Italy & France who have experienced a big increase in funding costs on the commencement of the Iran-US-Israel War.

The coexistence of high inflation and high unemployment through the 1970s was miserable, giving birth to the misery index the sum of these two variables hitting a high of 21 in 1980. Sitting at 7 today things aren’t yet miserable, but emotional policy making in Washington raises the stakes that a measure of misery may yet come.

Stagflation arose from pre-oil price shock flaws in policy making which tried to trade-off higher inflation for lower unemployment which did little more than ratchet inflation and inflation expectations up. When the oil price shock arrived inflation took off. We are in a better position today as decades of inflation targeting leaves us with the knowledge, tools, and experience to manage an unwelcome surge in inflation that is close to the 2.0% target and inflation expectations are better contained than they were in the early 1970s.

Today’s shock is big, and we can’t rest on our inflation control laurels and do nothing so we need to know what kind of shock we have.

Oil price increases can be supply or demand driven. Negative supply shocks move inflation up and GDP down so the two move in opposite directions, this is the pattern of the 1973 & 1979 oil price shocks. Demand shocks move the oil price level up and GDP up so inflation and growth move in the same direction. This we observed in the early 2000’s following China’s rapid economic expansion.

Today we can rule-out a demand shock, what we need to get to grips with is whether the oil price increase is a temporary or persistent shock as there are much different inflation management implications.

The chart shows what taking-out twenty percent of global supply, which can neither be rebuilt quickly nor satisfied elsewhere, will do to prices. The short-run supply curve moves to the left (S₁ to S₂) and prices double ($60 to $120). While supply may fall below the 100 MM barrels a day needed to power the globe, the price does not capture a long-lasting loss of supply as the market has bet supply will roar back at the end of hostilities (despite production infrastructure damage in the Gulf.) This is today’s bet.

However, if the conflict escalates and supply potential is destroyed, then the long run supply curve shifts left (LRS₁ to LSR₂). The price could easily gap to $200 and beyond. This is devastating for inflation control and global growth as monetary policy will have no choice but to tighten and tough-out the ensuing recession until the inflation shock has been contained. It won’t be pretty.

The crucial management issue is the duration of the price shock-- is it temporary or persistent? If oil prices go back to their pre-war level in a matter of months then this year’s inflation will be next year’s deflation. Some of the price increase will get into core – all items inflation less food and energy and the better predictor of future inflation – but it will not be sustained. Core and all items inflation will converge at a slightly higher rate than before. This may require a monetary response – either no more easing or even a small tightening -- but it won’t be a major interest rate event.

In contrast, a permanent increase in the price of oil will first raise all-items CPI inflation, which will dissipate once the oil price settles at the new and higher price. However, all-items and core are more likely to end up at a higher rate, above the 2.0% target. And, past modelling shows that core will continue to drift up. This is not what the central bank wants to see nor where it wants to be, as a sustained and higher rate of inflation in the presence of unchanged nominal interest rates, will deliver an unhelpful passive easing in real interest rates.

CPI inflation can both settle in at a higher rate compared to the pre-shock level and also build upward momentum that would require a response.

Look Out for Forecast Errors

Monetary policy decisions are based on central bank forecasts of which interest rate path is most likely to keep inflation on target two years from now. Prior to the conflict, the Fed has been on hold since December 2025 tilting its risks to the downside. Rates have been on hold likely because inflation has not returned to 2.0% in the post Covid period and that any easing would only have come on a downside forecast surprise. That no longer seems likely.

This is the biggest and fastest energy price shock since 2022 and is rivaling the 1970s. First comes the price response and then the supply scarcity which is now mere weeks or days away. I am old enough to remember speed limit reductions and car-free Sundays in the Netherlands as scarcity’s bite was felt across the globe.

The Covid-era supply-chain disruptions showed us how quickly the market can respond to price changes. Supply chain managers showed they can regroup and redirect supply relative to bottlenecks. But producers also learned how to respond to price signals, suggesting that the pass-through of higher energy to core inflation may be faster than anticipated.

Food prices, already stressing consumers from the surge three years ago, will quickly rise. Fertilizer price increases have already been reported just as the spring planting for summer growth is underway. More to the point, it takes between seven and ten calories of fossil fuel energy to produce and distribute each single calorie of food consumed in advance countries.

Finally, the use of algorithmic pricing is increasingly widespread so the speed of price changes will be both fast and asymmetric, meaning prices go up the elevator but will come down the escalator. Price persistence will be a key feature of this supply shock.

The inflation of 2021-2023 was a wake-up call to central banks, who misjudged how much excess demand was in the system as economies opened-up after the Covid lock-down. Large wage increases necessary to restart domestic service economies collided with large relative price changes necessary to restart supply chains. A relative price change that was seen as temporary became an economy-wide price change, and inflation rose far above expectations that required central bank tightening to contain.

Central banks were late to the party and they won’t make that mistake again. The US in particular is in a very difficult position, as post Covid US inflation has remained well above 2.0%. Energy prices are rising at 6.3% on a year-ago basis and food is rising at 3.1%. Pre-shock, one-year ahead, inflation expectations were 3.6% in February and they are very sensitive to energy prices. They are likely substantially higher than the 2.4% ten-year break-even inflation rate. Consumer and investor inflation expectations are diverging.

It is tempting to think the Fed can “look-through” the oil price inflation shock as a one time increase in the price level. However, this is unlikely to be the case today. The Fed’s favoured inflation measure, the core personal consumption expenditure index, was running at 3.1% at the start of the year. Pre Covid, core good price inflation was -1.0% on a year-ago basis. It temporarily surged to 8% on lockdown reopening, ending up at about -1.0% again in 2024. However, we are back to positive 2.0% again. Years of goods price deflation was a key offset to core service inflation of 3.0%. And, it is likely that the 2025 tariffs have yet to feed into PCE inflation.

Today’s initial conditions are inconsistent with a do-nothing Fed stance. It, along with others, has learnt from the Covid experience that even a temporary shock requires action to ensure it remains temporary. Key today is to contain a rise in inflation expectations which have not fully converged to the 2.0% inflation target. It’s better to start with short-term interest rates at 3.50% than 0.25% but this is no assurance that inflation can be contained at the current interest rate.

Look Out Below

The market has concluded that a presidential tweet-storm is the equivalent of a ceasefire treaty and is again looking for easing into the end of the year. Please, call me Casandra. Permanent energy price shocks have a long tail. For example, higher diesel prices are transmitted immediately but it takes time for higher energy prices to raise the cost of making a truck.

US self-sufficiency in oil does not insulate it from the impact of a higher global price of oil. The price impact is immediate and the cost response is lagged. First, transportation demand for oil in a country as vast as the US is inelastic, so income is transferred from consumers to producers. Oil producers and shareholders both have a smaller propensity to spend. This should do some of the adjustment for the Fed, especially since the labour market is already weak. But its likely not enough.

Lower income cohorts will experience an unjust measure of pain. High income households are sustaining consumption from their gains in wealth, but this will be at risk given the transfer of resources to a more concentrated group of oil producers and shareholders. More importantly, if all equity markets experience a significant drawdown that is not offset by the higher profits and the share prices of energy producers, then GDP growth will inevitably slow. This is a plausible risk.

We don’t know at what oil price the growth versus inflation trade off frees the central bank’s hand. Central banks are not going to pre-emptively tighten, but if we start to see inflation higher than expected, and more persistent than expected, then rates will go up and growth will go down. The lesson from the 1970s was don’t ease into lower-than-expected growth until you are sure you have met your inflation objective. The AI crowd will cry foul arguing that its expected productivity gain will absorb the inflation shock. Again, it is better to be surprised positively rather than negatively: you can always lower rates later.

Debt Deficits and Momentum: What Could Go Wrong?

Lots. Neither fiscal policy nor monetary policy is starting from a good place to tackle the potential inflation challenges from a prolonged negative supply shock. Debt dynamics could see deficits and debts absolutely explode as interest rates climb and growth dips, constraining policy makers ability to soften the blow to demand and employment. Bond markets did discount some of this risk with those economies most at risk suffering most.

Debt dynamics are not well positioned to cope with rising sovereign financing needs which will rise as higher interest rates meet lower growth, primary deficits, and high debt ratios. If this risk case is realized, the outcome will also not be pretty.

The October 2025 IMF Fiscal Monitor presents some pretty disturbing data. The US and the UK are estimated this year to have gross debt ratios, the base on which debt momentum builds, of 133% and 105% of GDP respectively. Both countries are running a primary deficit of 4.0% and 1.0% of GDP and a revenue vs expenditure gap relative to GDP of 9% and 4%.

Markets have not fully priced-in this danger and are underappreciating the potential level of equilibrium real short-term interest rates needed to contain the potential inflation that may take the entire yield curve higher.

Diversification Benefit? What Diversification Benefit?

Everything we own is a discounted cash flow and many asset prices are vulnerable to drawdown, which might gain momentum in light of the financial leverage in the system. Diversification doesn’t work for you if bonds and equities both decline, which is what happens when the equilibrium interest rate re-prices at low interest rate starting levels.

A simple 60:40 asset mix of equities and bonds helped in the face of equity drawdowns in the 2010s. There were about five notable S&P500 corrections between 2010 and 2020 where the S&P500 declined in a range between 15% and 35% and UST’s rose in a range of 5% and 25%. So diversification helped. However, between January 2022 and October 2022, when monetary policy tightened to lift the equilibrium rate of interest higher, both the S&P500 and US Treasuries declined by about 15% as there was no diversification in this simple asset mix.

In this world investors likely won’t receive much of a diversification benefit if real short rates must rise but instead need some downside protection – an obvious trade is to buy short break-evens -- especially if ugly debt dynamics get a grip of the bond market.

There is a lot to play for in the next six months, and bad debt dynamics may become top of mind.

I’ll deal with that interesting dynamic in a week or so.

Wither the Indispensable Market?

The US economy, once considered to offer the indispensable market in a highly globalized economic and financial system, is showing signs of wear. This is traced to unsustainable fiscal policy, predatory behaviour towards friend and foe alike, a casual disregard for the law, and an emerging domestic economic system based on tribute. Its growth is slowing and is increasingly vulnerable to a shock that may not be easy to stabilize.

US economic growth surprised on the upside through the middle of 2025 but began to peter-out at the end, rising just 2.2% on an annual average basis a fall of about half a percent over 2024. Core inflation continued to decline from its peak in 2022 but remains stubbornly 0.6% above the 2.0% target.

US GDP growth is narrowly focused, propelled mostly by personal consumption driven by just the top 20% of households. In contrast, the AI data centre boom is assumed to be a strong add to GDP growth, but in actuality it contributed just 0.4% to growth in the year, all of it traced to ICT investment. ICT investment added less to growth than commonly held largely because so much of what sits in data centres is imported. Finally, non residential construction subtracted from growth in the year. If there is an AI boom, it is mostly in equities.

The US economy has very little breadth, leaving it with little to fall back on should consumption growth slow. The economic airplane may be flying high, but one air pocket could easily put it dangerously close to the ground, and if you are flying low you best not hit an air pocket.

The smaller than appreciated boost from ICT spending was examined in a note by the St. Louis Fed, which showed that while growth in ICT software and data centre construction was substantial, it was dwarfed by the sheer relative size of consumption. In its assessment, the St. Louis Fed showed the ICT spending surge actually peaked in Q1 and drifted down thereafter.

Labour isn’t working

The labour market stagnated through the year and seems unaffected by robust consumption and AI investment activity. Despite the surprise January increase in employment, the underlying tone is weak. Flow in and out of the labour market has ground almost to a halt and sits at pandemic lows. Labour market lassitude signals, at least for some, more interest rates reductions to come. But it is not clear whether this is enough to move the Fed given that inflation is above target and the expected boom in AI driven productivity is yet to be apparent.

The labour market may be less influential in interest rate determination, short of a recession, because rising income inequality has concentrated income and wealth growth in the top 20% of households. This makes the US economy less sensitive to changes in employment related income.

Since 2019, the top one-fifth of households have experienced a cumulative income gain of 20% before taxes and transfers, mostly driven by realized capital gains. This highlights the growth exposure to changes in the wealth of high income households. Even if employment were to shrink and equity prices continued to rise, the subtraction from growth given employment shrinkage would likely be too small to push the economy over the edge and prompt a round of interest rates reductions. Rather, the risk to GDP growth is a reversal in asset prices.

Inequality raises risk

The trend to higher US inequality has favoured the top fifth of households, and the financing of US consumption from wealth gains is traced to rising equity prices. The two top drivers of economic growth, consumption and ICT spending, are joined at the hip. Growth in net worth is driven by tech equity prices, and expectations of future gains to non-tech equities from the adoption of AI feed the overall equity market. Tech stock growth has been more volatile of late, and the wide dispersion in equity prices is consistent with investors picking winners and losers in the AI disrupted tech world. Major indices are struggling to make headway and are likely warning of potential investor and economic trouble ahead.

On the flip side of income, wealth and consumption concentration is the four-fifths of US households account for about two-fifths of the economy, depending on who’s data you use. Research by the Dallas Fed shows that the top quintile of households accrue 60% of income, own 71% of net worth, and account for 57% of total consumption. The rest of the economy must get by with 40% of total income and a claim on just 29% of the country’s net worth.

The Dallas Fed researchers conclude that the US economy today is much more sensitive to a reduction in the return on assets held by the top income quartile than to a widely distributed loss of labour income growth from a broad-based economic slowdown.

Just as the arrival of AI and its impact on equities is boosting the income and wealth of the top fifth of households, it is suppressing the welfare of the bottom four-fifths. AI driven job displacement is generating a labour market undertow, with skilled and unskilled workers pushed onto the back foot as corporate executives view AI as a tool enabling headcount reductions to boost profitability rather than deploying AI as a productivity and income enhancing tool.

While substitution of AI for labour may give a sugar high to non-tech stocks, it could result in a significant increase in the duration of unemployment for those with few assets to fall back on. This is likely – along with the stubbornly high cost of living – behind the low level of consumer confidence.

The dangers of belief to assumption setting

AI driven structural transformation will not change the economy overnight, and AI any related productivity gain will likely be hard to detect. And, such a profound shock will redistribute productive resources causing more near-term distress than long-term happiness. Resource transfer associated with general purpose technologies is asymmetric in both incidence and time to completion. The firms going down can collapse overnight, but the firms that replace them take time to emerge.

The introduction of a new general-purpose technology initially reduces productivity before it boosts it, generating a persistent and strong growth undertow for some time. This reduces demand in tandem with supply potential. The economy will appear weak as this transition completes and is unlikely to take inflation down with it as no effective slack is opened up. If productivity fails to expand, and the economy does not open up a large measure of slack, then it is hard to be assertive with monetary easing unless inflation trends unexpectedly downwards.

The US economy is now overexposed to an equity market claimed by a minority of the population. With the bulk of the working population experiencing either no income growth or declining income growth, and with inflation well above target, there is little to support demand if high income households experience capital loss.

Belief in a positive view on an AI productivity growth boosting demand and economic growth and lower inflation, one that can accommodate lower interest rates, is pollyannish and inconsistent with the stylized facts of the impact of general-purpose technologies on economies.

Consider, if the trend rate of growth is higher, then the economy should be able to support a higher real interest rate even if inflation converges to target. If growth is already on the higher trend path, and there is no slack in the economy, then there is little case for lower interest rates. Hence the Fed’s cautious approach that infuriates the current administration.

With the lower end of the central bank’s interest rate target at 3.5%, and core inflation (the better predictor of future inflation) at 2.6% the real rate is roughly 0.75%, a bit too low given the current distribution of growth and inflation risks. Two-percent inflation would deliver a real rate of 1.5% which would be a more comfortable position to either trim rates a bit or sit and wait for the AI boom to show itself. But it’s not here yet.

The signature of a positive supply shock is higher than expected growth and lower than expected inflation. Two quarters of strong growth – Q2’s 3.8% and Q3’s 4.4% are like an early sighting of swallows: they do not a spring make especially when winter reappeared with a 1.4% rate of growth.

GDP growth came in close to its 2.0% trend in 2025, consistent with labour productivity growth of about that magnitude. The immigration clamp-down limits the growth contribution from the labour force, so expectations of a rise in trend GDP is riding on AI delivering on productivity sustainably above 2.0%. Again, we aren’t there yet.

Cutting real interest rates can do little to support 80% of the economy’s earners who sustain just 40% or so of consumption, most of it likely non-discretionary. Fiscal policy is redistributing even more income from the bottom to the top, so this might help prop-up upper end consumption growth for a bit.

Positioning for lower interest rates is really, over the short-term, a bet on the fortunes of those at the top of the income heap, who in turn rely on buoyant asset returns to sustain consumption. Given dystopian levels of income inequality, and the productivity miracle a wish and a hope, the best the US economy can seem to do is trend growth carried by the top of the house.

From indispensable to dispensable market – not quite there yet

The AI complex of inflated growth and near-term productivity expectations, extreme income inequality, entrenched and large fiscal imbalances, the drift away from the rule of law and at the mercy of tribute crony capitalism leaves the US highly vulnerable to a major financial or economic shock, and with it the potential for capital flight.

Sceptics will point to the global scramble for cash following the US-Israel attack of Iran has been dollar positive, signalling that the US retains it ability to be a shelter for cash in a global risk reduction. However, it is not clear whether the run-up in the US$ was capital seeking shelter or a wider de-levering of dollar positions on risk reduction. The implied interest on US ten-year bond yields rose 15 basis points to 4.11% suggesting that we should be circumspect concluding the dollar jump reflect a flight to safety.

The weakening structural foundations of the US$ makes it vulnerable to a combustible mix of reactive politics and heterodox economic policy. This combustible mix and has twice moved the US$ against expectations in the past year, suggesting that the US is making the transition from the indispensable market to one increasingly best avoided. Time of US driven stress has seen the US$ move down against a simple model of interest rates and equity market volatility instead of up, as shown in the chart below[1].

Most investors have yet to exit the US market, instead hedging their exposure and directing new investment elsewhere. But the time is coming when the US authorities will likely have to use an already unsteady fiscal policy to stabilize their economy.

They may find that after extorting and bullying friend and foe alike, this will neither be easy, painless, or cheap, and the dollar will be a key adjustment variable more likely to move down rather than up and with it interest rates.

[1] Steve Kamin proposes modelling the US$ on three explanatory variables: two-year US yields, the slope of the 10yr-2yr yield curve and the VIX.

The Five Stages of Grief

In 1969’s On Death and Dying, Elizabeth Kubler-Ross developed a framework to track the emotions that follow a profound personal shock that shakes one’s existential core. She identified five stages of grief in the face of impending death. Anger, denial, bargaining, depression and acceptance.

In the geopolitical context of economic and security relations, the subordination of US foreign policy to the needs of one man’s ego has upended our economic lives and undermined our collective security. While we are not facing death, the shock is existential enough to put us on the Kubler Ross emotional path.

The five stages of geopolitical grief, shared most acutely by US neighbours Canada & Mexico but also Western Europe, come in no particular order. But, they are bookended by the anger instilled by levying tariffs against allies and acceptance that the world has permanently changed by the threat of military force against European allies to take Greenland.

Anger. Canada and Mexico were on the front lines of tariff threats and felt betrayed having invested significant resources in production integration with the United States. Canada was first to feel Trump’s menace with the threat of annexation and political integration into the United States.

Second denial: “it won’t happen.” Many felt that American threats of economic destruction were merely well-known maximalist negotiation terms. Third, bargaining (that became appeasement) or throw Trump a bone, take the hit, and adjust to the change of terms. Fourth depression, on the realization that meeting one demand merely encouraged even more outrageous grift. Finally, acceptance that the repeated game of escalation dominance would not end. With just about every taboo broken by the US, it was time to take a stand.

Cometh the Hour

Being closest to the action, Canada walked the Kubler-Ross ,path in a mere six month’s from Trump’s election. After his election, Carney moved immediately to acceptance, drafting and initiating a plan to diversify away from the US both economically and politically, flying first to Paris and then London. He didn’t waste time on being angry or depressed, nor did he bargain as a supplicant. He acted, and now the Europeans have joined him and are prepared to act in the face of rupture.

However, there is a big gap to be filled between here and there. Luckily for Canada, expansion of an oil pipeline to the Pacific coast has brought much needed earnings to paper over some of the economic loss incurred elsewhere, and to provide resources to build for the future. But if Trump follows through as USMCA expires Canada will be in trouble. As usual, the C$ will likely decline to cushion the blow.

Europe is in a much stronger position than Canada, and has a lot of fire power if push comes to shove. The US relies on the EU for almost 20% of its economy’s intermediate inputs, yet the EU relies much less on the US -- half of that amount. More to the point, Europe provides high value precision inputs to the US that it could neither produce nor immediately find anywhere else in the world.

The Europeans have been reluctant to exercise this leverage given its defence integration with the US through NATO. But Trump crossed that line in pursuit of Greenland, so now the Europeans feel that despite the pain it is time to draw a line.

TACO – fact or myth?

True to form, in the face of push back and the recognition of a powerful foe, Trump backed off his threat to invade Greenland (for now) taken aback by the addition of a few hundred Danish and European troops to the Greenland garrison, in what looks like area denial.

Financial markets also responded negatively to Trump’s belligerence, confirming the market’s bias to discount Trump’s menace as noise until it looks a bit hairy.

While many believe in the power of the market to deliver a TACO, and the so-called Fed put on equity markets, these are myths. The Fed makes policy for the economy and inflation not the equity market. While Trump does back away from maximalist action to match his rhetoric, he still creates damage. The market has some impact, but only to limit Trump’s most extreme threats.

What comes with this TACO is not salsa, but Smoot Hawley tariffs: some chickening out. And, once tariffs are in place they are hard to remove. And once you cross the line and threaten a NATO ally, NATO is not the force it was. Ironically, it is likely to remake NATO into a Europe+Canada alliance which in time would be formidable.

Trump blinked because he got a glimpse of Europe’s power. Patronizing beliefs towards Europe shared among Anglo chauvinists ignores the fact that Europe is rich, and while its productivity growth may be small, its productivity level is high. The European military area denial raised the stakes, got Trump’s attention, and got under his skin, But it also made him think twice because in the end all bullies are cowards.

Predictable Surprises

A predictable surprise is a disaster that is known to be coming yet still takes those who could have acted to prevent it by surprise. Many anticipate that the end game of Trump acting on his grievances will be costly, but clear warning signals are ignored because the cost of preparing now is immediate and the consequences are distant. So those that can act often choose to hope for the best rather than prepare for the worst, as we saw prior to -- and subsequent to -- the financial crisis of 2008-09.

This past week’s TACO confirmation should not lead to investor complacency. The risk of a predictable surprise is great in this game of global brinkmanship. Real damage is being done and will be done.

The US is very exposed financially and economically to push back from those it threatens. Threatening economic prosperity is one thing, and capitalist economies can adapt quickly as Finland’s recovery from the collapse of Soviet Russia in the early 1990’s attests. But threatening another country’s sovereignty is quite another and is asking for a fight. Repeated coercion will not be tolerated by countries with agency.

If nothing is off the table in Trump’s exercise of US power, then no one’s US$ denominated assets are safe. The less liquid the asset, the more costly it is to protect . Even catastrophe aware investors move slowly to protect their investments. And, even if some actors want to act, vested interests often prevent a predictable surprise from being extinguished.

Monopoly Returns are Hard to Give Up

When you hedge a future risk you have to quantify the risk and time it right. Too early and you are out of the game and hit with opportunity loss. Too late and you can lose it all. Markets are good at pricing short-term “cross-sectional” risk – or relative-value risk -- but they are not good at pricing long-term structural uncertainty. Someone is going to get hurt.

The US has a monopoly over many global services, especially in tech firms whose financing is underpinned by the value of the US$ as the global payments currency and global reserve asset. An end to this arrangement could be costly if ignored. Ask the market to price the erosion of the US$ as the global payments currency, and the response is “there is no alternative”. Ask it to price-in fiscal dominance and the response is “the Fed is independent”. The risk is thus rationalized and essentially ignored. Investors want the global monopoly rents the US has captured, but it doesn’t want to incur the cost of protection.

Few manage catastrophic structural risk at all, so the potential cost of failure builds. The rot in the US financial system was ignored prior to 2008-2009. It could have been managed with tighter regulation and closer financial system oversight but was not. The stabilization costs to clean up the mess were enormous.

The long-term is made up of the sum of short-terms, so long term risks can be managed one adjustment at a time to stay in the game and minimize the clean-up cost of the predictable surprise when it arrives.

Market action ahead of Liberation Day and Davos did see hedging of US assets creep in, and surprisingly so for many the US did not attract safety capital as the crises grew. Unlike the financial crisis and Covid-19, US treasury yields increased by more than any other peer country (other than Japan which is struggling to adjust to the recontracting price now that inflation is higher).

The dollar fell against most currencies, and gold surged by 4.0% . US thirty-year bonds rose by almost 8 basis points prior to Trump’s Davos retreat, higher than Canada, Germany the UK and France. This is not the normal pattern.

Markets are terrible at pricing structural change in one fell swoop, and investors hope that a sharp shock from the market will constrain Trump. But it is easier to buy into a myth than it is to price and execute on the basis of counsel, logic, and rational argument.

Be prepared for the predictable surprise.

Europe Barks Back

The trust between the US and Europe has been shattered. Leveraging the security relationship in an attempt to dominate Europe over Greenland has generated blowback. Withholding US military support for Europe is the trump card for sure, but Europe’s financial leverage over the US is substantial now that it has been played.

First, Europe holds US$ 300 more in US fixed assets than the US holdings of European fixed assets. Across the world FDI exposure sums against the US by about US$ 1Trn. Secondly, the US owes Europe and Canada about US$ 3.7 Trn in debt. About 42% of that is owed to government with the private sector holding the balance. Japan’s holdings are US$ 1.2 Trn and adding-in other major Asian countries sees this climbs to US$2.4 Tr.

The Greenland fiasco has reawakened the sell America trade. China is commonly believed to be the marginal seller to be feared. Yet China is not the largest holder of US Treasuries, far from it. China is the third largest holder at US$ 683 bn behind Japan and the UK at US$ 1,207 and US$888.5 respectively.

Willingness and Ability

The single biggest issue for any creditor is the willingness and ability to pay its debts. Depending on the kindness of strangers is never a good place to be. Absurdly, the US is making strangers of friends, potentially putting it at the mercy of strangers when it will most need their help – in a crisis.

Carney’s Davos speech incensed Trump and his acolytes by telling it as it is. Given a now overriding sense that the world is ready to face down US coercion, I am frequently asked if I think aggrieved parties will sell their US Treasuries following the old saw “don’t get angry get even.”

An emotional response is not in the interest of the holders, as it will blow back equally on them. Keynes observed that the bigger the loan the bigger the problem for the bank. The US is the borrower and foreign holders the bank. But that doesn’t mean that the lenders are powerless.

Contrary to the belief that the US$ will remain the global reserve currency because there is no alternative, other countries do not have to buy US Treasuries even if the market is deep and liquid. Euro debt markets are increasingly deep, and the Euro is the payments currency within the Euro area. There is absorptive capacity in the Euro debt sovereign market should European countries decide to reduce their US dollar exposure. There are always alternatives.

The US debt market is deep and liquid, and those characteristics are valuable if you trust the borrower’s willingness and ability to pay; but if you have doubts, then you might want to go elsewhere.

As the world disengages from US trade and finance, demand for US$’s will decline. Given that US financial markets no longer behave as the indispensable market in times of stress, the more challenging it will be for the US Treasury to fund its deficit both affordably and effortlessly.

The markers of deteriorating US Treasury demand are found in such metrics as the bid to cover ratio, an indicator of demand strength. To date there is no indication of a break from trend, and sudden surges in the ratio tend to accompany periods of acute stress. And while there is no shortage of stress emanating from Washington, the market is becoming inured to bluster and threats that do not eventuate. Yet non-resident investors routinely take down10% of all US bond auctions, and the danger to efficient and affordable financing for the US because escalation dominance goes too far is not trivial.

A bond auction is unlikely to fail because primary dealers are obliged to take-down an auction, but if their share of future auctions is trending-up then this signals declining investor participation.

Economics and finance theory tell us that it is the marginal (or last) bond sold that matters for price determination. Given Washington’s behaviour, and the sheer size of the annual deficit, US willingness and ability to honour its obligations should be questioned as a matter of course.

Acceptance Is the End of Appeasement

Momentum is a well-known investment strategy, one that investment firm manager AQR asserts has behavioural origins. Investors do not suddenly react to new information as they tend to adjust to news and pattern changes slowly. But they adjust.

When we reach Kubler-Ross acceptance, we can move on. Countries have agency and Canada has laid down the marker for where we are going. The US won’t feel it immediately just as the Brexit shock took about ten years to become apparent. But the 8% loss in UK growth potential has clear and negative consequences for living standards.

Small but incrementally large financial change is underway. Bond giant Pimco has signalled it is diversifying away from US Treasuries despite being a US firm. The Danish pension fund manager AkdemikerPension has liquidated its US$ 100MM Treasury holdings citing political risk. As acceptance of the rupture gains momentum, others are likely to follow. Great power games can be expensive in treasure and lives, and Trump has been shown the limits to military power even if you are the most powerful on earth.

Trump has made his decision to lever US dominance. The world didn’t want to believe it and tried appeasement to minimize the consequences, which only encouraged escalation. But with acceptance comes adaptation. The rest of the world is moving to protect itself from America through disengagement from what it has become. This will have negative consequences for all. America can no longer rely on its friends, and to fund its debt it is now at the mercy of strangers.

The New Year has got off with a bang, especially in Caracas, but Washington’s policy making and execution is performative rather than strategic making the US the nexus of policy uncertainty. So it is no surprise that the Economic Policy Uncertainty index remains elevated, but what is surprising is that market-based measures of risk remain quiescent in the face of policy ill discipline.

Over half of US economic growth in the past year has come from investment in AI infrastructure, and the sheer scale of investment presents significant downside risks to both financial stability and economic growth if the AI profitability hype goes unmet.

Beneath the financial calm lurks growing concentration of risk in public equity markets, and the voracious capital appetite of AI scaling is now reaching into debt markets.

Take up of AI applications by the non-tech private, and the broad public, sectors has tailed-off. AI applications have been sold as prediction and decision tools that enhance operational decision making, adding to both top and bottom lines. However, AI’s capacity to do so is a function of the data on which LLM’s have been trained. When confronted with the real world, AI’s ability to meet expectations has fallen short. Having laboured for many hours early in my career estimating behavioural equations for the UK government, those models can fail miserably when confronted with new data.

One response to improving AI capability has been to capture more training data and this requires more computing infrastructure to do so. Unprecedented AI investment expenditure has been funded mostly by the strong balance sheets and cash flows of the so-called AI hyperscalers[1].

Risk Concentration is Growing…

The expectations of super profits from AI and the investment activity this has stimulated is likely well ahead of itself. Yet to date the underlying assumptions remain intact, and no counterfactual data has emerged to mount a compelling challenge even as the number of subscriptions for AI services remain few and prices are inadequate to support the competitive investment in infrastructure.

The growing value of tech stocks – both the Magnificent Seven and other tech firms -- now make up close to 50% of the S&P500’s market capitalization with tech in total valued at 100% of GDP.[2] Moreover, the Magnificent Seven have experienced a 30% increase in earnings-per-share in the past 12 months compared to just 5% for the rest of the S&P500. How can the rest of the economy both adopt AI given weak earnings growth and feed Tech profitability expectations?

According to the BIS, the PE’s of Magnificent Seven stocks are a lofty 30 plus, withe other tech stocks much higher at 55 with the remainer shouldering a PE at a relatively high 28. With such concentrated equity and sovereign risk, institutional investors have systematically reduced their exposure to US equity markets by $200 bn in the past nine months.

Retail investors showed no such circumspection, increasing their exposure by $150 bn to take up the slack from institutional investors. Retail investors are much more likely to focus on returns alone and as serious momentum investors they pay little heed to the quality of returns despite warnings of drawdowns and the potential bursting of the AI hype.

And Migrating to the Debt Markets

The sheer scale of future investment – by some estimates up to $5Tr in the next five years – will require debt financing[3]. Some 60% of hyperscaler capex is funded from operating cash flow, but companies need cash to operate safely so future financing will surely come from accessing debt markets increasing enterprise leverage.

Debt financing of AI rose rapidly in 2025, and AI related debt issuers now make up almost 15% of JPM’s JULI IG corporate bond index, higher than the normally dominant position occupied by banks. For now these issuers are rated at about A- but leverage is creeping into the AI hyperscalers balance sheets.

And exposure is seeping beyond public capital markets into the private space, and ultimately into the banking sector. Private credit and venture capital investors are active either as GP’s or as agents providing off-balance sheet financing vehicles for hyperscalers who want to present relatively clean balance sheets.

Leverage has driven much of the value created in the private space, and this requires bank lending. Banks are in the game, but they like to securitize this debt to avoid regulatory capital loads so some AI financing is being packaged in CLO’s and CDO’s and sold to investors. This sounds familiar to those who watched the financial crisis unfold in 2008-09.

Circular Financing Opacity & Complexity Risk

Complexity and opacity were central features of the financial crisis. As loss awareness grew through 2008-09 capital markets became increasingly illiquid because players did not know where the bad debt was, how big it was, and who would be short of liquidity and thus potentially insolvent. Lenders and investors were unable to identify who held the losses and whether transactions between counterparties would transfer losses

John Taylor of Taylor Rule fame coined this the Queen of Spades problem, drawing on the dynamics of the card game hearts[4]. Players incur a significant points penalty if they are left with the Queen of Spades at the end of the game. And in this financial game of hearts, there was more than one Queen of Spades!

Today, the Queen of Spades is not bad mortgages, but potentially the debt financing of AI processing data centres that may prove hard to carry if sufficient revenue is not forthcoming. Diseconomies of scale are increasing operating costs, and usage of tech production capacity is well ahead of the rest of the economy. Electricity is in short supply with some centres unable to connect to the grid. Portable diesel generators are in short supply, so in all costs are beginning to rise as revenues have still yet to meet frothy expectations.

Today’s complexity centres on the circular financing arrangements between Nvidia, Open AI, Oracle, Microsoft and CoreWeave -- just to name a few. Not only are the arrangements complex they are opaque. If losses in any financial component or funding structure emerge, the market will want a more clear picture of cross-company and systemic structures than they can currently see.

Pressures released in the 2008-2009 financial crisis were amplified by the leverage and liquidity mismatch across the system. This prevented levered investors and lenders from managing their losses, even if they could identify them. The system was unable to cope with the forced deleveraging and seized-up.

In their analysis of this phenomenon, Brunnermier and Pedersen isolated the dynamics of the leverage-liquidity mismatch which delivered a downward asset price spiral.[5] As the collateral channel closed on lower asset prices, many investors could not raise cash to margin their positions so were forced to liquidate and take a loss.

If the scale of any negative information shock is large enough, financial markets -- and in quick succession the economy – enters an illiquid equilibrium and a margin spiral that can crystalize investor losses even if the asset is ultimately money good. This dynamic could easily emerge in the current environment.

What Could go Wrong?

Sustaining the valuation of the AI hyperscalers and startups relies on the capture of future cash flow that meets lofty expectations. The bar is already high but consider the potential financing needs to keep the momentum going until cash starts to flow. Revenues to date are estimated to be about 10% of cumulative investment. That’s OK but likely not enough.

Many companies that now dominate the tech sector burned through billions of dollars before they became profitable. Amazon burned $3bn and Uber $30. However, open AI is expected to burn through $140 bn by the time 2029 rolls around so a potential cash gap could easily open-up. Funding the AI computing power necessary to meet expected demand likely requires $2Tr in revenue by 2030 – and at almost 7% of US GDP there has to be more than hope to get us there[6].

So what could go wrong? The viable and strong cash flow business models of today’s tech businesses have assured investors that comparisons to the dotcom boom and bust 25 years ago are unwarranted. But expectations today could easily be disappointed.

AI has been sold to end users as a prediction and decision tool to boost top and bottom lines but the investment frenzy to date is partly due to the fact that today’s LLM’s have fallen short of expectations. Predictions are only as good as the data AI is trained on, and decisions have not always been positive for those sold on the hype. This flaw is now well known and is contributing to the slow pace of AI adoption relative to expectations. Results have been disappointing.

Corporate leaders have talked- up the potential for a substantial share of labour income to be redirected to capital from job displacement. But past expectations for tech substitution of labour, and anticipated cost savings, have run into the automation paradox where jobs were added rather than destroyed as new technology is deployed.

Geoffrey Hinton’s call for the medical profession to no longer train radiographers has proven wrong and there are now more radiographers than ever. Even as AI is an impressive radiographical tool, its power is helping doctors make the right diagnosis but it hasn’t replaced them.

Economic Risk that Matches Financial Risk

The AI boom is concentrating downside economic risk just as it is concentrating financial risk. AI related capex spending is crowding-out non-AI economic activity. Over half of US growth in the last year has come from AI investment in infrastructure. Spending on information processing equipment is expanding at 20% on a year-ago basis with other business and residential construction spending at a standstill.

AI crowding-out of the rest of the economy renders the whole economy weak, making the economy less able to absorb any sharp pull-back in data centre and other AI related investment expenditure.

Successful penetration of AI into the real economy to support bloated profitability expectations would minimize fears of financial instability. Yet this merely trades financial risk for economic risk as broad adoption of AI would stimulate structural change both shedding labour and rendering some businesses obsolete so destroying capital. Depending on the scale of the shock and implied losses could create a damaging economic undertow retarding economic growth..

Financial Instability is Growing but State Resources are Constrained

Arresting the economic downturn generated by the 2008-2009 financial crisis required significant state resources, leaving all advanced industrial countries with a permanently higher debt ratio and rising debt interest charges. Bringing resources forward in time through debt restrains future prospects.

In the 2008-09 financial crisis the US raised debt of $1.9 trn or 13% of then GDP to stabilize financial markets and the economy. And it did so with relative ease and cheaply, a key benefit flowing from the dollar as the world’s payments currency. Thirty-year bond yields declined 190 basis points over the next five years with help from the Fed which boosted its balance sheet by $ 1.9 Trn or 15% of GDP.

The COVID19 lockdown saw the US Treasury raise another $6.0 Trn or 28% of GDP and the Fed expanded its balance sheet by about $5 trn or 19% of GDP and 30 yr yields dropped at the trough by 58 bps before quickly reversing.

IF things get ugly, and assuming a $7Trn stabilizing intervention, debt interest costs could exceed $1trn at today’s funding rate of 3.5%. The US would have to go to global capital markets at a time when it has treated its friends shabbily. Assuming the US can tap markets with ease and at low cost is heroic, with the risk that the Fed will have to resort to money financing such debt expansion.

Non-US investors would be taking significant inflation and currency risk by stepping-up. Finally, with trust in the US diminished, it is no longer clear that it will be the beneficiary of safe-harbour flows if things get bad.

The Value of Liquidity

All financial crises begin with the failure to provide for liquidity, so pay heed to the Bank of England which notes the potential AI risk facing the banking sector. Material credit losses could have spill over effects to overall credit conditions, and thus financial and economic stability. The BoE suggests that potential losses from debt financing of AI investment might equal the exposure of the 2008-09 mortgage crisis.

While 2026 got off to a bullish start, financial and economic risks are growing as investment and economic activity becomes ever more concentrated. If there is an AI bubble and it bursts, the economic undertow could be deep, long lasting and expensive to stabilize.

[1] Microsoft, Amazon, Google, Meta, Oracle, & Apple

[2] The market capitalization of the S&P500 was about $58 trillion in early 2026.

[3] Bank of England Financial Stability Report December 2025.

[4] The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong John B. Taylor* November 2008

[5] Market Liquidity and Funding Liquidity, Brunnermeier & Pedersen, NBER Working Paper 12939 February 2007.

[6] Bain & Company 6^th annual Global Technology Report.

Why is the gold price so high for a physical asset that provides no dividend or coupon. Why has gold soared to new heights relative to standard measures such as oil and the consumer price index, and why has this been sustained since the early 2000’s? Is gold along for the ride as an additional expression of American Exceptionalism or is it a hedge against extreme American dominance?

The launch of gold ETF’s in the early 2000’s made fractional access to gold available to a large base of retail investors. This financialization of gold boosted demand. Gold ETF’s are relatively expensive, attracting fees plus the drag from negative roll yields given that the gold futures curve is in contango. Nonetheless, the costs of financialization is a convenience price compared to the high cost of buying, selling, and storing physical gold. You might be able to buy an ounce of gold at Costco, but you can’t sell it back to them.

The World Gold Council shows about half of annual gold demand satisfies investments, split almost equally between retail and institutional investors (ETF’s, central banks and physical gold, jewelry demand is about 43% and industrial demand at 7%. Recent price action matters for the changes in the distribution of demand between years.

Industrial demand is insensitive to prices given gold is essential in production of many electronic goods. However, demand from both central banks and jewelers is inverse to the price trend, declining as the gold price increases. Only investment demand rises with the price of gold, most likely reflecting herding and momentum investing by retail investors flooding into ETF’s and physical holdings.

In 2024, the supply of gold equaled about 4,957 tonnes to satisfy demand, and any excess demand beyond that supply must be met from the existing stock, which is surprisingly small. The upper estimate of the total outstanding amount of all gold ever mined is just 216,250 tonnes, physically occupying a space of 22 cubic metres.[1]

The big sustained change in demand since 2005 is traced mostly to the rise of retail gold ETF’s. Harvey and Erb[2] attempt to quantify the impact of gold financialization with a simple plot of the real price of gold against subsequent ten-year returns. The equilibrium price is where a fitted line cuts the horizontal intercept, so comparing the intercepts of the pre and post financialization of god should reveal an y price impact.

The real equilibrium price for the period 1988 to 2005 is $1,071. However the equilibrium price for the period after 2005 – identified as the year gold was financialized for mass distribution -- is $2,143 implying that this one-time jump in gold demand has doubled the real price.

Demand from institutional investors, mostly central banks, was steady at about 11% between 2010 and 2021 but took off after Russia’s invasion of Ukraine, central bank demand doubled to about 1,000 tonnes a year.

But this year, retail demand has been the key driver of the gold price overshoot, consistent with an inelastic supply curve that simply cannot be flattened. ETF demand surged in 2025 and true to form, central banks pulled-back in the face of sharply higher prices to give retail some space.

Non-Price Forces Driving Gold Demand Higher

Portfolio diversification is a big driver of gold demand separate from return driven ETF needs. Reserve accumulation of gold by China, Russia and Turkey is driven by the desire to minimize exposure to US$ assets and the US$ centred global payments system so they can retain a degree of freedom of action and sovereignty in their international economic relations.

Diversification and de-risking are often confused. A diversification benefit exists if by combining two or more assets the resulting risk is reduced proportionately more than any reduction in return. Given gold has no return other than the spot return, or the change in the price, selling US$ assets with a coupon to buy an asset with no coupon is, more accurately, derisking rather than diversification.

Countries that may find themselves on the wrong side of weaponized American dominance reduce their risk advisedly, as denial of access to the US$ payments system infrastructure is a tool used to meet foreign policy objectives.

Demand for gold by many central banks surged following Russia’s invasion of Ukraine and the freeze of Russian US$ assets held in custody outside of Russia. US sanctions, and the closure of access to the SWIFT global payments messaging, system complicates economic integration into the world economy for targeted countries. Naturally, many countries that are not currently targeted have noticed, taking steps to reduce their exposure to the US$ in reserve assets and payments.

Central banks have direct security over their holdings of gold, and given gold has the potential to act as a medium of exchange, it retains its monetary character so can be liquified to make payments.

Attempts to preserve monetary sovereignty by many countries, and to protect themselves from the coercive effects of US foreign policy, has been characterized as a desire to de-dollarize. Recent US behaviour designed to maximize coercion and US dominance has undermined America’s reputation as an honest broker. The de-dollarization motive adds an additional gold demand increment, adding to upward pressure coming from financialization.

Private investors buy gold as a diversifying asset, and as protection against equity market drawdowns where the latter are experienced every decade or so. However, research shows that the diversification benefit gold offers versus equities alone is small, and gold alone does not provide much of an offset to a drawdown in equities.[3] There are two parts to maximizing the diversification benefit between tow assets and first they must have a low return correlation coefficient, preferably closer to -1 than zero, and their return volatilities should be fairly close together (for example the annual volatility of the S&P500 since the mid 1970s is about 16% and the monthly volatility of gold is 27%.) While gold has sufficient volatility to compensate for equity drawdowns, the return correlation coefficient is marginally below zero implying that the diversification benefit from gold is small.

Inflation risk is elevated

Gold has been a reliable hedge against inflation given its monetary character. And you don’t have to be an “end-of-the-worlder” to be so concerned given the precarious balance in world affairs and large stocks of government debt.

Investors have a justified fear of future inflation as inflation in most countries is still about 1.0% higher than the commonly shared 2.0% level central bank inflation target. A rising interest payment share of government expenditure is beginning to crowd out other fiscal priorities. The crude exercise of economic policy in the US is putting pressure on the Fed to forsake inflation control in favour of relieving funding pressure. All the more alarming when the deficit is about 7% of GDP when the economy is at full employment in the midst of an investment boom.

Gold’s real return in the OPEC induced inflation of 1972-74, where the CPI rose 24%, was 166%. And, the oil impact of the Iranian Revolution of 1977-1980 pushed the CPI up by 37%, and the price of gold shot up by 154%[4].

Since inflation surged higher in early 2021 following the Covid-19 disruption to economic activity, the consumer price index has risen 23% but the price of gold price has increased by far more, up 223% more than compensating for inflation to date. Is there more inflation to come or is the market pricing something else?

De-Dollarization

The desire by many countries to pursue de-dollarization should not be taken lightly. While much of the stimulus for de-dollarization is driven by the weaponization of the US financial system in its sanction regime, a growing non-aligned group of countries have a strong desire to protect themselves from more general US overreach. The current project to de-dollarize driven by a small group of non-aligned countries, is a widely-shared institutional project to construct an alternative payments system, reshaping the dollar-centred global monetary order by building their own[5].

Many dismiss de-dollarization, citing the current dominance of the US$ both as a reserve asset as a form of self insurance (many Asian countries built up large US$ reserve after the 1997-98 crisis to avoid borrowing under onerous conditions from the IMF) and its use in global trade and payments.

Many also cite the lack of a competitive reserve currency alternative to the US$ but this is likely reflects complacency rather than mounting a compelling argument. What has gone relatively unnoticed is the growing use of inter-country central bank foreign exchange swap agreements to facilitate payments outside the dollar area (China is pursuing swap agreements aggressively to steer export payments into RMB given their capital account is closed.

These agreements offer a source of assurance in difficult times that effectively bypass the need to transact in US$’s, and counterparties seem willing to exchange the US for China as the “honest broker.” This abrupt change in US behaviour marks a change in the balance of global power, illustrating that US power and leverage is seeping away as China rises.

The dollar’s dominance of the global payments system presents financial costs on beyond the constraints this puts on sovereignty, especially for poorer countries and these costs are not well understood. Raising and financing dollar reserves, plus the costs of managing FX volatility are not trivial for many countries. Gross US$ reserve accumulation can create a large fiscal burden.

FX volatility can be a silent killer. South Korea exhausted its US$ reserve in 1997-98 by financing corporate FX obligations, so that when the crisis hit the central banks had no dollar liquidity to support the sovereign. South Korea became insolvent because it was illiquid.

It is no accident that central bank swap agreements between Asian countries and China are on the rise and are now employed in cross-currency transactions to avoid the US$ altogether. Innovatively, China allowed Argentina to use over half of its $18bn swap line to make a 2023 payment to the IMF in Renminbi.

While the use of swap lines between China and other countries is likely not sufficient for the RMB to emerge as a global payments currency to challenge the US$, it does give those countries that want to exercise their sovereignty free of hindrance from the US an alternative.

Stablecoins

The rise of Stablecoins and their regulation by the US Treasury following the passage of the GENIUS, act is felt by many to be the enabling act that brings decentralized finance into the mainstream.

Just as ETF’s tapped-into pent up demand for gold, so the arrival of gold tokenization is heralded as a potentially very powerful driver of additional gold demand. The crypto currency Tether is reported to have build substantial holdings of gold. Even though gold has been tokenized, it is not yet qualified as a stabilizing backing asset for stablecoin.

Decentralized finance using the blockchain has the potential to revolutionize finance, offering continuous around-the-clock payments and settlement at a fraction of the cost of centralized finance. Wide take-up of tokenized gold given its superior transactions capacity, speed and cost, would offer a whole new way to hold gold, and so potentially create significant demand as well as be more price competitive than prevailing ETF’s.

High Quality Liquid Assets

Further out on the demand wish-list for gold bulls and responding to rumours that gold could become a high-quality tier-one capital asset for liquidity (Basel II) purposes, Harvey and Erb assess a potential regulatory driven demand source for gold.

Following the 2008-09 crisis, in addition to additional capital banks are also required to hold sufficient liquidity to avoid going to market in stressed conditions by holding enough high-quality sovereign assets to last 30 days.

If gold qualified as a HQLA, the US alone could generate almost 2,000 tons of additional gold, almost double the estimated investor gold demand so far in 2025. This is not trivial.

However, this is highly unlikely. Technically, gold would not qualify for the so-called singleness of money, which is why it currently has a 20% haircut when presented for collateral. That said, lower rated assets with sizeable haircuts equal in volatility to gold are accepted, so there is a case to be made given that it is relatively liquid gold could one day make the cut[6].

What to do With Gold?

The surge in gold to an all time high over a short period of time looks like the left-hand side of the Eiffel Tower, and mean reversion is a constant of economic and time series that inevitably blows off the froth. But gold’s ascendancy, alongside the equities tracing their value to a belief in American Exceptionalism may instead be a hedge instead against American dominance and overreach.

[1] World Gold Council.

[2]Harvey, Campbell, Erb, Claude “Understanding Gold” SSRN-5525138

[4] Neville et al “:The Best Strategies for Inflationary Times” SSRN-3813202

[5] Quintana, Francisco J “Dollar Dominance, De-Dollarization & International Law” Journal of International and Economic Law

[6] HQLA include cash, central bank reserves, government bonds, hi grade government (15% HC) Corporate bonds & equity indices ( 20%-50% HC)

AI is a general-purpose technology, a technology that fundamentally changes every aspect of economic and social life. Past examples include the steam engine, railways, electrification and information and communication technologies.

General-purpose technologies revolutionize what we do and how we do it, transforming our lived experience. They stimulate large gains in productivity and boost our standard of living. But, they take significant time to deliver that change, often extending over decades.

Past general-purpose technologies, most notably, electrification, and the ICT revolution, took some 70 years and 40 years respectively to generate the economic transformation the technology promised, and to deliver an outsized contribution to economic growth.

Leveraging any general-purpose technology requires a change to the methods of production and work, changes that take longer to achieve than the speed of progress of the technology itself. Another way to think about this is that the organizational change necessary to move a business forward takes longer than the pace of change in the technology itself.

General-purpose technologies improve productivity by making existing activities more efficient, and they birth entirely new industries and services that are efficient from the start. Contrary to expectations, both labour and capital share in those gains but so intense is the period of change and so devastating are the adjustment costs to individuals a general feeling of insecurity and precariousness dominates the mood. It feels like a recession even if the data suggest otherwise.[1]

Given the length of time it takes general-purpose technologies to distribute economy wide gains, and given the huge investment already made, investors need to ask: to whom will the benefits of AI accrue; over what time horizon will gains accrue; and, whether earnings expectations can be delivered fast enough to satisfy capital’s impatience for the pay-off. Much of the earnings euphoria is premised on a belief that the speed of AI’s dispersion will be faster still than ICT.

Fire Burn and Cauldron Bubble

Economic Historian Nicholas Crafts illustrates how the speed and force of general-purpose technologies has changed since the industrial revolution. ICT boosted labour productivity by 33% in just forty years accounting for half of total economy labour productivity growth, compared to 25% for steam that extended over 130 years. The contribution from electrification was just 8.5% over 50 years, but this quantitative measure understates the qualitative impact electrification had on living standards.

Crafts identifies three distinct periods in the ICT transformation. Its effect began in 1974, running to completion in 2012. After a slow start between 1974 and 1995, ICT’s contribution to growth in labour productivity was staggeringly high at 1.5% per year for ten years between 1995 and 2004, and while falling in half until petering out by 2012.

The positive impact of ICT is clear in Crafts’ data, even though commentators at the time claimed computers were everywhere but in the data. Crafts offers compelling evidence it was there, but that its effect could not be felt across the whole economy because of weakness elsewhere.[2]

While the economic impact was strong, many of the companies that built ICT hardware and software were not the principal financial beneficiaries of the technology. The big winners of the ICT revolution turned out to be the large networked tech firms that make up today’s Magnificent 7. The companies apply the technology successfully create top line growth rather than focus on bottom line growth through substituting capital for labour. If the expected gains to AI are centred on cost cutting, investors may be disappointed in the results.

Running Ahead of Regulators

The economic and political power of the big tech winners from ICT is traced to their introduction of entirely new services and products. Big tech found they could exploit an information advantage over their users, whose online activity revealed their preferences and price sensitivities which was multiplied by global network effects where the value to the platform increases as more people use the service.

Conceptually these phenomena were long understood in economics, but practically they had not been exploited so powerfully and the network platforms faced no regulatory frictions to protect customers’ data from exploitation.

US tech companies, especially, the social media companies, were able to exploit their algorithms for vast profit despite the widespread social problems they created. They remain completely and utterly unregulated.

The concentration of earnings facilitated by ICT are entrenched by the forty-plus year trend to weaker competition and excess concentration of market power, which continues unrestrained by competition policy and enforcement. Economies that sponsor competition have higher standards of living, so intensifying US dominance and grift does not augur well over time.

The US tends towards an ideological loathing for regulation. The excess profit that large dominant tech companies gather is not a function of competition but flows from first mover advantage and established dominance. The tech experience is shaping expectations of a repeat bonanza from the introduction of AI.

The US assault on the European Union, the only regulatory authority in the world that is able and willing to flex its regulatory muscle to balance the power distribution between consumers and producers, is designed to maintain and leverage regulatory laxity world-wide to entrench American tech dominance further with AI. And investors are buying-in.

Applying the big tech model to AI is less about plundering and monetizing consumers’ consumption preferences and more about the theft of intellectual property to train generative AI. Investors need to think clearly about whether the input providers to AI are the firms that will deliver the expected earnings from AI, or whether the gains will flow to companies that have yet to emerge.

Either way there was -- and is – inadequate legal protection and enforcement of privacy rights of consumers and property rights for the producers of intellectual content. At the heart of risk taking is the state’s defence of property rights. If capitalism is to be accepted as an efficient if inequitable means of production and distribution, we are on a slippery slope in the face of such bald-faced and open exploitation.

Invention of a Method of Invention

Accompanying the introduction of general-purpose technologies is the positive, what’s called invention of a method of invention. General-purpose technologies makes the process of invention much faster and more efficient. Importantly, it has the capacity to be dispersed across many different scientific disciplines.

At the advent of the industrial revolution in 1760, there was no real body of scientific theoretical knowledge and no well-defined scientific method. Improvements, changes and modification to early general-purpose technologies, like the steam engine, took much longer because adjustments were made through trial and error.

With the emergence and development of scientific institutions, such as Britain’s Royal Society, the process of invention and discovery could be accelerated by applying the scientific method.

AI promises to be a superior invention of a method of invention; the most often cited example is the technology’s ability to assist in the invention of new pharmaceuticals. AI is able to crack problems more quickly than humans because of its iterative ability to absorb and process huge amounts of information at speeds beyond human capacity.

Many corporates justify their AI investment by emphasising cost cutting, traced to AI’s ability to achieve the same productivity impact in services as that experienced in manufacturing. But, as the failed Kraft-Heinz merger shows, you can’t cut your way to sustained profitability. Firms have to determine how to use AI to enhance their labour force rather than pursue machine-human substitution.

Interestingly, few corporate reports focus on how AI will boost their top lines, as it takes a significant amount of time to transform organizations. AI is just another technology, and firms have to figure out the applications that boost their organizations’ top lines rather than just cutting costs to boost the bottom line. The focus should not be solely on margins.

However, researchers at Cornell University have shown, experimentally, that the application of the scientific method through generative AI can boost the top line by augmenting existing staff rather than replacing them.[3] The research also shows AI’s ability to reduce information asymmetries, which may redress the current welfare balance in tech between producers and consumers. However, equal access to information was foreseen with the emergence of the internet, a future thwarted by the control big tech asserted over the web for its own benefit.

Technological change is challenging, but people are not afraid of technological change itself – who wants to live in a world without antisepsis? What people fear is the excesses of capitalism. Sharpening this fear is the anticipation that all the profits from change will go to the corporations and all the adjustment costs will be borne by those with the fewest resources to absorb them.

Past periods of technological change have been jarring, but we need to be analytical about it while acknowledging the labour market is brutal in allocative efficiency. There are two effects we know from history, the labour market displacement effect – the erosion of the skill premium because technology allows the unskilled to do the work of the skilled and the effective displacement of the unskilled – and the reinstatement effect – the emergence of an entirely new world of work that ultimately needs people, who are complemented by AI not replaced by it.

Skilled weavers, or Luddites, protested the impact on their wages from the introduction of the Spinning Jenny by smashing machines. The unskilled could now do the work of the skilled. But what goes around comes around. The wages of a hand loom weaver, occupations that took on the work of former skilled weavers, jumped dramatically from 75 pence a week in 1770 to 276 pence a week in 1805 only to plumet back to 75 pence in 1830 as the power loom in turn displaced them.

The impact on weavers took sixty years to complete. We don’t have the luxury of time to manage today’s Spinning Jennies, as a repeated displacement cycles raise the possibility that the reinstatement effect is obsolete before it emerges. AI is proceeding at a blistering pace and is straining our ability to keep up to manage the change in an orderly way. The danger with AI is that the reinstatement effect may emerge far too late to help those displaced, and no past technology has presented with the potential capacity to completely outperform humans in all tasks.

The dominance of large corporations suggests that centralized adjustment, which tends to be slow and steady, may supress the positive productivity effects. While a decentralized approach can be wasteful and costly, it has the benefit of surfacing invention and discovery much more quickly. It may well be that productivity growth takes a long time to emerge and much of investors investment is wasted in the process of discovery before we see positive benefits.

Even if AI can completely outperform humans in all tasks, it is hard to see the displacement of work to justify expectations of value. Otherwise, we are making a low probability, catastrophic, event a central tendency.

The reinstatement effect may ultimately dominate and the optimists will note that as general-purpose technologies have evolved, their impact is both stronger and distributed over a shorter period of time. Disruption in the labour market suggests that the displacement effect is well underway. Canada’s youth unemployment rate today is about 14.7%, almost three times as high as the 5.5% rate for those over fifty-five, a gap that has been steadily widening since Chat GPT was introduced in 2022.

We ignore the speed and force of change at our peril. The lesson of the globotics adjustment in manufacturing is that unmanaged labour market brutality upends the social and economic power balance, leading to inequality, political discontent, and the rise of populism.

Troublingly, there is no political awareness of the need to reduce adjustment costs of labour market adjustment to speed-up the emergence of new jobs to absorb those made redundant. There is certainly no empowered political leadership that is prepared to do so.

AI Will Be Most Powerful if it Enhances Not Replaces Labour

Anyone who has used AI in their professional and personal lives will know that AI is an extremely good research assistant, it saves time, it removes the drudgery of mundane intellectual work and allows us to better leverage our time and professional competency.

Experience to date suggests AI is a good complement to humans in the arrangement and execution of work, making us more productive, creative and empowered. It strongly indicates it will be a complement to labour if we are smart about how we use it.

High expectations over the value of the displacement effect to investors and its threat to individuals is likely overdone. Computer scientist Arvind Narayanan argues that lawyers will not be displaced by AI because a lawyer’s job is to convince a judge to be favourable to his or her client, and it is highly unlikely that the judge will accept a robot as a substitute for a lawyer.[4]

History suggests lowing the cost of production from technological change boosts demand as the relative price decline raises disposable incomes. So if the price of lawyers drops then the demand for legal services should rise.

But this past effect assumes competitive markets, but competition is weak in North America. Two factors that make many economists worried about what is to come: the potential for AI to displace so much of human work activity, and the inadequacy of competition law and enforcement to block excess market power distorting outcomes.

A Lot at Stake

The sums piling into AI are surely staggering. In 2024 alone, investment in AI exceeded the inflation adjusted cost of the Manhattan Project by a factor of ten. No wonder bubble talk is everywhere. To get a good return on that investment, we need to know corporates have defined the problem that AI is there to solve to justify all that investment. If not, money will be wasted.

While AI will transform our economies and societies by inventing new products and services, they have yet to surface in substantial force for corporate transformation in the S&P 500 companies minus the magnificent seven. While the diffusion of general-purpose technologies is speeding up, and the benefits are accruing more quickly, organizational change is difficult and ultimately it is businesses that have to capture the benefits.

The ultimate beneficiaries of this new industrial revolution may not be the providers of the general-purpose technology itself, but those that apply it. We don’t yet know who they are, and the fact that Nvidia is financing its customers to buy its products is not a supportive signal.

The payoff is likely to come later than many investors expect, as economies change much more slowly than the technology itself.

[1] S.B. Saul The Myth of the Great Depression 1873-1896.

[2] Starting in 1974, ICT boosted total productivity by about 0.8% a year until 1995 but accelerated to 1.5% a year for ten years between 1995 and 2004 before receding but still adding a substantial 0.6% a year until about 2012. Overall it contributed to half of all economy wide labour productivity from introduction to transformation completion.

[3] Generative AI and Firm Productivity: Field Experiments in Online Retail. Fang et al, October 2025

[4][4] AI Snake Oil, Narayanan, Arvind & Kapoor, Sayash.

The US$ has been the world’s reserve and payments currency since sterling relinquished that role at the end of the second world war. The eighty-year dominance of the US$ in foreign reserve holdings, and its role as the global payments currency, gives the US financial market depth and liquidity that is unrivalled, making it the indispensable market.

The US government has slowly but surely been exploiting the US$’s dominant position to achieve strategic and political goals, honed through the post September 11, 2001, war on terror. Deploying its vast resources in data capture and processing to track the financial flows of adversaries marked a significant turning point in US foreign policy and its attitude to both friends and foes. The ends justified the means.

Over time, the methods used have become both more intrusive and coercive in the furtherance of US political and strategic goals. The current activities of the incumbent administration are now turning this persistent and long-term trend of intervention and coercion to the monetization of hegemony.

Sanctions are the primary tool to apply US leverage in international relations. By targeting adversaries and instilling fear of application of sanctions to third parties if they abet sanctioned countries, the US has impaired freedom of agency for those countries that do not align with its interests. The dominance of the US dollar in the global payments system is the key device in achieving successful dominance short of the exercise of raw military power.

The infrastructure underlying the global use of the US$ provides the US the ability to exclude nations from the global trading system. The SWIFT global payments messaging system, even though it is based in Europe, is part of this infrastructure and has been used to exclude adversaries from trade. Wary allies and adversaries have noticed.

The US’s coercive strategies are in no small way facilitated by the network of alliances and the rules-based infrastructure it built. While the US has dominated this infrastructure, it has also been interdependent with it. The administration seems to discount the power that stems from its international relationships and alliances in the exercise of dominance, If it applies coercion to friends as well as foes, then it is undermining its ability to do so in the future as friends distance themselves to protect themselves. The net result of maximizing economic benefit from coercion may mean that we are at the point of maximum US power.

In response to these coercive tactics, many global players are seeking alternative payment arrangements that bypass the US dollar and the US financial system. Although the US dollar still accounts for a significant portion of global transactions, regional differences are emerging. For example, while the Euro dominates European export invoicing, the dollar remains dominant in Asia due to underdeveloped local currency capital markets and the lack of a large anchor market that can provide international payments services.

The composition of global reserves has changed significantly, with the US dollar’s share decreasing from 72% in 2001 to 58% today. This decline coincides with the weaponization of the US dollar’s role in global payments post-September 11, 2001, as the world adjusted to the US exercise of heavy-handed intervention in the affairs of others.

The rise of the Euro, with its deep and plentiful supply of securities to absorb reserve holdings, has facilitated reserve diversification away from the US$. But what is not well appreciated but is increasingly apparent is that US$ reserve holdings have also been entwined with defence agreements, traced to the nuclear non-proliferation movement in the late 1960s and 1970s.

Extension of the US nuclear umbrella kept many nations from developing their own nuclear deterrent to maintain better conflict control. But not all is well. The failure of the signatories to abide by the Budapest Memorandum in return for Ukraine’s surrender of nuclear weapons to Russia is not lost on those sovereigns who rest beneath the US nuclear guarantee.

When those agreements were struck, the US mostly kept its agreements but the current administration is undermining its international credibility to by being inconsistent and unpredictable. Donald Trump keeps friends and foes off balance to maximize leverage and monetize dependency, bluntly questioning US commitment to NATO article five unless allies cough-up. While this might sell a few more F35’s over the next few years, it undermines US credibility and power when American power abroad is derived as much from trusting alliances as it is raw military muscle.

The stock of US$’s held by non nuclear states sheltering under the US nuclear umbrella is substantial compared to nuclear states. Foreign sovereigns that hold US$’s for defence reasons do so in amounts beyond the level desirable for economic self insurance alone. Eichengreen et al show that non-nuclear armed states like Germany, South Korea, Japan and Saudi Arabia own between them about 35% more US$’s in their reserves compared to nuclear armed states like France[1]. This is not new. Over history, past defence agreements lead to excess holdings of the dominant reserve currency with which a smaller country has a defence dependency or agreement.

With allies quietly questioning the value of the US security guarantee, one has to conclude that the excess holdings of US$ may not be a permanent feature of non-nuclear states rainy-day reserves. The authors estimate that if the consequences of an elongated period of US coercive activity was to breed doubt in prior US defence agreements, then almost US$ 1 Trn of excess holdings of US$ could be liquidated adding potentially 80 basis points to the US yield curve. The US treasury market would undoubtedly become less liquid as a result.

The recent history of what Todd Hall calls “emotional diplomacy” and Richard Baldwin articulate as the grievance doctrine has upended the rest of the world’s assumptions about the US place in the world. While it will take time for countries on the back foot to adjust, they are already seeking new alliances as insurance. Moreover, many have not applied countervailing tariffs on the US instead preserving their citizen’s purchasing power to soften the blow and speed up the process of strategic realignment. It is likely that many countries are even now slowly disengaging from both the tightly knit US supply chain and their defence linkages in order to minimize US leverage over them.

Most alarmingly this will likely apply to both economic and military relationships, and a new era of nuclear proliferation. Nuclear latent states include Japan, Germany, the Netherlands, Brazil, Taiwan, Iran, South Korea and even Canada. Moreover, Politico magazine reports that US allies including Germany, South Korea, Japan and Poland are considering their own nuclear deterrent although Poland is not considered to have nuclear latency. And, Saudi Arabia is inching closer to Pakistan to provide it with an Islamic nuclear umbrella as a hedge against increasing US unreliability.

The depth and liquidity of the US Treasury market is a key funding cost advantage for the US, and this is crucial in times of crisis. Given the current US administration has sought to monetize its global economic and financial dominance by ensnaring friend and foe alike, this new era -- defined by economic, military and technological coercion – leaves many countries hostage for the time being to US control over financial and information chokepoints.

Momentum is building in foreign exchange holdings away form the dollar, and gold is making a reappearance. Gold is also re-emerging as a sizeable share of global foreign reserves. Sanctions have had an impact, especially following Russia’s invasion of Ukraine, yet this had been until recently constrained to China, Russia, and Turkey. Other countries are now in the game.

This is a big change in trend, as most reserve managers substantially reduced their reserve holdings of gold starting in the early 1990s because of the high opportunity cost of holding an asset with no yield and its lack of intrinsic value in the post gold standard monetary world.

The gold share of foreign reserves has grown by almost 10% since 2024 to about 25%, mostly a price phenomenon rather than an increase in gold volumes. Explanations for gold’s rise are many and varied, but the potential for the US$ to fall in the face of future extreme events is surely one of them given the now negative correlation in times of “emotional diplomacy” crisis between US interest rates and the US$.

According to the World Gold Council, gold’s share of overall reserves remains well below the 60% share prevailing in 1980. Moreover, the real price of gold is 28% higher today than it was at its last peak in 1979 suggesting that gold is under-owned. And, private holdings of gold relative to all private holdings is at 4.0% and remains well below the peak of 8% in 1980. Especially notable is that per capital holdings in China very low despite a large gold reserve share.

The latest iteration of US efforts to bend the world to its will has raised the stakes, especially as the US drifts towards institutional decay belying its past role as a reasonably honest broker. Global capital markets have largely shrugged-off concern about property rights and fidelity to the rule of law, consigning such concern to a high impact but low probability event. But this is a probability that is inexorably rising which can have unexpectedly large price effects even if macro trends are intact.

Sustained US coercion in international relations has the potential to affect all asset prices, as the long-term consequences of such behaviour will inevitably weaken the dollar’s global role both as reserve asset and payment currency dominance.

The US was able to stabilize its economy quickly following the 2008-09 financial crisis by raising significant fiscal resources in global capital markets at very low interest rates. In the two years between 2007 and the end of 2008 the US Treasury borrowed $1.9 Tr and long-term interest rates fell 198 basis points. And, during the Covid emergency the US raised $6Tr and long yields declined 37bps from what was a low starting value.

The US is taking its privileged position for granted, and the cost of a more volatile international system may be reduced access to the world’s capital when it needs it most. Will the US still then be the indispensable market?

Many investors sustain an insouciant attitude to the potential end to the dollar’s global dominance because they cannot see an alternative. Well, perhaps that is the very point. There may not be one.

“In economics things take longer to happen than you think they will, and then they happen faster than you thought they could.”

Everything financial begins and ends in the economy, so the late Rudi Dornbusch’s observations on the economic drivers of financial crises should be top of mind.

The arrival of the “post-American world”, in which the US has become extractive in its dealings with the rest of the world, has been facilitated by the trashing of norms and unrestrained extra-legal behaviour.

The world is adapting the existing rules-based order to, eventually, work around America rather than with it. But it cannot escape working with the US so long as the US$ remains the world’s payments currency.

Adding to the stresses from trade disruption, but consistent with the pursuit of heterodox economic policy, the rise of fiscal dominance threatens the US commitment to inflation targeting. Given the dominance of the dollar, loss of US inflation control will spill-over to others. Blocking US price pressure will put upward pressure on local currencies that some jurisdictions may resist.

Yet investors seem relative unperturbed by the coming breakdown of the US economic superstructure. They continue to rely on the historical reliability of such institutions as private property and the rule of law despite evidence that observance of the law by the administrative branch has become discretionary.

Financial journalists and analysts continue to focus on the superstructure – or the economic and financial foundations of the economy – and assume the underlying foundations remain robust. Investors know the strategic issues need to be managed but doing so does not fit into the short-run management horizon and capacity.

Strategy is sexy but tactics make money. Only when the sands beneath our feet wash away will the strategic adjustment come. So, the US equity market continues to march upward, even if price volatility is rising.

Given the regime change already well underway, we should be prepared for things to “happen faster than you thought they could”. Best to have a plan even if now is not the time to execute.

Risk is concentrating in a small subset of equities

Value measures are warning that US capital markets are incredibly vulnerable to a drawdown, given that the value in major US equity indexes are increasingly concentrated in a handful of stocks. When value is poor, risk of loss is high.

Examples include earnings growth that is far stronger in the so-called magnificent seven, outstripping the rest two to one. Yet even concentrated Mag7 stocks cannot escape the economy, with earnings growth now about half what it was a year-ago. Nonetheless, in level terms, the rise in forward earnings per share is far above growth expectations in the non-tech economy. If value investors had any sway, this relative value play would be attractive.

Much of the recent inexorable growth in S&P500 earnings expectations is traced to the AI boom. The AI bubble is emerging to be many times the IT bubble of twenty-five years ago, and the financial excess is creating a potential real economy investment excess if the expected productivity revolution turns out to be hype. Any future reversal – and AI is taking longer to show its promise than expected – will deliver both financial and real economy pain. Capital overhangs must be either absorbed, leading to slow growth, or scrapped, leading to steep downturns.

While the economic risks are clear, there are financial factors both amplifying and extending what feels like an unsustainable AI overinvestment. If so, this will distribute the potential pain of any future downturn directly to households.

Passive investing may be cheaper but it could be riskier

The mutual fund industry for decades offered the potential for above market returns for high active management fees, but the industry failed to deliver. Outed as high-priced asset gatherers, investors realized that the high annual fees reduced their participation in rising markets.

The cost of accessing market returns is close to zero, with many market-cap ETFs charging just a few basis points limiting fee drag to maximize investor participation in rising markets. The rise of passive investment facilitated by low-fee ETF’s as a better investment leads to a mechanistic buying of indexes regardless off their relative value.

Duke University academic Cam Harvey and his colleagues at Research Affiliates show that passive index investing is now the dominant driver of equity price momentum. They argue that relative value opportunities presented by company fundamentals cannot be easily captured given passive investment dominance.

The vulnerabilities produced by the substitution of passive investing for active investing is clearly set out in the paper “Passive Aggressive: The Risks of Passive Investing Dominance.” Harvey et al show that passive funds account for over 50% of assets, making passive investing the dominant capital allocation strategy.

Their key insight rests on the indifference of index-seeking capital allocation to value, resulting in mechanistic, auto-pilot like, buying that ignores relative value. Passive investing herds investors into momentum as the dominant investing style.

Getting into the nitty-gritty of passive investing reveals that mechanistic index buying from new investors favours the stocks with the biggest index weight; overvalued stocks grow as a share of the index to be ever more overvalued. The higher the stock goes, the more capital it is allocated to it, and the higher the price goes to free stock for new buyers. Expensive stocks become ever more expensive, and cheap stocks become ever cheaper.

Ignoring the intrinsic value of each stock removes an important mechanism that better balances risk across portfolios and the economy. The greater the share of capital allocated passively, the greater the detachment of price discovery from fundamental company information.

The diversification benefit of beta exposure is reduced and risk of loss increases. Passive investors become ever more exposed to overshooting.

The dominance of any one style of investing not only makes active management relatively unprofitable, but it also reduces active management or alpha as a portfolio diversifier. Moreover, the failure to embed fundamental information in capital allocation reduces market efficiency. Market price deviations from fundamental value now attract fewer active investors to enforce market efficiency.

If markets are efficient – and Gene Fama maintains he did not mean markets are always and perfectly efficient -- anything we know is in the price. Even in the absence of excluded fundamental information, if we push Fama’s observation to the limit and argue for perfect efficiency then excess returns are only possible by taking excess risk.

Monotonic index buying excludes important information, raising risk of loss beyond that associated with market efficiency. The fundamental information being ignored includes R&D, capital expenditure, profitability, free cash flow, and revenue growth all of which are distorting economic activity.

The detachment of market price from intrinsic value makes it difficult for active managers to succeed. Their investment processes, and the decision thresholds they have derived from past understanding of market structure based on fundamental parameters, have been dulled by index investment flows.

Yet if there is an economic case for a price overshoot and subsequent undershoot, then there is a case for smart traders and portfolio managers to position for the correction. For those with deep pockets, lots of liquidity, and good risk control, the impact of passive investing has created a significant opportunity for value style investors if they have patience.

Extrapolative overshooting comes faster than anticipated

Overshooting has a dynamic all of its own. So long as the expected gains exceed expected loss, reinforced by mechanistic buying, momentum remains intact. But at some point the trend becomes over-extended. When expected losses turn to exceed expected gains, momentum reverses to plumb the downside.

Speed of adjustment can be jarring. The end of the Japanese yen carry trade in 1998 witnessed an 18% decline in the yen in just days, vastly exceeding the annual interest return to the carry position. A similar decline in gold in the early 2000’s was also fast and furious. While the underlying volatility creation from these two carry trades is different from index fund momentum, at some point the power of index buying could easily result in mechanistic liquidation. Market drawdowns can emerge quickly, reacting to which puts investors on the back foot.

Does capital flow drive the price or does the price drive capital flow?

Many investors track data on market flows to assess price momentum and the likelihood of a change in direction. Traders focus on market technicals to anticipate short-term price changes from changes in overweigh or underweight positions. Passive index complicates this activity.

Prices adjust to ensure balance in the market so this isn’t a particularly helpful approach and really wasn’t even before the rise of passive investing. For every overweight there is an underweight, for every buyer there is a seller, otherwise the market would not clear.

Analysis of capital flows and balances are backward looking, so are not all that helpful. The price has already changed to reflect changes in relative value. Price information beats quantity every time.

Capital allocation momentum in price discovery is dominant until it isn’t, as a price adjustment driven by expectational change occurs before the change in the capital flow. Changes in the magnitude of the flow can sustain a price change but doesn’t cause the change.

Expected asset prices are determined by the probability-weighted average of all possible outcomes that determine a full probability distribution. If there is a change in the weight assigned to the less likely outcomes, then large price changes can occur even when the market’s overall average of expected outcomes remains unchanged.

This means that investors must not only focus on what future price is necessary to achieve equilibrium when circumstances change, but also whether the probability assigned to negative outcomes will change.

Changes in the distribution of outcomes

The recently retired Jan Loeys of J.P. Morgan argues that when large movements in asset markets are not driven by a change in the underlying economic and financial forecasts, this most likely reflects a change in the expected return probability distribution, especially the left tail assessment. This disturbance doesn’t change the most likely outcome it merely shift perceptions about the probability and scale of potential large losses.

A pricing of the emerging economic regime or superstructure that affects the most likely outcome will have a much bigger impact on asset prices by changing the entire future distribution rather than a change in the probability of a change in the tail of the existing distribution.

Economic factors and the policies governing them are the drivers of the major trends in capital market asset prices. To wit, policy circumstances in the US are unrecognizable today compared to just six months ago. That’s a big change, one that has yet to affect the modal or most likely outcome reflecting only changes in the tails.

Is the US no longer the indispensable nation?

The US is held to be the “indispensable market” yet despite evidence that challenges this assumption, investors fail to question whether this is still the case; they are merely pricing different potential outcomes reflecting how it is managed not whether indispensability will persist. Tail risks are changing but the central assumption remains intact.

The belief in indispensability persists since investors cannot see the alternative. But the bigger issue is not who can and would assume the mantle; the bigger question is whether no one will. Interference in the Federal Reserve is breeding concern about inflation control but the market should be concerned that politicization of the Fed could diminish effective oversight of financial stability.

History tells us this is a sufficient condition for a financial crisis, and if the US needs to raise stabilizing capital from world markets at a cheap rate it might be unpleasantly surprised. Given the over extension of asset values, the required stabilizing capital might be substantial. Moreover, global banks that don’t have access to the Fed discount window should assume that reciprocal dollar central bank swaps lines with the Fed will come at an extortionate price.

The more liquid, informationally sensitive, fixed income and foreign exchange markets are pricing in a slow emergence of fiscal dominance and the decay in the US terms of trade. Equities are the outlier.

The correlation between one-week changes in two-year yields and thirty-year yields has swung to be negative so far this year after being close to perfectly positively correlated since the late 1970s. Given every asset is a discounted cash flow, the slow steepening in the US yield curve will eventually matter for less informationally sensitive asset markets like equities that that Harvey et al demonstrate is a growing problem.

The swing from monetary to fiscal dominance https://substack.com/home/post/p-161615684 has been flagged, but the market is focused on the minutiae of whether Trump will or won’t fire the Fed Chair. While crucial, this tactical play is irrelevant relative to the forces of negative debt dynamics that will make achieving the inflation target unlikely regardless of who is Fed Chair.

Today’s market pricing is responding to the current economic slowdown as if it were a cyclical not a structural feature. Demand growth has slowed but so too has potential growth so it is not clear that expectations of an assertive Fed easing are justified if the goal is 2.0% inflation.

Market pricing is responding to the current economic slowdown as if it were a cyclical not a structural phenomenon. The fragilities are adding up across the market, and the potential for costly policy errors is rising.

How sensitive is the market to a shock?

The suppression of value investing by passive investing creates an indifference in capital allocation to firm-specific information. The loss of an active management diversification benefit increases portfolio risk, reduces market efficiency, and demands downside risk be explicitly managed.

Volatility is the product of leverage and surprises. Ignoring the impact of passive investing in extending concentration of equity risk, and the failure of the market to price the deterioration in the US legal and institutional superstructure, is setting the global financial system and its economy up for a shock – it takes longer to arrive than you think and happens far faster than you thought it could.

Political leadership is not what it was. During the Great Financial Crisis of 2008-2009 leadership came not from top politicians – George W. Bush and then Treasury Secretary Hank Paulson – but from Ben Bernanke and his colleagues at the Fed. Technocrats have become our leaders when it comes to stabilizing economic crises and today is no different.

At the political level, US economic policy making proceeds on the basis of belief, not clear analysis and the weight of evidence. Indeed, describing today’s US economic decision-making process as policy formation and implementation is a stretch. The random application of tariffs to all trading partners at shockingly high rates – even to countries with whom the US has a trade surplus – is barely concealed political bullying. Extortion of sovereign trading partners and corporations is also thrown in for good measure.

This random process, ostensibly designed to eliminate bilateral trade deficits, is creating many distortions. Along with the expulsion of immigrants, the US is laying the foundation for a future economic crisis of weak growth and higher inflation that the Federal Reserve will have to manage; arguably it already is, and it’s only just getting started.

The US has imposed a negative supply shock on itself by withdrawing the country from the global trading system and its benefits. The random and ill thought-through approach to trade is creating distortions and introduces inefficiencies in domestic production that makes the US economy less competitive and productive. The tariffs are also beginning to feed-though to inflation given lags in the system. Finally, the random and cruel expulsion of immigrants, regardless of status, is reducing available labour supply.

A negative supply shock means economic growth consistent with 2.0% inflation is lower than it was before. To avoid higher inflation -- or put another way to keep inflation as close to the 2.0% target as possible -- demand growth needs to decline in line with the reduction in potential GDP growth.

Normally a reduction in real trend growth would be accompanied by a lower real equilibrium interest rate. But this adjustment cannot be done when inflation is above the 2.0% target unless it is clear that future demand growth will slow in line with growth potential.

As tariffs are a regressive consumption tax born by US consumers, there is a danger that sustaining demand on a path above potential as labour supply growth is falling could trigger additional cost-push inflation pressures though higher wage demands. Moreover, US inflation expectations have already moved higher given the sheer scale of tariffs imposed on all US imports from all countries making this more likely.

Many of these same countries finance a third of America’s budget deficit! If you are reliant on the kindness of strangers its probably best not to upset them. And to top it off, the lack of fiscal discipline and large long-term financing needs are pushing-up long-term inflation expectations.

Targeting and calibrating tariffs to eliminate bilateral trade deficits while allowing and encouraging demand growth to run hot would, perversely, remove an inflation pressure relief valve the US has relied on for some time. US domestic production cannot meet demand, so imports fill the gap easing the challenge of meeting the 2.0% target. If Trump’s policy of import substitution were to be successful, the Fed’s ability to meet 2.0% inflation would be compromised and would come with an unjust measure of economic pain.

Is the Fed doing the right thing by keeping interests rates unchanged given the clear signs of slowing demand? Yes. Despite Trump’s hectoring for lower interest rates, the last thing the Fed should do is reduce interest rates in the face of a labour supply constraint, a loss in economic efficiency from full participation in global trade, inflation that is above target, and an inexorable deterioration in fiscal dynamics.

General Purpose Technologies and AI

Many point to the productivity promise of AI as a Gordian Knot solution to these self-inflicted economic ills, so we have to get a bit technical to flush this out.

The average rate of non-inflationary economic growth is determined by the rate of growth in the labour force and the rate of growth in labour force productivity. The CBO estimates that between 2008 and 2024 US labour force productivity grew by 1.4% per year and the labour force grew by 0.6% adding-up to about 2.0% per year. The CBO expects the US economy to repeat this performance for the next ten years.

But is this likely? The first challenge to this view comes from the likely path of labour force growth. The indiscriminate round-up of immigrants, regardless of their legal status, has already forced a reduction in the foreign-born labour force by 1.6 million since the local peak in March of this year. The domestic born labour force has grown more slowly than the foreign-born labour force, so isn’t taking up the slack.

The outlook for productivity is more complicated. Artificial Intelligence is a general-purpose technology or GPT, meaning it will affect a range of economic activity well beyond the immediate applications of the technology itself. GPT’s boost productivity over time, but when they are first introduced they lower, not raise, productivity

The transformational impact of GPT’s comes in two phases: first, the disruption phase displaces now obsolete production processes and employment relations leading to lower growth and lower productivity. Resources released from old activities take time to be absorbed and overall growth is slow even if beneath the surface an intense period of structural change is underway.

The disruption phase gives way to the adoption phase as a new, more productive, economy emerges. What makes AI a significant growth challenge is the speed of change and the potential distributional effects it implies if it results in widespread job loss and reduced labour income.

The lags between disruption and adoption have got shorter with each new GPT. Electricity was first deployed in 1882 and it took fifty-plus years for full adoption. In contrast, the lag between the introduction of the internet and its full adoption was a mere six years.

AI may be the source of continual disruption given the breakneck speed of the technology’s advance. It has the potential for unremitting economic disruption before the adoption phase can even emerge. The rise of generative AI and the so-called Invention of a method of Invention (IMI) – or automation of the scientific method – has the potential for huge upheaval.

The very short implementation lags and the potential for continuous disruption will make economic management very difficult. For example, IMI will accelerate the building of a bridge between the generation of new scientific ideas and their commercialization promising huge profits for those that can capture the impact of change the fastest. Hence the race to build AI capacity. The lesson from the emergence of the internet was that large rewards came to those that captured consumer network effects before the competition and become dominant.

IMI suggests that entirely new organizational structures and unforeseen economic relationships will emerge. An understanding of this transformation process will strain any attempt to manage it. Moreover, doubt about the quality of US data is now front and centre as former independent statistical agencies are coming under political control.

What’s the Central Bank to Do?

A negative supply shock presents as lower than expected growth and higher than expected inflation. This is the signature of lower potential growth that tariffs will most likely deliver given the implied losses in economic efficiency. Should the Fed lower interest rates to accommodate weaker than expected growth, or hold interest rates steady – or even raise them – to constrain higher-than-expected inflation?

Whether or not you meet your inflation target depends on how well you understand the pressures on the underlying economic structure, how good your data and information is, and how good an economic forecaster you are. The shifting structure of the economy from AI as a GPT and the potential deterioration in data quality will make forecasting very hard.

Without some clear evidence that demand is falling below growth potential, that inflation expectations are consistent with the inflation target, that tariffs are not getting passed through to prices, this is no time to cut interest rates as the loss function it not favourable. Policy does not have the luxury of taking big bets on forecasts in this highly uncertain and disruptive time.

Pressures on Inflation

So far the high inflation many feared earlier this year is missing in action. Tariffs are a one-shot change to the price level so they are not strictly inflationary. Inflation has been relatively well behaved given the chaos for what passes as policy. But core inflation is 3.1% far from 2.0%. And, core is the better predictor of future inflation trends so we need to be cautious.

There are lags between monetary policy changes and the impact on prices, so today’s rate of inflation likely reflects policy decisions made more than a year ago. There are also lags between the imposition of tariffs and the time it takes for them to be passed through to prices. With inflation expectations still well above 2.0%, we cannot be confident that inflation will return to 2.0% anytime soon.

And it has stated. The round-up of immigrants is clear in the producer price data, which pin-point the effects of an agricultural worker shortage precisely. Farm product prices rose fifty percent in the month of July alone.

Because US tariff policy has been on again off again, importers have paid the tariffs and taken a profit hit in hopes that, after Trump stood down in April, the cost shock will be less than initially feared and may even dissipate. But this can’t go on forever, and many tariffs are now in place and likely to stay there.

Profits had already stagnated ahead of tariff implementation with the GDP measure of profits flat in the first quarter of this year. However, firms ultimately respond to a sustained profit squeeze when they can’t raise prices by shedding labour, a reliable precursor to recession. Perhaps the weakness in job growth reflected an attempt to correct the profit depletion used to pay the early tariffs. Regardless, pass through is coming to restore profitability.

And what about the grand plan to reshore manufacturing and create legions of new high-paying manufacturing jobs? Where will the people come from to fill the new positions, and what impact will that have on wages if those available don’t have the skills manufacturers need?

Immigrants won’t fill the gap. While the foreign-born share of the total labour force is quite small, it is a large contributor to labour force growth. Since 2008, foreign born workers have entered the labour force at a rate eight times higher than the domestic labour force can grow, allowing wage growth to remain consistent with the 2.0% inflation target. The Fed can’t count on this help looking forward, so it can’t risk validating cost-push inflation pressures just as economic efficiency is dwindling.

Observers have to decide what is the outcome of high tariffs imposed by decree: higher inflation, recession, or somewhere in between? This is stagflation in all but name. The lesson for central banks from the 1970s is to respond to the inflation surprise, not growth, and this will put meeting the Fed’s dual objective to maximize employment and minimize inflation into considerable conflict.

Stagflation and Asset Prices

Nearly all financial assets appear to be overvalued unless the AI revolution delivers a stunning and imminent boost to productivity that is well distributed across the economy. History suggests that the arrival of GPT’s does not work out this way, and the history of the past forty-five years is that capital captures most of the gains from economic change.

A recent Fed paper looked at the impact of stagflation on equity and bond returns. The authors argue that investors mark-down expectations of corporate free cash flow growth as inflation rises and economic growth slows. The equity risk premium goes up and equity prices decline. Rising inflation expectations lead to an increase in the inflation compensation component of bond yields, so steepening the nominal yield curve. Real yields should move down in response to slower growth but will struggle to do so if expectations of monetary easing are priced-out as inflation moves higher.

Perhaps the most interesting finding is the differential fortunes of businesses with and without market power. When stagflation emerges it is interpreted by investors as a shock to marginal costs. Large businesses with market power are able to pass-through the cost increase to consumers. But those that have no market power cannot do so and struggle to regain competitiveness, usually by shedding labour.

A survey by the Pew Research Center in 2024 estimated that small businesses employ 46% of all US private sector workers, and it is these businesses that are likely to pay the price of tariff folly. Employees who work for businesses that must compete are likely to be most at risk of losing their jobs, and many small businesses will go under concentrating the overall loss of economic efficiency.

The US is in for a difficult time, and Jerome Powell is in for an even rougher ride as he is the only policy adult left in the room.

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Ken Rogoff’s latest book, “Our Dollar Your Problem” comes at an opportune time. Rogoff argues that the US$’s ability to function as a global store of value and a means of exchange is compromised by fiscal profligacy, political extremism and the weaponization of the US$ by exploiting its role as the world’s payment currency.

Rogoff warns that the US has put the exorbitant privilege of the dollar’s global dominance at risk. The US inflation commitment – to manage the purchasing power of US$’s to an annual depreciation of 2.0% -- is important to non-US holders of dollars as the quid pro quo of dollars held in honour of trade and security agreements.

The US sponsored and rapid growth of trade and sustained financial globalization since the emergence of the Washington Consensus laid the groundwork of sustained inflation control. But US policy is now driven by economic populism, a shift that signals the era of easy inflation control, at least for the US, is over. The return of great power conflict is merely the closing act.

The return of high inflation will likely be seen by the holders of US$’s as a default in any other name. Given it is the product of the deliberate abandonment of policy discipline, it will viewed as an abuse of the dollar’s global dominance by the administration. This is nothing new.

The US has abused its privileged position before, yet the dollar’s reserve and global payments status has not only survived but gone on to be even more dominant. Nixon’s closure of the gold window in 1971 triggered an immediate foreign currency depreciation in the US$ , lowering the foreign currency value of US$ denominated debt held by other countries as part of their obligations to the Bretton Woods Agreement. Additionally, the US made a commitment that after the suspension of gold convertibility that inflation would be controlled; a commitment it did not keep.

Recent administration action leaves few convinced the US will honour its international obligations, undermining the reserve value of the US$. The “high handed and reckless” attitude towards governance suggests the US dollar’s “unique borrowing privilege” may not be as freely available in the future, especially as the ancien regime is fragmenting and a global, multipolar, financial system is emerging in its place.

The dollar’s status as a reliable means of exchange is also eroding, reducing demand for payments balances. Many countries use the US$ as the intermediating transaction currency because it is more efficient and cheaper to do so than exchange currencies directly with one another. In furtherance of its global political aims, the US has weaponized the dollar’s payments dominance. Taking note, the SWIFT global payments messaging system, headquartered in Brussels, has moved all data storage related to European transaction to Europe. It has done so to be both complaint with European law and to ensure that the US cannot arbitrarily access European banking information to leverage its predation.

Strategic Foreign Exchange Hedging

Questioning the staying power of the US$ as a reserve currency is, and should be, the most important question in global finance. The adversarial posture of the US to all trading partners represents a challenge to the security, safety, and foreign currency value of all US$ holdings by other countries.

This is especially so for Canadian asset managers and major pension plans that have a significant share of their assets denominated in US$’s. Yet their liabilities are in C$’s. A depreciation in the US$ relative to the acquisition price creates a loss in C$ terms, and if that loss is big enough it could hamper investors’ ability to meet future liabilities or future value goals.

Hedging foreign exchange exposure is a perennial challenge for any asset manager, but it is especially difficult now that the past currency dynamics between the US and other currencies is in flux. The foreign exchange challenge presents two separate management realms: strategy – what are we going to do – and tactics – how are we going to do it?

The strategy choice is a risk management policy decision. The decision is a function of many different variables, such as the currency of liability, the relative structure of domestic versus foreign asset markets, the expected investment horizon – long or short – and the risk of loss from doing nothing.

Important to the strategic FX decision is the risk management framework of the asset manager, with the caveat that not all asset managers have holistic and integrated investment risk management frameworks. Usually it is better to include risk explicitly in investment decisions rather than do nothing implicitly.

Risk tolerance is a major input to taking both strategic and tactical investment decisions. All market exposure creates a risk of loss, and asset managers should deliberately choose the magnitude of loss they can tolerate. Generally, loss minimizing organizations tend to be return minimizing organizations. Those organizations that are willing to tolerate a greater risk of loss within a well-defined risk framework tend to be return maximizing.

Canada’s pension plans are aging, as there are fewer active members to fall back on to absorb losses. Many plans now pay out more in benefits than they receive in contributions. This adds up to a diminished ability to take investment risk. With such a large weight to US$ assets, foreign exchange risk is neither a strategic risk to be ignored nor a tactical risk to go unmanaged.

There is no consensus on strategic foreign exchange policy hedging other than choosing the hedge ratio of least regret, usually landing at 50% smack in the middle between unhedged and fully hedged. The choice is similar to the decision to take an umbrella on a day when there is a chance of rain. If you take the umbrella and it doesn’t rain you will be embarrassed. However, if it rains you will be dry and smug compared to those who don’t.

The fully hedged choice eliminates risk of loss from FX and protects against adverse trends, but it comes with FX market access and operational costs adding to the fact that the expected returns to foreign exchange hedging are zero. The unhedged choice eliminates hedging costs, has no operational risk, and frees up liquidity. There has to be a reason to create exposure to adverse FX trends.

Empirically, leaving the C$/US$ unhedged has provided a diversification benefit for Canadian plans. Other currencies do not offer a compelling diversification benefit so need to be either hedged strategically or managed tactically.

The extent of any diversification benefit is a function of the correlation between return streams and the volatility of those return streams. Matching the volatility of a pair of negatively correlated return streams is crucial to maximizing the diversification benefit. If the return of asset one falls at twice the rate of rising asset two, then the loss on asset one will not be offset by a gain in asset two. The investor needs twice as much exposure to asset two to reap the full diversification benefit of the negative correlation.

The volatility of commodity returns is close to the volatility of equity returns, and the returns tend to be negatively correlated. Together they have in the past offer a solid diversification benefit. The price of commodities is a significant driver of the C$ explaining why the optimal FX hedge ratio for Canadian investors US$’s is zero. For example, during the financial crisis of 2008-2009 the S&P fell 56.8% from October 2007 to the trough in March 2009. Over the same period the C$ depreciated by about 25% reducing the C$ loss to 43%. A hedged position would have delivered approximately the US$ loss of 56% in C$ terms. Moreover, the need to deliver on a forward contract would have encumbered liquidity, leaving cash unavailable for other needs at a time when cash is the most valuable asset of all.

What Drives the US-Canada Exchange Rate?

There are three major drivers of the US$/C$ exchange rate and in order of explanatory power from largest to smallest they are:

1. The price of commodity exports relative to the price of imports.

2. The difference between the slopes of the US and Canadian yield curves.

3. And, the role of the US$ as the safe haven currency in times of heightened financial risk, even if the US is the source of that risk.

The relative price of commodity prices has been the principal source of diversification that determines the zero-policy choice, as it determines the long-term tendency for the exchange rate to return to its fundamental value, and gives the exchange rate the long-term price volatility that enhances the diversification benefit. The powerful net impact of commodity prices on the C$ -- or more precisely the commodity terms-of-trade -- was first formulated in the early and mid 1990s.

Even when the broad specification of the underlying drivers of the US$/C$ are not affected by sudden policy shifts, changing underlying economic relationships will affect currency determination. For example, as Canadian oil production grew, oil prices became a key and dominant driver until 2014 when US imports of crude oil fell from 12MM barrels a day to small net exports in 2025. The power of oil prices to explain the C$ declined over the same period.

Other factors can drive substantial but short-term deviations from the commodity drivers of the exchange rate. While the impact of the relative yield curve slope carries less explanatory power relative to commodity prices, large deviations in monetary and fiscal policy that affect the US Canada yield curve slope can overwhelm the commodity price driver.

Typically a steepening in the US yield curve relative to Canada would tend to push the US$ up but if the US yield curve is steepening to reflect greater relative US inflation risk, and because investors are now wary of high-handed US abrogation of treaties and agreements, its explanatory power will likely wane. Moreover, the sign may change meaning the US$ now goes down rather than up reflecting the US loss of its safe haven function.

Finally, a large and persistent rise in financial market volatility traced to financial disturbance, such as the 2008-2009 financial crisis, can detach the US$/C$ from the commodity determined equilibrium for some time.

The C$ has depreciated in the past when heightened concern over risk of loss prevail. In periods of global turmoil, asset owners seek shelter in the US$ treasury market until the froth is blown from the market. However, the dollar can no longer be assumed to rise when volatility spikes.

The great reversal in April of this year saw the US yield curve steepen and the dollar decline as the rise in financial market volatility was met with dollar outflows instead of inflows. The degradation in US governance -- the apparent optional adherence to the law and the bald-faced abrogation of existing international treaties -- became clear and was priced.

Time to Review the Strategic Hedging Decision

Despite the ability of financial markets to facilitate almost instantaneous transmittal of new information, investors take time to implement changes to their beliefs and assumptions. It can be costly to be hasty. Long term return correlations and relative volatility relationships typically change slowly.

Many Canadian asset managers and pension plans have chosen to have a large portion of their US$ exposure unhedged because total balance sheet risk is the often the same regardless of whether the US$ is hedged or unhedged given the commodity dominance in the US$/C$ valuation.

The reliability of the other two determinants – yield curve slope and the disruptive impact of periodic volatility --are at risk pushing the US$ down in stead of up. Econometric models used for asset pricing and risk quantification rely on stable explanatory parameters. Structural breaks in the explanatory variables typically violate prior assumptions, and failing to adjust for them can lead to outcomes that are different than expected.

Recent US policy and administration behaviour is an abuse of the dollar’s privileged global role, and it is a clear structural break. A steepening US yields curve now results in a falling US$ as does the spike in financial market risk aversion as measured by a spike in financial market volatility.

At the very least, Canadian asset managers need to constantly monitor the effective explanatory power of the different variables and the expected sign that form the model underlying their FX hedging policy choice—whether they realize this is the underlying model or not.

Stablecoins for All

The US seems to experience serial financial crises more frequently than other countries. US economic culture tolerates high-risk financial innovation and is prepared to experience financial crises as an acceptable cost of maintaining its economic dynamism and comparative advantage. The relatively lax approach to US financial regulation leads the US to downplay the financial risk that builds off-balance sheet even though it is clear that it is growing, as past dollar dominance has facilitated access to, relative to other countries, cheap stabilizing capital.

The GENIUS act and the promised regulation of Stablecoin – crypto currencies that are tied to the US$ to dampen their volatility – is designed to enhance crypto currencies ability to function as a store of value and become a reliable means of exchange. The door is being opened for crypto to enter the inner sanctum of the centralized and regulated financial system. History shows that fixed exchange rate regimes are usually over powered by economic and financial forces.

The financial system is there to provide financing to economic activity, not to be a growth driver in and of itself. The US record on regulation and risk assessment is not encouraging, as the global distribution of US asset-based derivative complexity and unhedged market risk in the early 2000’s laid the foundation for the 2008-2009 global financial crisis. Many economists believe that the entry of crypto to the regulated financial system lays the foundation for a new financial crisis in a repeat of earlier regulatory failures.

Rogoff argues that this time is different -- the title of his 2009 book coauthored with Carmen Reinhart. The combination of a predatory stance towards the rest of the world, the rising risk of a major inflation from fiscal unsustainability that erodes the foreign currency value of US obligations, the weaponization of the US$’s role as the global payments currency, and a likely financial crisis traced to crypto currencies, sets the stage for a nasty and negative surprise.

Of one thing we can be sure, when the next financial crisis arrives, a populist capture of the Federal Reserve will ensure its intensity and depth will be hitherto unmatched. The US has already spent much of its fiscal resources on stabilizing the 2008-2009 financial crisis and the Covid-19 disruption and has chosen to encumber even more future resources though unfunded tax cuts.

When the US needs to use its fiscal resources to stabilize its financial system in the future – which is a high probability -- it is not clear that the rest of the world will be willing to lend a helping hand without demanding a penal rate of interest at a favourable exchange rate.

Although they are the most dangerous four words in the economic lexicon, it looks like this time (really) is different. Strategic FX hedging choice needs to be reviewed, and tactical FX hedging programs need to be resourced.

The Trump administration has undermined decades long trade, defence, payments and reciprocity agreements, and compromised the founding principles of the nation. Whether the US$ can remain the global payments and reserve currency is the most important issue in global finance, presenting practical challenge for foreign exchange management.

The US$ has been at the centre of global finance since the Bretton Woods agreement, signed in July 1944. The world’s acceptance of US$ dominance went hand in hand with US security alliances and a mutual desire to expand global trade and post-war reconstruction.

The emergence of the US$ as the global reserve and payments currency created excess demand for US$’s, putting upward pressure on the dollar. The presence of the US trade deficit leads less sophisticated actors to believe the US$ is overvalued rather than signaling excess aggregate demand. The current administration believes US$ overvaluation is both a cost to the economy and a constraint on domestic policy goals.

At the same time, excess demand for dollars needs to be absorbed by the US treasury market, so delivering lower interest rates, often dubbed a “safety” premium as in times of global crisis capital has flowed to the US even if it was the cause of trouble. This tended to put upward pressure on the dollar and downward pressure on interest rates. Not anymore.

The Trump administration has chosen a coercive approach to foreign relations and an authoritarian approach to domestic policy, the former necessary to gain compensation from its perception of an unfair international trading framework, and the latter to push through domestic policy goals. This came as a shock even though it was well telegraphed in the election campaign, a shock beg enough to upend relative asset price relationships.

The foreign exchange market has an uncanny ability to price structural changes in the relationship between countries. The FX market is telling us the US is no longer considered a safe haven for non-resident assets, so the dollar now goes down in response to policy surprises and interest rates now go up, reversing decades of predictable relative price action. The emergence of a negative correlation between bond and US$ returns on the declaration of trade war has yet to show clear signs of reversal. The market is thus discounting a wholesale change in the US$’s role in the global financial system.

The coercive application of tariffs and non-tariff trade constraints will lead to a reduction in the US trade footprint, and the dollar’s international role will diminish. Both the economic withdrawal from global trade and the bad faith actions of the administration, internationally and domestically, gives other countries no alternative but to protect themselves against US malevolence. They will trade more with themselves and less with the US, so reducing the need for the US$ as a payments currency and the need to park excess balances in US treasuries.

The central international stabilizing role of the US authorities must also be questioned. The US administration has put significant pressure on the Federal Reserve to lower interest rates, so far to no avail. But the Fed has been constrained by a presidential executive order demanding that Trump have control over all regulatory actions the Fed might take. This implies that the fidelity of the US to international financial agreements, of which the Fed is the central player, is now at the whim of the president.

One must assume that the prior availability of US$ liquidity by foreign central banks cannot be assured. The US administration is also promoting Stablecoin as a payments vehicle ,and is pushing the integration of crypto into the existing financial system. This raises the probability of a disruptive systemic event. If the Fed is constrained from freedom of action to stabilize an incipient financial crisis then other sovereigns must reduce US$ exposure. No wonder other central banks are encouraging their commercial banks to minimize their reliance on the US$ mindful of the 2008-2009 crisis when international banks became national in death.

What’s the Alternative?

The US under Trump has systematically undermined its security, trade, and financial agreements in pursuit of zero-game monetization of international relations. The lesson is that any agreement with this administration will sour as quickly as unrefrigerated milk.

Yet many investors cling to the comforting assumptions provided by an eighty-year-old ancien regime that played by the rules and evolved slowly. They would rather bet on this rather than adapt to the current chaos. While investors have taken note, it is hard to review assumptions and change beliefs about how the world works lest you take action that may prove costly. Many want to believe the dollar’s dominant world role will remain intact, and besides there is no alternative reserve and payments currency.

The much-followed Torsten Slok, Chief Economist at hedge fund Apollo Global Management, cheerfully implies that concerns about the US$’s role in the world are not pressing. He cites the size of the domestic US economy, the importance of US economy in international trade, the size, depth, and openness of US financial markets, the convertibility of the currency, and the stability of US domestic macroeconomic policies. So we’re good right? Nothing’s changed right? And, if there’s no competing substitute then we don’t have to change our assumptions do we? We merely need to be alert to unanticipated policy changes. Yet these comforting US parameters are merely sufficient conditions for the status quo.

Values not Economics Build Solid Foundations

Barry Eichengreen, author of Exorbitant Privilege, the Rise & Fall of the US$ and the Future of the International Monetary System takes a subtle but more powerful perspective on the dollar’s challenges. Eichengreen identifies the necessary conditions, beyond the sufficiency of market depth and economic presence, for the dollar dominance to prevail.

Values matter more; the domestic assault on the country’s legal system, its civil service, its universities and health sciences, selective adherence to the rule of law, and the overall corruption of public life all signal institutional collapse. This deviation in values from former democratic allies creates an imperative for those countries to reduce the intensity of their economic and financial engagement with the US.

The world watches the bad faith actions of the US administration with dismay. Recent moves to end the equivalent tax treatment of residents and non-residents signals that equal defence of property rights for non-residents cannot be assumed. Essential to the generation of profits is equal protection of property rights lest you find yourself defenestrated.

Wariness towards future arbitrary actions by the US, notably respect for the rule of law and the predictability of contracts, must surely eclipse Torsten Slok’s blithe assumption that the lack of alternatives leaves the dollar’s dominant role intact. If the sovereign decides the law, then the US will have departed from the shared values of predictability and safety upon which the US sponsored global financial and trading system was built.

To assume the dollar will remain dominant because there is no alternative assumes that the underlying trade and financial arrangements are fixed. But how can this be? Practically the US retreat from global trade will diminish the need to price in US$’s and transact in US$’s so demand for other currencies will rise as demand for dollars falls. Other countries will surely be unwilling to engage given the breach of trust by the US, building on the efforts of others to avoid the dollar area following the weaponization of the Swift payments system to achieve US foreign policy objectives. The US no longer differentiate friend from foe. All are fair game in this a most dangerous game.

Goodbye Inflation Targeting & Sound Regulation

The most important factor for foreign exchange management is the end of Federal Reserve independence. This cannot be understated. The embrace of heterodox economic policies with the passage of the GENIUS Act and the repression of regulation on the behest of the crypto world is a red rag to a financial crisis bull.

Constraints on Fed regulatory action and the exit of Jay Powell in 2026 — if not earlier — demands an assessment of whether the US is now on a path to accelerating inflation. Moreover, an even more fundamental question is whether the US$ still qualifies as a suitable payments currency in the international arena.

The Federal Reserve may have an inflation target, but given the administration’s disruption to institutional integrity will it be able to deliver it? The inflation target is set and owned by the government, but meeting it is contracted-out to an independent central bank. The latter can make cold hard technocratic decisions unrelated to the political cycle and so can induce pain if necessary to keep inflation on target. If you can’t meet the target then it hasn’t any value. Monetary policy becomes unmoored of one framework is discarded into a vacuum.

Two developments suggest that the Fed will be unable to meet its inflation target in the future. The first is that Trump doesn’t want to meet the inflation target, as it is remote from his desire to have low interest rates. He has already ended the contracting out arrangements, we just haven’t noticed. Like all other US federal appointments, the composition of Fed interest rate decision makers will be reconfigured one retirement at a time to anoint rubber stamping appointees that deliver the President’s whims and wishes rather than policy integrity.

The second more distant development, but one that is nearer than imagined, is the explosion in US debt and the potential for higher financing costs to induce a financial crisis. The current share of US debt satisfied by foreign investors will likely become more expensive. If so, then the Fed may have to do more QE to finance the US treasury. If it has a fiscal target rather than a monetary target, such capture of the Fed will make it impossible to keep inflation near 2%

Dollar dominance led to the emergence of large dollar holdings outside of the US, and to ensure that offshore financial instability did not rebound on the US, the Federal Reserve established US$ swap lines with other central banks. Ability of non-US central banks to access the Fed discount window both reduced the probability of financial crises and their severity. Given that Trump now holds a veto over the Fed’s independent exercise of non-interest rate actions, can other countries whose banks have large dollar balance sheets rely on the ability to draw down on the swap lines? And if not, then they need to minimize their economic exposure to the dollar.

Given these significant developments, does the US$ continue still qualify as an international payments currency? There are three abstract tests that determine currency acceptability: it must be information insensitive, meaning we don’t have to do due diligence about its value when we use it to transact. It must be issued by any central bank that has equivalent value at a given exchange rate, or “singleness”, and it has integrity – users can trust the sovereign that issues it.

The US$ is no longer information insensitive for international users given the decay in the institutions of the US state. Potential constraints on access to central bank dollar swap lines threatens singleness and the relative stability of exchange rates, and the coercive behaviour towards other countries and the degradation of public life means the currency lacks integrity.

The dollar looks shaky as a global payments currency.

Multiple Currency Areas and Reserves

To ask for a dollar alternative is to assume the world is as it was. Maurice Obstfeld in a recent paper notes “the parallel Trumpian offensives on international and domestic fronts threatens all the major foundations on which dollar dominance has relied.” He sees an inevitable retreat from the dollar as the world fragments.

Prior to the US$’s dominance, the dollar’s role in global transactions was, in the 1930’s, shared with sterling and the franc. The past has seen the world function with multiple currency areas in an economically fragmented world, often based on political and military alliances. History tells us that those countries that sign onto security agreements with one another tend to hold each others’ currencies, notably the pre–WWI European Triple Alliance – Germany Austria-Hungary and Italy --and the Triple Entente – Britain, France and Russia.

We should remember that those who thrive are not the fittest, but the most adaptable. While many doubt that the US$ will be toppled from its perch, the disintegration of US institutions, the drift to isolation, autarky and a command economy free of the constraints of law have changed its place in the structure of international economy and financial system. There can be no going back for a generation.

The upshot: the US has imposed a structural break on the global trade and financial arrangement meaning that the relationships between economic and financial variables has changed. Structural change is abrupt, not gradual, and has destabilized the underlying model we use to assess the distribution of return and risk. This must invalidate prior decisions.

Other economies and sovereigns are already out of the gate, seeking to insulate themselves from harm. They are building new infrastructure – physical and administrative – to redirect trade away from the US. Many are also arranging to make payments in currencies other than the US$.

As capital flows change to reflect the new global trade realignment, so too will the relationships that underpin today’s foreign currency hedging decisions. An accompanying note next week will examine what this implies for strategic and tactical foreign exchange management.

Making alternative private equity and debt funds available to retail investors is framed as the democratization of private investing, meaning that private asset returns are now accessible for the affluent retail investor.

Looking at private equity reveals a diverse space that encompasses a number of different investment styles and structures. Wider accessibility beyond institutional investors also reflects a necessity given the reduction in economic participation in public equity markets.

Popularized by the Yale Model pioneered by David Swenson in the mid 1980s, and according to AQR’s Antti Ilmanen, private investors gained as much as 3% above public investors when the Yale Model was initiated, but as of today the premium is barely 1.0%. The best days for private are likely long gone despite the potential for greater participation.

Before we assess whether this is the time to bring private equity to the retail investor, it is worth understanding why private equity and other alternatives (meaning not public equity and fixed income securities) have grown to be a large share of the institutional investor asset mix.

The institutional investor preference for private equity in particular is at first strategic. Allocations are driven by higher expected returns and lower volatility of returns ( the latter interpreted to mean both lower risk of loss and a better portfolio diversification benefit.)

Many institutional investors also believe that they have better information on private companies from fund participation, information that enables them to better manage risk, compared to the information available on public companies listed on public markets.

The private returns come from the dividends generated by the investment, the expected growth premium over a public investment, any multiple expansion and leverage through the use of debt. The generate the extra risk premium, the capital is locked-up for a period of time which is necessary for the manager to meet these return expectations. From this emerges the liquidity premium paid to the investor.

The share of illiquid investments in institutional investor portfolios took off following the 2008-2009 financial crisis as central banks rates fell close to zero, dragging down risk-free fixed income yields to levels far below most investors hurdle rates. This caused an asset allocation push from cash to find higher returns for an acceptable risk of loss. Hence the desire for private equity, real estate and infrastructure.

Private investments require that funds be invested for up to and sometimes exceeding ten years, making them relatively illiquid. If investors want their capital back before the fund’s maturity, they must sell their stake at a substantial discount. And in times of financial stress, the discount can be significant. So to avoid a forced sale, investors hold cash to meet other investment management needs – or they should. Anecdotal evidence suggests that institutional inflows to private equity have declined, leading funds to exit positions to return capital to investors through sales to secondaries which may demand a discount of up to 30% of the current assigned value.

Given the lock-up, most institutional investors hold liquidity reserves and have robust liquidity management policies and processes. When an investor sells a public equity investment to buy a private equity stake, the investor may have to sell -- for example-- $1.05 of public equities for every dollar of private investment, holding 5% back as a cash reserve. Entry into private equity means that the investment must both beat the public equity risk premium and overcome the drag from cash. Finally, investors also want to hold cash to prevent a forced sale of private assets to avoid being insolvent because they are illiquid.

What about retail?

The motivation to accumulate private equity exposure, or private credit and infrastructure exposure, is to boost returns to secure future value goals. While defined benefit pension funds with long investment horizons are ideal private investors, and have the ability to manage illiquid holdings and recover from losses, are retail investors so equipped?

The economic risk in a private equity portfolio is the same as investing in the public portfolio, and the risk remains primarily beta or market. But, there are many financial risks to private asset holdings beyond the exposure to common economic factors. And, potential retail investors need to review whether they are equipped to manage these risks.

Even for sophisticated institutional investors, the illiquidity risk is substantial. Many defined benefit pension plans are aging, where the proportion of retired members now exceeds active members placing them in a net contribution deficit. This means they must provide for an even greater measure of cash when they invest in illiquid private assets because their ability to recover from any loss is reduced. They want to avoid being forced sellers at the worst time to meet benefits.

Many plans would have been in a difficult spot in the 2008-2009 crisis, but central banks came to the rescue by providing generous liquidity support. This cut short the liquidation cycle, but the benefits were not distributed equally. And, the resulting consolidation of losses – that took many years to distribute and absorb -- meant that official rates were kept at 25 bps for some eight to fifteen years depending on the jurisdiction.

Many plans were forced to take more risk when they should have been taking less risk to male up lost ground. Any plans that had overallocated to illiquid assets suffered an even greater measure of pain. It is best to manage liquidity yourself than rely on the official sector to do it, especially in the current chaotic policy environment.

Accidents do happen – even to sophisticated institutional investors

Many investors are subject to information asymmetries, where one party to a transaction has an information advantage over the other. While investors feel that they have a better sense of the risk they are taking in private equity, the potential for adverse selection remains (as the manager or general partner GP typically has an information advantage over the limited partner LP.)

This is best animated by the industry term “blind pool risk“ where the investor, the LP has committed capital that has yet to be invested by the GP in an underlying portfolio. Only after the investment has occurred can the LP begin to understand and manage the risk of the emerging portfolio.

Once the portfolio has been built, investors are give a valuation on the portfolio holdings, and one should not confuse the GP determined valuation with a valuation determined by an observable market price (mark-to-market.) (Often funds will transfer holdings between fund vintages in the same fund family at non-market prices.)

Private equity also has lower disclosure standards and requirements compared to investment in public markets. Despite the assumed information edge of private versus public market investments, there is a degree of valuation uncertainty in the private space because of the quarterly lag in financial disclosure. A lot can happen in three months.

Even big institutional investors can suffer significant losses when valuations are uncertain. Investment giant Blackrock is one of the most sophisticated asset managers in the world, and it forfeited $600 billion from its controlling position in alacrity solutions, an insurance claims manager. Benjamin Shefflin observed “that if sophisticated institutional investors can suffer losses because private market assets are hard to value what chance do retail investors have in private markets?“

In addition to liquidity and valuation issues, the apparent reduction in return volatility and the enhanced diversification benefit this confers is less than meets the eye. Because the volatility observed is not market determined, we can be less sure it is an accurate representation of risk of loss. And, volatility merely defines a range of possible returns. It is not the same as the risk of loss, sometimes from which an asset never recovers as Blackrock experienced. And if the volatility is not representative of the risk, then is the assumed gain in the portfolio diversification benefit real? Most likely not.

Mixing assets that are valued (often by the GP managers themselves subject to some external validation) with those based on observable market price can lead to a false sense of risk and thus potentially inadequate risk management. In fact, in choosing an optimal portfolio in mean variance space often results in models over allocating to private alternative assets at the expense of public assets because of the apparent reduction in return volatility.

What factor risk assessment says

Using a factor-based approach to risk assessment, a recent benchmark study by GARP-APTimum of the top twenty-five US public pension plans looked at the resilience of these plans to adverse economic and financial shocks.

In the past ten years, the top funds returned about 8% annually on a diversified asset mix that included a weighted average alternative holding equal to one third of the assets. While the authors noted that this asset shift was appropriate to the lower for longer interest rate period studied, the funds remain exposed to concentration and liquidity risks.

Applying a factor-based approach, the study found that portfolios are dominated by equity risk, accounting for 85% of total risk of loss! This should not be a surprise given the positive return correlation that is created by the common exposure of private and public assets to the same economic return drivers.

The GARP-APTimum study shows that the assumed volatility and superior diversification benefit expected of private assets is something of a mirage. While pension plans do have a long investment horizon, and most have sufficient resources to ride out such shocks, retain investors are much less aware of the risks and – depending on their level of wealth and cash holdings – less able to ride them out.

Let the Buyer Beware

Private equity returns are now available to investors. Here in Canada investors can access, for example, the Mackenzie Northleaf Private Equity Fund either as a series F for a fee of 1.65% or a series A fee of 2.65%.

The fund, offered to accredited investors, invests about 75% of the fund’s NAV in the Northleaf funds, and the remaining balance in a private equity replication strategy which also acts as a liquidity buffer. The fund offers quarterly liquidity of 5%. Impressively, the fund has returned an annualized 26% since its 2022 inception.

The fund information document, written for investment advisers, shows returns as net of fees, including the “material fees and expenses” charged by Northleaf. The fund report does not present a volatility nor does it show drawdowns. That said, the funds are gated – meaning that withdrawals in extreme circumstances can be blocked – to give the managers time to recover any lost value.

Oxford University Professor Ludovic Phalippou[1] argues that private equity returns – after fees – do not offer any substantial return advantage to public markets. He and others argue that investors are better off, after adjusting for fees and risk, investing in the Russel 2000 for which low fee ETF’s are available. Many of Canada’s big pension plans know this, building large internal private equity management teams in order to internalize management at lower cost and to manage the risk themselves. This would be beyond the resources of most retail investors.

Retail investors now have access to investment returns that have traditionally been reserved for institutional investors and those with a high net worth. However, they need to question whether the fees they pay for exposure to illiquid private equity exposure and other illiquid assets is worth the liquidity lock up given that risk factor analysis suggests private assets are equally as prone to drawdowns as a cheap equity ETF.

Most passive ETFs charge barely six basis points for public market exposure, and many actively managed ETF’s that begin to approach private equity returns and risk do so often for less than 100 basis points compared to the hefty fees charged for the fund structures now offered to retail.

Retail investors should also be wary of providing liquidity to institutional investors at a stage in the cycle where liquidity is hard to come by. Secondary funds do this, and they are experienced sophisticated managers.

At a minimum, retail investors need to think about providing for the risks of this asset class in the same way that institutional investors do.

Cash is king for a reason: it is most valuable at a time when it is most scarce.

[1] Private Equity” A Reality Check.