• Market volatility reveals an investor’s true risk tolerance

• Behavioral biases often distort how much risk people think they can handle

• Use market drawdowns as diagnostic feedback to assess true risk tolerance

Thinking about risk tolerance may be an afterthought for some investors, but it’s a crucial component. The reason: a key part of investing success is ensuring that an individual owns a portfolio that’s appropriate for a given risk tolerance.

Identifying a suitable risk tolerance can be tricky because what an investor thinks he can endure in theory may not be realistic in practice. That’s a problem because a mismatch can lead to panic selling at or near market bottoms.

The recent market volatility has been a useful stress test for gauging how someone reacts under pressure—panic, patience, or something in between. Monitoring reactions during market corrections may provide a more accurate read on the capacity to handle downturns compared with questionnaires and other efforts to quantify investor behavior.

In other words, market volatility is more than short‑term noise to be endured. It’s also a diagnostic tool that can reveal the degree of emotional resilience and decision‑making under stress.

Consider the drawdown history of the S&P 500 Index, proxied in the chart below by the SPDR S&P 500 ETF (SPY). The latest selloff, following the start of the war with Iran, left the S&P down nearly 9% from its previous high. The drawdown in the spring of 2025, during the tariff‑related decline, cut the market even deeper—a 19% peak‑to‑trough drop at one point. Observing behavior during these events offers an opportunity to determine an investor’s true level of risk tolerance.

Market declines can get much worse, as the 2008 crash reminds. During that event, the S&P fell nearly 52% from its previous high.

Volatility is a feature, not a bug, of financial markets, which highlights the potential for trouble if investors overestimate their risk tolerance. That’s a non‑trivial issue because everyone suffers from various behavioral biases, according to numerous studies over the years. Examples include overconfidence bias (investors overestimate their abilities and knowledge), herd mentality (mimicking the actions of a larger group), and loss aversion (investors experience a deeper emotional impact from losing vs. winning the same amount of money).

The challenge is compounded because researchers have documented a gap between what investors say about risk perceptions and how they behave.

The good news is that there are various strategies for managing risk so that an investor’s portfolio aligns with her risk tolerance, which can be expressed as a subjective, psychological willingness to lose money. A foundational approach is building a globally diversified portfolio and structuring the asset allocation to match the investor’s risk tolerance, time horizon, and other factors unique to that person.

Developing a rebalancing plan and working with a financial advisor can also help.

In the end, volatility doesn’t just test portfolios—it tests people. Investors who treat these episodes as feedback rather than failure gain something far more valuable than short‑term returns: a clearer understanding of the risk they can truly live with.

• Markets expect the Fed to hold its target interest rate steady, but inflation risk from the energy shock is rising

• Bond yields are edging higher, hinting at early pricing of renewed inflation pressure

• Powell’s final meeting comes as Warsh prepares to take over amid growing policy uncertainty

Markets are pricing in a near-certainty that the Federal Reserve will leave interest rates unchanged at Wednesday’s policy meeting, but the high‑confidence forecast for standing pat belies the challenges that lie ahead for the central bank.

The main uncertainty that will lurk over policy decisions in the months ahead is the threat of higher inflation triggered by the supply‑side energy shock that’s reverberating from the Middle East conflict.

Fed funds futures are betting that the path of least resistance is to do nothing, for tomorrow and beyond. The implied odds for policy through the end of the year favor keeping the Fed’s target rate steady at 3.50% to 3.75%. The question is whether that’s a reasonable forecast if inflation pressures continue to build due to elevated energy prices.

The effects of the war are already conspicuous in the March report for the Consumer Price Index (CPI), which shot up to a 3.3% annual increase—a sharp change from 2.4% in February. Markets are bracing for a repeat performance in the April update, and possibly an even higher pace, in the wake of an ongoing shutdown of energy exports from the Middle East.

TMC Research’s Fed Funds Model still estimates that the policy stance is modestly tight, which may give the central bank cover to argue that leaving rates steady is reasonable while inflation concerns linger. But as today’s update of the model shows, the hawkish bias has faded lately. The current reading indicates that the actual Effective Fed Funds Rate is roughly 35 basis points above the estimated optimal level for the target rate. That’s near the lowest degree of hawkish tilt in more than a year — far below the 120‑basis‑point spread as recently as September 2025.

The argument in favor of doing nothing at tomorrow’s Fed meeting—and for some time after—is that the inflationary effects of the war (and the subsequent stalemate that’s restricting Gulf energy exports) are unclear. Although most forecasters expect higher inflation in the near term, economists are debating how long the run‑up in pricing pressure will last, and how forcefully the Fed should react, if at all.

The risk is that the central bank repeats the mistake of responding too slowly to the 2021–2022 inflation spike. Critics are quick to note that even before the war with Iran started on Feb. 28, the Fed hadn’t fully repaired the damage from the previous price surge, as shown by year‑over‑year inflation running above the 2% target in recent years.

But if inflation risk is rising, presumably the bond market would be reacting by demanding a higher yield premium. Treasury yields have increased since the conflict started, but the increase has been moderate and has yet to break decisively higher.

The benchmark 10‑year yield, for example, continues to trade in a middling range relative to the past year or so, closing at 4.35% as of Monday’s close. But as the chokehold on Middle East energy exports continues, inflation pressure is still on a path to rise.

One sign that the bond market is beginning to price in elevated inflation risk: the 10‑year yield trades close to the upper range of one standard deviation from the mean for the current rate vs. its 200‑day average. For now, the 10‑year rate is holding in a “normal” range, indicated by the grey zone in the chart below. If the market lifts the benchmark rate closer to the upper level of this range, that shift would suggest that investors are becoming anxious.

An added twist: tomorrow’s decision on interest rates will be the last for Fed Chair Jerome Powell, whose term ends next month. His pending replacement, Kevin Warsh, is back on track for confirmation after Republican Senator Thom Tillis on Sunday ended his opposition to the nominee. Because of the GOP’s thin 13‑to‑11 majority on the Banking Committee, Tillis’s vote is crucial to advance a vote on Warsh to the full Senate.

Warsh is expected to push for rate cuts after he takes the helm at the Fed next month, or so his recent comments suggest. But with surging energy costs threatening to keep inflation higher for longer, it’s unclear if he can persuade enough hawks at the Fed to ease rates and potentially create conditions that lead to another policy mistake.

For now, the Fed can stand still; the question is whether the economy will let it in the months ahead.

• The price of oil has come to be widely recognized as a valuable real‑time gauge of Iran‑war risk

• Moves toward either price extreme since the war started would signal a shift in macro expectations

• Stability near the midpoint implies investors see the status quo holding—for now

Tensions between the US and Iran remain elevated as a fragile ceasefire holds, but the war’s trajectory is still highly uncertain. Assessing risk in real time is difficult given how quickly conditions on the ground are evolving. One practical way to monitor sentiment and expectations in this environment is to track how crude oil trades relative to its history since the war started on Feb. 28.

Markets are imperfect, but shifts in oil prices tend to reflect a global, real‑time synthesis of information related to the conflict. The supply-side energy shock remains the war’s primary transmission channel, with disruption of oil and gas exports through the Strait of Hormuz driving the key macroeconomic and financial‑market risks for the global economy. Pricing this risk through oil offers a first‑order approximation of how investors are interpreting the conflict’s shifting contours.

Oil, in short, functions as a risk indicator—capturing sentiment about the war and the implied level of threat it poses for the global economy. A useful starting point is to frame the risk in terms of the range of oil prices since the attacks began on Feb. 28.

Using the US benchmark (West Texas Intermediate), prices have traded between roughly $70 and nearly $120 a barrel. The current level—around $97 (as of Apr. 23)—is near the midpoint of that range.

A significant move away from this middle zone toward either extreme, particularly over a period of days or weeks, would likely signal a meaningful shift in expectations about the war’s path. Such a move would also carry implications for the outlook on inflation, economic growth, and broader macro conditions.

For now, oil’s relative stability near the center of its war‑era range suggests that global investors expect current conditions to persist. The key development to watch is a decisive break—up or down—from this middling zone, which could reflect a material change in the conflict’s macroeconomic implications relative to the current outlook.

Ultimately, this framework deserves close attention because it distills a complex, fast‑moving conflict into a single, market‑based signal that captures how global investors are repricing risk in real time. Oil may not tell the whole story, but it reliably reflects the channel through which the war is most likely to affect macro conditions generally in the weeks and months ahead.

As long as the Strait of Hormuz remains a potential flashpoint, tracking crude’s price within its post-Feb. 28 range offers investors a clear, disciplined way to monitor whether the macro narrative is shifting—and how quickly those shifts may ripple through markets and portfolios.

• CAPE signals elevated valuation for the stock market, but a shorter-term measure suggests conditions remain “normal”

• Divergent signaling reflects differing methodologies and limits of single‑metric views

• Current conditions imply that traditional valuation measures may not be the main driver of near-term market risk

Stock market corrections may look similar from a top-down perspective of falling prices, but different factors can trigger corrections and bear markets at different times. High market valuation is a possible warning lately, but a markets‑based estimate suggests risk is lower than an accounting-based review of equities indicates.

There are multiple ways to measure valuation for stocks, and so conflicting signals are possible—if not likely—at times. Current conditions highlight the divergence. Consider the Shiller PE Ratio, a widely followed measure of market valuation. The Cyclically Adjusted Price‑Earnings Ratio (CAPE) is lofty and close to its highest level in decades, based on the April estimate from Professor Robert Shiller’s data. On that basis, stocks look substantially overvalued.

By contrast, TMC Research’s Excess Return Oscillator (ERO) for the S&P 500 suggests that the market remains in a “normal” range, as indicated by the gray zone in the top chart below. (Our previous ERO update was published in January.)

The sharp difference between the two indicators can be explained by methodology. Whereas CAPE reflects the S&P 500’s price relative to the average of real (inflation‑adjusted) earnings over a rolling 10‑year window, ERO compares the S&P’s rolling 5‑year return to its rolling 5‑year median, with results reframed as z‑scores indicating how many standard deviations returns are above or below the average on a rolling 5‑year basis.

Each valuation estimate has a distinct set of pros and cons, although both share the standard caveat that neither metric can reliably predict the market’s future performance, especially in the short term. That said, ERO’s long‑term history suggests that when the indicator moves toward or exceeds a +1 reading, the odds rise for a relatively significant near‑term top.

ERO’s current reading reflects market conditions in a “normal” range. That doesn’t mean market risk is nil. Rather, the ERO profile suggests that downside risk appears more likely to come from other sources than valuation in the current macro climate.

Debate rages, of course, over what defines a reasonable valuation these days. For example, bulls argue that artificial‑intelligence‑driven opportunities have raised the premium investors should be willing to pay for a given level of corporate earnings. ERO is agnostic on this point, but coincidentally the metric seems to favor an AI‑based analysis.

Ultimately, measuring market conditions and how they relate to “fair value” requires looking beyond a handful of indicators. Meanwhile, ERO’s current level suggests that a tactical view of valuation doesn’t look threatening.

Encouraging, perhaps, but with a number of other risks lurking—including elevated geopolitical dangers—ERO should be used as an initial measure of market risk rather than the last word on what factors could weigh on investor sentiment in the near term.

• Redemptions are rising and managers are starting to limit withdrawals

• Software‑linked lending is flashing stress signals

• A sharp jump in Treasury yields could trigger more outflows

Private credit has gone from a niche backwater to an increasingly mainstream allocation, but investors are discovering that its headline attraction — lofty yields — may come with real, often underappreciated risk.

Minds have become more focused on the risk aspect lately as questions about the viability of the market come under critical scrutiny. In years past, worries about private credit could be ignored by most investors, but the industry for lending by private equity firms has boomed, especially in the post‑pandemic years. Critics are now asking whether this former backwater is becoming too big to fail and poses a threat to the wider economy.

The value of debt financing beyond conventional borrowing channels (banks and the bond market) in the US was $1.34 trillion in 2024, roughly five times higher than in 2009, according to the Federal Reserve. Some estimates now peg the figure above $3 trillion-plus in 2026.

A Boom That’s Finally Drawing Scrutiny

Few observers saw the growth of alternative lending sources as a problem until recently, when investor redemptions began rising sharply, persuading some managers to limit withdrawals. One trigger for turning cautious on private credit is the industry’s hefty lending to software companies, which have come under pressure lately on the view that artificial intelligence threatens their business models.

Right or wrong, a more cautious view on the outlook for software firms is reverberating back into private credit. The fear is that a stress‑driven correction in private credit, given its breadth and depth in the financial ecosystem, could create a liquidity shock on Wall Street and beyond.

Some analysts point to rising stress signals, such as an increasing default rate among US private‑credit borrowers. But in a sign that the worst may have passed, Fitch Ratings estimates that the default rate in US private credit declined to 5.4% in February, down from January’s 5.8%, the highest since August 2024.

Even if you never touch private credit, the industry is worth tracking because stress in this opaque corner of the market can transmit outward — through bank funding lines, credit spreads, and real‑economy financing — and turn a niche disruption into broader financial and economic strain. A useful starting point for monitoring sentiment is watching two ETFs that have been plying these waters.

The funds in the chart below represent two measures of the private‑credit industry. The Virtus Private Credit Strategy ETF (VPC) tracks the Indxx Private Credit Index, which is composed of US‑listed business development companies (BDCs) and closed‑end funds (CEFs) focused on private credit. The VanEck BDC Income ETF (BIZD) targets the MVIS US Business Development Companies Index, a proxy for the performance of publicly traded BDCs, which are funds that invest in small- and mid-sized companies.

Note the recent upturn in both funds, which may be a sign that the market is beginning to look through the recent turbulence. Some high‑profile observers of the market appear to be softening concerns about the risk outlook. JPMorgan Chase CEO Jamie Dimon said this week that he’s “not particularly worried” about his firm’s $50 billion allocation to private credit.

The Signals That Could Matter Most For Private Credit

A rise in interest rates could change minds, but here too the latest numbers suggest the market has steadied. The 10‑year Treasury yield, for example, has increased moderately since the start of the war with Iran, but the current 4.32% yield remains in a middling range for the trailing one‑year period. A rise above the recent peak (roughly 4.45%) could be a new warning sign.

Perhaps the critical variable is when — or if — banks dramatically pull back their credit lines, a source of liquidity that has been instrumental to date in financing new deals and managing cash flow. Those lines of credit may come under closer scrutiny if more investors try to liquidate their private‑credit holdings.

What might trigger a new round of investor withdrawals? There are many possibilities, but a sharp rise in Treasury yields is near the top of the list. That scenario may become more plausible if incoming inflation data is hotter than expected due to the supply‑side energy shock unleashed by the war.

• Inflation is rising on the energy shock, but growth indicators still look resilient

• Oil’s 50‑day average is above $80, which suggests energy risk is becoming elevated

• Fed policy is still on hold for now

Economic risk is rising as the Middle East conflict keeps energy prices elevated, but several business‑cycle indicators tracked by TMC Research suggest that the war’s negative effects remain limited for the US economy so far.

The situation remains fluid, and facts on the ground can quickly change the analysis. Current data, however, indicates that economic activity remains relatively resilient. Conditions could deteriorate, but it’s encouraging that, for now at least, the war’s blowback has yet to make a meaningfully negative impact.

Oil prices remain the critical variable. The recent spike pushed the US benchmark (West Texas Intermediate) above $112 a barrel last week, but the price quickly pulled back and remains just below $100 (as of Apr. 13). The run‑up in price volatility is worrisome, but the main risk is if oil stays elevated for an extended period. In that scenario, energy prices generally will remain high, which could trigger demand destruction and raise inflation.

The challenge is defining what counts as “elevated,” and for how long? One way to monitor the risk is by tracking the 50‑day average price of oil, a crucial input that filters through the economy. Economists debate where the tipping point lies for signaling a danger zone. A reasonable starting point is watching the rolling 50‑day price: a rise into the $80–$100 range that persists for a month would be a warning sign that energy costs are poised to threaten the economic outlook.

The 50‑day average has recently crossed above $80, suggesting that the outlook for inflation and economic activity is starting to look worrisome (red line in chart below).

The supply‑side energy shock has already lifted inflation. The Consumer Price Index (CPI) at the headline level rose to a two‑year high of 3.3% for the year‑over‑year change through March—sharply above February’s 2.4% increase. TMC Research estimates that the longer the 50‑day average stays above $80, the higher the odds that inflation will hold at current levels, if not rise further, for some period of time.

Economic activity, however, has yet to show a meaningful impact from the war so far. One example is the Dallas Fed’s Weekly Economic Index (WEI), a real-time measure which continues to reflect year‑over‑year economic growth at a mid-2% pace, based on data through Apr. 9.

TMC Research’s model for estimating US recession risk in real time still reflects a low probability that an NBER-defined contraction has started or is imminent, based on data through early April. Our US Recession Probability Indicator aggregates and models data from three business-cycle indicators published by regional Fed banks (see here for details).

Market expectations are still anticipating that the Federal Reserve will leave its target rate unchanged for the foreseeable future, based on Fed funds futures. That suggests the debate remains open about the severity of the inflation threat.

Several policymakers at the central bank are considering that rate hikes may be needed to counter inflation, according to the minutes of the March 17-18 meeting. “Some participants judged that there was a strong case for a two-sided description of the [Federal Open Market] Committee’s future interest rate decisions in the post-meeting statement, reflecting the possibility that upwards adjustments to the target range for the federal funds rate could be appropriate if inflation were to remain at above-target levels,” the minutes said.

TMC Research’s Fed Funds Model estimates that monetary policy continues to reflect a modestly hawkish bias. That stance may give the central bank time to determine whether the war‑driven increase in inflation is temporary or requires a new round of rate hikes. For now, keeping policy steady appears to be the more likely path.

Oil remains the critical variable in the near term. The latest sentiment on Wall Street leans toward cautious optimism that a peace deal with Iran is still possible following failed negotiations over the weekend and Monday’s implementation of a blockade of maritime traffic to and from Iran’s ports.

“I can tell you that we’ve been called by the other side,” Trump told reporters on Monday. “They’d like to make a deal very badly. Very badly.”

The war hasn’t broken the cycle yet. Whether it stays that way may depend on how long oil prices stay elevated. The economy can absorb a lot, but the clock is ticking. If oil keeps grinding higher, the pressure may reach a tipping point.

• Managing behavioral risk should be a top priority for most investors

• Psychological factors can meaningfully shape investment decisions

• Designing portfolios that help investors live with market volatility is essential

Risk management matters for several reasons, but it starts with a simple fact: investment losses don’t always behave symmetrically.

This mismatch threatens to weaken an otherwise sound investment plan because behavioral risk can spike when markets decline. In those periods, the average investor is prone to letting emotions drive ill-timed decisions that can have adverse effects on portfolio performance for years.

For most investors, there’s a strong case for managing portfolios in an effort to soften the periodic volatility spikes that are part of the normal ebb and flow of markets through time.

There are several reasons why developing portfolio strategies can help cushion short-term declines, which can trigger behavioral mistakes. A review of the math tells the story and illustrates why buy-and-hold investing can be so difficult to endure when markets hit a rough patch.

Consider the hurdle required to regain an investment loss. To fully recover from a 10% decline requires an 11% rebound. A 20% decline needs a 25% recovery, and a 30% slide is healed only after a subsequent 43% increase. As the table below shows, the math only gets uglier as losses deepen.

The chart below highlights the exponentially higher performance hurdle associated with deeper losses.

The key lesson is that while market risk can’t be avoided, it can be managed to a degree. Holding a multi-asset class portfolio is one dimension of risk management. Another is adjusting asset allocation systematically based on risk analytics, which can help minimize volatility spikes relative to a passively managed strategy.

Although risk can’t be completely avoided when investing, it is possible to reduce the odds of enduring the deepest losses that are mathematically and behaviorally difficult to recover from. The wisdom of using risk management isn’t only about outperformance, although that can be part of the strategy agenda. No less important is preparing for the emotional response that can arise during the deepest market drawdowns.

Numerous research studies over the years find that investor psychology can be a key factor in portfolio performance. Although some investors can muster the steely discipline to look through bouts of market volatility and focus on the long run, such restraint is generally rare.

The average investor, by contrast, may be vulnerable to an array of behavioral biases—fearing losses more than enjoying gains (loss aversion), following the crowd (herding), and overestimating skill (overconfidence), to name a few. Developing an investment strategy to help manage these risks is a critical input for tipping the odds in favor of achieving long-term financial objectives.

To the extent that risk management can help mute volatility spikes, it lowers the odds of emotional decisions that can disrupt long-term plans.

• TMC Research’s markets-based estimate of Iran War risk still indicates an elevated risk regime

• The surge in oil prices is the main driver of heightened risk expectations

• Additional factors that are raising risk perceptions: credit spreads, stock market volatility, inflation, and the US dollar

The war with Iran continues to roil financial markets. At some point the risk will peak, providing context for deciding if the worst has passed. Estimating that point will be useful but also challenging in real time, in part because it’s a task that requires analyzing a wide variety of data. As a first approximation, TMC Research is tracking an aggregate of five relevant risk dimensions based on market signals via a set of ETFs.

There are several ways to estimate war-related risk through a markets-based lens. TMC Research’s Iran War Risk Index (IWRI) represents an initial estimate of war-related perceptions. This model can easily be updated in real time for tracking how markets are reacting to news events. Short-term changes can be noisy, and so the daily data are smoothed with a LOESS regression model to highlight the trend.

IWRI is comprised of five inputs that are germane for monitoring the war. ETFs are used as proxies for each variable:

• Crude oil (USO)
• US dollar (UUP)
• Stock market volatility (VIXY)
• Credit spread (IEI–HYG spread)
• Inflation risk sentiment (TIP–IEF spread)

The weights of the five factors are slightly skewed relative to an equal weighting and give oil the highest weight (30%), followed by 25% for the credit spread, 20% for the US dollar, 15% for stock market volatility, and 10% for inflation risk.

The current reading continues to show an elevated level of risk, as of Apr. 6. The data are shown in z-scores, and so levels above +1 equate with high risk. Accordingly, a drop from the current level below +1.0 may be an early clue that markets are starting to price in de-escalation. Such a change in sentiment, for now, doesn’t look imminent, with IWRI trading above +2.0, which is far above the pre-war range.

A sustained decline in IWRI toward its prewar range would be a sign that markets see the danger fading. Until then, elevated readings suggest that a high-risk narrative remains in play.

• Oil’s rise is adding to recession risk, but history suggests the signal remains mixed

• The US is less sensitive to energy shocks than in past cycles

• The war’s impact on global supply and sentiment in the weeks ahead will determine how much risk ultimately materializes

Oil has been a central pressure point in most US economic downturns of the post‑WWII era, but not every spike in the commodity automatically leads to a recession.

Higher oil prices clearly raise economic risk, largely because crude is a primary feedstock, influencing a wide range of products, services, and prices. A sharp rise in energy costs tends to ripple across the economy. But the effects vary, depending on the economy’s strength at the time of the price jolt, prevailing financial conditions, and how long the surge lasts.

The risk from an oil shock can be significant, although the potential for blowback is lower than in previous decades. One reason: the US is less vulnerable than many other countries because America pumps more oil than it consumes. Another advantage: lower energy intensity. The amount of oil needed to generate a given unit of GDP has fallen sharply in recent decades.

Lower risk isn’t zero risk, however, in part because oil is priced globally, as TMC Research discussed earlier this month. That means higher energy costs stemming from disruptions in Middle East exports will spill over to the US to some degree.

Gauging how much of a shock the economy will absorb is challenging because the medium‑term effects of several key variables remain unknown. At the top of the list: How long will the war last, how quickly will Middle East exports rebound toward normal levels, and how will US consumers and businesses respond in the interim?

What we do know is that previous oil spikes don’t always line up with recessions. Consider the year‑over‑year changes in the US oil benchmark — West Texas Intermediate (WTI) — in relation to economic contractions, as defined by NBER.org, the official arbiter of the US business cycle. The key lesson: recession risk rises when oil prices rise sharply, but the relationship varies because other macro conditions matter, too. Higher energy costs usually slow growth, but to varying degrees, depending on other conditions that are unique to each point in time.

For example, following the economy’s recovery from the financial crisis in 2008 through the eve of the pandemic in early 2020, oil rose sharply relative to the year‑ago level on four separate occasions. In each case, the economy sidestepped a business-cycle recession, even if there was a price tag to some degree.

The reasons why an oil shock may or may not push the economy over the edge vary. Energy is a crucial factor for the business cycle, but conditions matter in other areas, such as interest rates, the labor market, consumer spending, and the pace of economic activity going into the spike, to cite a few examples. These and other macro factors play a role in determining how a rise in energy prices will affect growth and inflation.

It’s also worth noting that the current increase in oil — approaching a 30% year‑over‑year gain, based on prices through Mar. 23 — is a hefty change from recent history. But the increase, so far, is still well below changes associated with the three recessions prior to the pandemic, which was unusual in the extreme and therefore of limited value for studying business‑cycle behavior.

If oil prices continue to rise, recession risk will follow. But until there’s more clarity on how the economy adapts to the war’s effects and the associated run‑up in oil, there’s still room for debate over whether a US recession is inevitable.

The determining factors that will have the last word are the war’s duration and the degree to which it constrains global energy flows and influences risk sentiment in the US and abroad.

• Stocks are down, but earnings help cushion the blow

• War pressure is rising, but earnings forecasts remain upbeat

• The longer the war lasts, the greater the risk that earnings could stumble

The stock market’s decline since the Iran war started isn’t surprising, but some market observers have been puzzled by the gradual, orderly slide in equities to date. Why hasn’t the conflict triggered a deeper correction? Robust earnings may be a factor.

The S&P 500’s current drawdown is -7.2%, which is still relatively modest by historical standards. No one knows if the decline will deepen, or when the war will end, but solid earnings data is a likely reason why the correction, so far, is still within a “normal” range.

Earnings are a key—if not the primary—driver of equity returns through time, which suggests that recent gains on this front, along with upbeat expectations for the near‑term outlook, may have helped limit the downside for stocks.

The research firm FactSet estimates that the equity market’s year‑over‑year earnings growth rate through this year’s first quarter is 12.5%. “If 12.5% is the actual growth rate for the quarter, it will mark the sixth straight quarter of double‑digit (year‑over‑year) earnings growth reported by the index,” writes the senior analyst.

For recent historical perspective, consider the stock market’s performance (S&P 500 Index) in context with earnings. Unsurprisingly, equities have been rising in line with earnings growth. If the bullish forecasts for earnings are accurate, the growth trend may provide support for stocks and help minimize the war-related downside risk.

Market volatility in the short term can spike for a variety of reasons, and so it’s never clear how much support earnings can provide over a few weeks or months. As the renowned value investor Ben Graham famously observed, “In the short run, the market is a voting machine, but in the long run it is a weighing machine.”

Wall Street remains generally upbeat on S&P earnings for 2026. The question is how much of a haircut could brewing if the war runs longer than the optimistic views suggest?

Analysts at Barclays this week wrote: “We believe the US continues to offer stronger nominal growth than other major economies and a secular growth engine in technology that shows few signs of stopping,” the bank’s strategists advised. “We are incrementally bullish on US equities, though the road likely stays bumpy until we turn a corner.”

The war is still the elephant in the room in terms of risk factors. The sooner the conflict ends, the higher the confidence that the growth trend for earnings can continue with minimal damage.

Another key variable to watch is economic growth. The Atlanta Fed’s current nowcast for the upcoming first‑quarter GDP report points to a moderate rebound in output following the sluggish rise in the fourth quarter.

If the war ends soon, and the economic headwinds from the conflict are relatively mild and short-lived, the odds will remain favorable that corporate earnings will continue to rise and provide a degree of ballast for the market in the months ahead.

• War costs rise as the deficit deepens

• Fiscal gauges flash pandemic‑era stress

• No credible deficit plan from Washington yet

The US budget deficit was already on shaky ground before the Iran war, and reports that the Pentagon will seek an additional $200 billion in military funding only complicates the outlook for fiscal risk. Defense Secretary Pete Hegseth has also suggested the request could rise depending on operational needs.

Whatever the extra costs associated with the ongoing conflict, higher spending arrives at a difficult time for the US budget outlook. In February, the Congressional Budget Office (CBO) revised its forecast for government finances and projected that the already hefty deficit will deepen this year to $1.853 trillion. Over the course of the decade ahead, the non-partisan CBO estimates that the deficit-to-GDP ratio will increase to 6.7% from the current 5.7%. If correct, the rise would mark the highest ratio since the pandemic.

The prospect of bigger deficits may be worrisome for several reasons, starting with the fact that the current level of debt is unusual for an economy that’s not in recession. Atypical or not, the fiscal burden poses a potential threat to financial markets by raising inflation and interest rates.

TMC Research routinely analyzes the data in this corner, but fiscal‑risk modeling remains inherently imprecise for estimating the true level of vulnerability and gauging debt markets’ tolerance for government indebtedness. But this much is clear: if the current level of outstanding government obligations increases from current levels — especially in relation to the size of the economy — the implied risk also increases.

“Higher debt adds to the risk of inflationary pressure in both the short- and the long-run, through aggregate demand, inflation expectations, crowding-out of private investment, and worries about fiscal dominance,” advises The Budget Lab at Yale.

Fiscal Risk Index

US fiscal pressure has increased lately, according to TMC Research’s Fiscal Risk Index (FRI). The current reading rose to 0.4, rebounding once again to the highest level since the pandemic.

The increase shows that four of FRI’s ten inputs (see table below) are flashing warning signs, relatively speaking, based on our assumptions for modeling the data.

For another perspective, the Fiscal Risk: Daily Bias Indicator sums the z-scores for the ten inputs above, providing a more sensitive profile of how the aggregate mix is trending. On that basis, fiscal risk is approaching levels last seen during the pandemic (see chart below).

Our standard caveat for these indicators is worth repeating — namely, modeling fiscal risk is challenging for several reasons and the analysis above is, at best, a rough first approximation. In addition to the difficulty of quantitatively estimating the level of fiscal risk, there’s also debate about how much debt the financial markets will bear before demanding a significantly higher risk premium.

Further complicating the picture is a recent research paper arguing that financialization and deficit‑fueled spending have been key drivers of profit growth and market expansion, propping up elevated equity valuations even as fiscal vulnerabilities mount.

The common theme from our analysis that aligns with reporting from other sources: the deficit trend is still moving in the wrong direction. That’s worrisome on its face, and even more problematic when you consider that Washington has yet to lay out a credible plan to address the rising tide of red ink.

• Market proxies are flashing an early warning for inflation

• Economy is still expected to grow, but war may strengthen headwinds

• Real-time indicators may highlight shifting macro trend ahead of hard economic data

The longer the war drags on, the greater the strain on the economy, keeping energy markets on edge and extending a period of uncertainty. That combination raises the potential risk for higher inflation, slower growth, or both — in other words, stagflation.

For the US, the risk still appears low, based on the data published to date, but a prolonged conflict could turn what was initially expected to be a short-term shock into a persistent headwind. In that scenario, financial conditions could tighten, and the macro outlook may deteriorate rather than stabilize.

Assessing stagflation risk is challenging because the relevant economic data — inflation, payrolls, GDP, and related indicators — are published with a lag and are subject to revision. By contrast, tracking real-time stagflation proxies is useful because markets often register early hints of inflation pressure and growth deterioration well before the official data confirm the shift.

There are many possibilities for estimating stagflation risk, but a practical starting point is monitoring how the market is adjusting interest rates that are sensitive to expectations for the Federal Reserve’s target rate. The Fed left its key rate unchanged at Wednesday’s policy meeting, and the central bank’s revised outlook indicates that policymakers expect rates to remain flat to lower in the near term. Will the bond market agree in the days and weeks ahead?

Short-term yields

Market yields on the shorter end of the curve continue to flirt with the possibility that flat-to-higher rates remain on the table. Consider what TMC Research calls the policy channel — yields closely linked to Fed policy expectations. In particular, the 1-year Treasury yield continues to trade in the upper half of the channel, suggesting that a hawkish bias may be poised to influence market sentiment. If the 1-month yield rises above the upper boundary of the channel, currently defined by the 3.75% discount window primary credit rate (blue line), the move would imply that traders are starting to price in higher odds of a rate hike.

Oil vs. stocks

Estimating stagflation risk is a multidimensional task, but another useful starting point is tracking how crude oil prices move relative to the US stock market. In the chart below, the ratio of two ETF proxies representing these assets is used to illustrate the relationship. The sharp rise lately implies that stagflation risk has likely increased. This is not a flawless indicator; rather, it is valuable for gauging how stagflation risk ebbs and flows. For example, in the second half of 2021 the ratio trended higher before spiking in early 2022, reflecting growing concern that inflation was heating up.

Treasury yield spread

Another useful indicator is the spread between the 10-year Treasury yield and its 2-year counterpart — a market-based proxy for recession risk. A negative spread reflects sentiment pricing in elevated odds of contraction in the near term. At the moment, the spread is still positive and reflecting the recent rebound in economic optimism. Lately, however, the spread has narrowed, and a continued decline in the current environment may signal fading confidence in the growth outlook — especially if the spread slips into negative terrain.

Treasury market inflation forecast

Watching the market’s expectations for inflation is also timely in the current climate. The yield spread between nominal and inflation-indexed Treasuries—the so-called breakeven rate—shows that investors are becoming more concerned. The 5-year spread has rebounded and is near the peak in recent history – 2.66%. A sustained rise higher from current levels would signal heightened concern for the inflation outlook.

Monitoring the Treasury market’s inflation forecast alongside the 10year/2year spread is especially helpful for assessing sentiment around stagflation risk. If the inflation estimate rises while the spread falls (or turns negative), markets would interpret the combination as rising odds of stagflation.

Markets can be wrong, of course, and the indicators above should be viewed with appropriate caution. But as a baseline, these metrics offer a reasonable starting point for evaluating how markets are pricing stagflation risk.

• Treasury-based inflation forecasts are inching up as the Iran conflict continues

• Markets aren’t alarmed yet, but firmer expectations could complicate the Fed’s path

• Persistent pressure from higher energy costs could reshape the Fed’s rate-cut timeline

The ongoing war in Iran has sparked inflation concerns following a surge in energy prices. Market sentiment has shifted, but only moderately to date, and so the implied outlook for inflation based on Treasury yields still leaves room for debate. The longer the conflict rages on, however, the greater the risk that a temporary increase in inflation could last longer and run higher than currently expected.

One way to monitor expectations is by tracking the bond market’s reactions, which provide a real-time measure of sentiment. Using the yield spread between nominal and inflation-indexed Treasuries—the so-called breakeven rate—shows that investors have lifted inflation expectations, but only moderately so far. The market’s implied 5-year inflation forecast has increased to 2.58% (as of Mar. 16), near the highest in a year. The jump in the 10-year outlook is less severe, rising to 2.36%, a six-month high.

The differing reactions suggest that while the market perceives inflation risk as modestly higher for the medium term, the rise will be temporary, as suggested by the lower forecast for the 10-year horizon.

More importantly, both estimates are still close to actual inflation measures, based on the Consumer Price Index. In February, CPI rose 2.4% over the year-earlier level, roughly in line with the 10-year Treasury market’s forecast and slightly below the 5-year outlook.

The question is whether market sentiment will lift inflation expectations further in the days and weeks ahead? If so, it could signal growing concern that the energy shock may persist and push prices higher than currently expected.

Historically, oil spikes have tended to lift headline inflation only temporarily, Long-term expectations remained anchored near 2.5%, even during periods of $100-plus crude oil. A key exception was during the 2021–2022 cycle, when the post-pandemic recovery and expansive fiscal policy amplified demand and allowed higher energy prices to intensify both demand-pull and cost-push inflation pressures. The current situation, by contrast, is war-driven, and some of the effects are expected to ebb, perhaps sharply, when the fighting stops.

Fed Policy Path Becomes Less Certain

Could it be different this time? If inflation expectations rise, and remain sticky at a higher level, the Federal Reserve may be forced to delay rate cuts, or perhaps even raise rates. Cuts are off the table for the next several policy meetings, based on expectations derived from Fed funds futures. Traders see a slight chance for a cut at the September Fed meeting, but the odds are close to a coin flip, and so confidence is low about where policy is headed. Part of that uncertainty reflects the risk that the conflict could keep energy prices elevated, complicating the inflation outlook.

The sooner the war ends, the more encouraging the odds that any jump in inflation triggered by surging energy prices will be transitory. But with the conflict now in its third week, and no immediate end in sight, the market may continue to anticipate higher inflation risk.

At present there is no consensus view among analysts on how or when the conflict may end, with timelines shifting as events evolve and energy markets price in a geopolitical risk premium tied to the possibility of persistent disruptions to oil flows through the Strait of Hormuz.

The challenge is that developing relatively high-confidence estimates of future inflation risk will take time—probably a few months at a minimum—in the current environment. Even if the war stopped tomorrow, a return to “normal” and resetting expectations will unfold slowly.

In the meantime, market sentiment will be valuable for guesstimating the future. Using the Treasury yield spreads shown above as a guide suggests that investors aren’t panicking, but they are starting to price in the possibility that inflation could rise to some degree for a period of time.

Until there’s more clarity on the war’s path, and its effects on energy and beyond, the market will struggle with pricing risk for the inflation outlook.

• Oil trades in one global market, so US prices move with worldwide supply, demand, and geopolitical shocks

• Fungibility, dollar pricing, and arbitrage keep benchmarks aligned, limiting any country’s pricing power

• No one nation controls enough supply to set prices, leaving global forces—not domestic output—in charge

The United States may be the world’s largest oil producer and a net exporter, but that doesn’t fully shield America from price spikes when global supply is jolted by events like the war in Iran.

Oil is priced in a single worldwide marketplace, which means that shifts in supply, demand, and geopolitical risk spill across borders regardless of how much a country produces. When global benchmarks jump, US prices follow because American barrels compete with — and are valued against — the same international forces that apply to all countries.

A useful analogy for how oil prices are set was outlined in a 2009 speech by Yale University Professor William Nordhaus, who explained the oil market as a giant bathtub holding the global supply of inventory. There are spigots of incoming oil from multiple countries that fill the tub, along with various drains that represent purchases. “The price and quantity dynamics are determined by the sum of these demands and supplies and the level of total inventory, and are independent of whether the faucets and drains are labeled ‘US,’ ‘Russia,’ or ‘Denmark.’”

Why Oil Prices Converge Worldwide

Oil is priced globally rather than locally for several reasons, starting with fungibility – the commodity is interchangeable with barrels of the same grade and quality around the world. There are two main benchmarks: West Texas Intermediate (WTI) for the sweet (low-sulfur) US grade, and Brent, the international benchmark for high-grade oil pumped outside the US. Although there are a number of other grades, standardizing the commodity in these two buckets fosters global pricing.

To the extent that pricing moves out of line in one trading venue vs. another, arbitrageurs exploit the gap for profit, which helps keep pricing in alignment around the world. Local price differences can still arise, if only at the margins, due to other factors, such as infrastructure bottlenecks, shipping constraints, and regulatory issues. But for WTI and Brent, the law of one price tends to prevail.

Another reason why pricing is set globally: crude oil is priced primarily in US dollars. By trading in one currency, the volatility in pricing that could emerge across different currencies is muted and largely transferred to the local buyer, who assumes any foreign exchange risk. Single-currency pricing, in short, promotes pricing that is directly related to global economic conditions.

Another driver that strengthens global pricing: the commodity is the primary raw material (feedstock) for a wide variety of fuels and products used nearly everywhere, with transportation as the main source of demand. Upwards of 85% of crude is refined into gasoline, diesel and jet fuel. The rest goes to produce petrochemicals, plastics, numerous consumer products, and beyond.

The rise of electric vehicles threatens to pare oil’s transport-related demand, but for the foreseeable future the transition is expected to be modest and gradual. Meantime, oil remains integral to most economies around the world, which translates to a relatively steady state of global demand.

No Country Controls the Price

The key result is that no single country, no matter how much it produces, has more than a marginal influence on global pricing. OPEC, the oil cartel that represents countries with about 35% of the world’s output, has more leverage, but it’s limited.

“OPEC membership has less to do with controlling oil prices and more to do with geopolitical and domestic political benefits,” notes a recent report by the Cato Institute, a think-tank in Washington. “The OPEC nations appear to use oil production as an international bargaining chip to provide the regimes with domestic legitimacy.”

The rise of US production in recent years, thanks to advanced drilling technologies, is not without its benefits. For starters, America no longer relies on imports to the extent that it did in decades past. Although certain grades of oil must still be imported, foreign-oil dependence is a fraction of what it was in the 1973-74 energy crisis, for example, when OPEC imposed an oil embargo on the US.

A repeat performance with deep economic effects is unlikely in 2026, thanks to the increase in US production. But one thing hasn’t changed: oil prices are still subject to global supply and demand factors, and lifting domestic output isn’t likely to change that basic framework.

• War-driven spike in oil prices pushes expected Fed cut from June to July at the earliest

• Energy inflation risk complicates the outlook for monetary policy

• The incoming Fed chair will be in the hot seat if war-related inflation heats up

The Federal Reserve was already facing a delicate transition as Kevin Warsh prepares to take over in May, pending Senate confirmation, when Fed Chair Jerome Powell’s term ends. The war in Iran adds another layer of uncertainty to an already fraught policy environment.

Energy prices have spiked since the US and Israel attacked Iran on Saturday, a conflict that’s slowed oil exports to a crawl through the Strait of Hormuz. Roughly one-fifth of the world’s seaborne oil trade moved through this strategic chokepoint last year. If this narrow waterway remains closed for an extended period, it raises the possibility that inflation could heat up and force the Fed to respond — if not by raising interest rates, then by delaying rate cuts for longer than recently expected.

Fed funds futures are now downplaying the odds of a rate cut in June. Before the war, this was considered the month when the central bank would start cutting again, extending last year’s run of easing. But the market is rethinking that logic and is now pricing in a moderately high probability that the Fed leaves rates steady in June, pushing out the expected date for the next cut to July or possibly September at the earliest.

The concern is that if energy costs remain elevated, the higher prices of crude oil, gasoline, and natural gas will soon feed through to the broader economy, delivering a so-called negative supply shock. Standard economic theory, along with the historical record, suggests that the higher prices will slow growth and lift inflation in some degree.

Energy prices are expected to fall once the conflict is over, but US and Israeli officials say the war could run for weeks. A related concern is that the widening damage to energy infrastructure in the Persian Gulf region from Iran’s retaliatory attacks will take time to repair, a bottleneck that will keep supplies lower for longer.

Geopolitics vs. monetary policy

The main concern for the Fed is how, or if, to respond to higher energy costs. To the extent that oil drives headline inflation higher, the shift presents an especially difficult challenge for monetary policy, since interest rates have no direct effect on the supply of crude. That’s one reason why the Fed and other central banks tend to target core measures of inflation, which strip out energy and food costs — a subset of pricing over which policy has substantial influence.

The Fed’s job will be even tougher because deciding if the war has raised inflation in a meaningful and persistent degree will take time. Next week’s scheduled release of consumer price inflation for February, for instance, is already irrelevant in the current environment.

TMC Research’s Fed Model continues to indicate that policy remains modestly tight, but the hawkish spread of the effective Fed funds rate over our estimated neutral rate is fading. As recently as late-January, the Fed’s target rate was more than 60 basis points above this proxy for estimating an equilibrium level. The premium (implying a moderately hawkish bias) has been sliding since, dropping to under 30 basis points on Tuesday (Mar. 3). In other words, Fed policy is approaching a neutral bias, and looks set to continue into dovish terrain – a trend that may quickly become inappropriate if inflation heats up.

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Hikes Off the Table — For Now

Rate hikes are still unlikely, based on market expectations for inflation. The Treasury market’s 5-year breakeven inflation rate (nominal less inflation-indexed yield) was just below 2.5% yesterday (Mar. 4), a middling level vs. recent history for this bond market inflation gauge.

The 1-month Treasury yield appears to be pricing in no change in the target rate, as it remains at the upper half of the policy channel. The calculus would change if the 1-month yield – currently at 3.75% — decisively breaks above the channel’s upper range, marked in the chart below by the Fed’s discount window primary rate, which is also at 3.75%. In that case, the shift would signal that the market is starting to factor in the possibility of a rate hike.

This macro mix would be hard enough for any new Fed chairman, but it may be especially challenging for Warsh, who has supported President Trump’s public calls for lower interest rates, partly on the view that an artificial-intelligence-driven productivity boom will boost economic growth without raising inflation.

Whatever the merits of that forecast (and there’s ongoing debate on the topic), the Iran war may rewrite the script for Warsh’s policy plans well before he arrives at the Eccles Building on Constitution Avenue.

• US recession risk was low at the start of military strikes on Iran

• The market was calm on Monday, but the situation is fluid and the risk profile will remain sensitive to headlines

• Oil is a key factor, with the possibility of sustained price spikes posing the main macro risk

The ongoing US-Israel military strike on Iran remains a highly fluid situation, with the potential for significant fallout for the global economy and financial markets. The conflict is still evolving and so it’s difficult at this stage to develop reasonable forecasts of the war’s effects, but US recession risk was still subdued ahead of the attack that began on Saturday.

The TMC Recession Probability Indicator (RPI) continues to reflect a low probability that an NBER-defined downturn has started or is imminent. The current estimate indicates a roughly 3% probability of contraction, based on data through Feb. 26 – an estimate that’s fallen slightly since our previous update three months ago. (RPI aggregates and processes data from three business-cycle indicators published by regional Fed banks — see here for details.)

Focusing on recent history shows that the trend (50-period average) has edged higher recently, but it’s fair to say that the current level suggests a high probability that the economy’s current bias remains strongly skewed toward growth.

The caveat is that RPI, and similar metrics, are designed to capture “normal” business-cycle fluctuations rather than so-called exogenous events, such as the military strike on Iran. To the extent that war will create headwinds for economic activity the transmission would likely come via an oil-price shock.

Roughly one-fifth to one-third of the world’s seaborne oil exports flow through the narrow Strait of Hormuz, the world’s most important (and potentially vulnerable) energy chokepoint. Iran has the ability to disrupt or close the strait, which could raise oil prices sharply as markets reprice the geopolitical oil premium.

The risk of a protracted war that materially lifts energy prices for an extended period could raise recession risk. That possibility still looks low at the moment, even after factoring in the Iran-related threat and Monday’s sharp increase in Brent, the international benchmark for crude oil. But much depends on how long the conflict lasts, how it evolves, how high energy prices rise, and how the war affects inflation and interest rates.

For the moment, the US economy remains relatively resilient to blowback from the war, in part because America has become a net exporter of oil in recent years due to the substantial rise in crude oil production related to advances in hydraulic fracking technology and the so-called shale revolution. As a result, the risk of another 1973 oil crisis is low, at least for now.

But low risk isn’t zero risk and the potential for economic fallout in the worst-case scenario could be significant. Exactly what that looks like and how it unfolds is speculative at this point, but the initial reaction in the stock market suggests that investors are assessing the fallout risk as low to moderate, based on the S&P 500 Index’s fractional rise in Monday’s trading, even though oil prices surged.

These are still early days, however, and it’s too early to confidently judge the depth and breadth of the macro risk that could be lurking. One reason for caution and reserving judgment: the odds currently appear low for a negotiated settlement. President Trump on Monday said the timeline for ongoing strikes could stretch out to four or five weeks, and he hasn’t ruled out putting US troops into Iran.

Meanwhile, Iran shows no sign capitulating. As we write, news reports highlight that Iran’s retaliatory strikes are widening, including hitting the American Embassy in Riyadh, Saudi Arabia.

It’s an open question how long Tehran can hold out against the combined military forces of the US and Israel, but early indications suggest that the regime is calculating that standing firm and lashing out is the less-dangerous path for survival.

From a US economic perspective, the war still appears to be a low-risk event in terms of triggering recession, but the calculus could change quickly, depending on how events unfold, particularly with respect to energy prices.

For now, the data suggest resilience, not recession. But with geopolitics suddenly sitting in the driver’s seat, the next several weeks will determine whether this remains a contained shock or the first chapter of a more consequential economic story.

• Macro liquidity conditions remain favorable for stocks

• The Fed is expected to keep rates steady for the near term

• The odds appear low that macro conditions will soon turn tight

The Fed is expected to hold steady on rates for the next two policy meetings, but liquidity conditions still look favorable for the stock market, according to analysis by TMC Research.

There are many factors that drive equity prices, and the overall degree of liquidity flowing through the economy is usually on the short list of relevant variables. In line with recent history, our broad measure of liquidity continues to skew loose, which is to say a tailwind remains intact. Whether that alone is enough to keep equity prices rising is unclear, but it helps tilt the odds in the bulls’ favor, if only on the margins.

By contrast, relatively tight macro conditions on the liquidity front are usually a headwind. Ahead of the 2022 correction, for example, conditions tightened, which was likely a factor in the S&P 500 Index’s slide that year.

When macro liquidity flips to tight conditions, as it inevitably does in every cycle, a new challenge for the bull run will emerge. Tighter conditions don’t always translate into immediate market stress, in part because other forces can temporarily counteract the drag. But to the extent that liquidity conditions move from one extreme to the other, that can be a sign of trouble ahead.

For now, a major shift from loose to tight conditions doesn’t appear imminent, echoing conditions in our previous update for this indicator in September. The implication: whatever the trigger for the next stock market correction, the catalyst isn’t likely to arise from restrictive liquidity conditions, at least for the near term.

The Macro Liquidity Indicator in the chart above uses five inputs to assess conditions: the US dollar, the high-yield bond spread, commercial bank loans and leases, consumer inflation, and the US 10-year Treasury yield. There are many variations on measuring this risk factor, but the mix shown above is a reasonable first approximation.

• Nowcasts for Q1 economic activity point to a rebound after Q4’s downshift

• CPI inflation cooled in January, moving closer to the Fed’s 2% target

• Fed officials signal patience, keeping rate‑cut expectations muted

The slower-than-expected growth rate for the US economy in Friday’s fourth-quarter GDP report suggests the Federal Reserve may cut rates sooner than expected. But Fed funds futures continue to price in a pause for the next two policy meetings. Support for this outlook comes from expectations for a rebound in economic growth for this year’s first quarter, along with a slightly softer inflation trend for January.

Nowcasts from various sources point to a pickup in Q1. The Atlanta Fed’s GDPNow model, for example, is currently estimating a 3.1% annualized increase for GDP (as of Feb. 20) for the first quarter, more than double the 1.4% rise reported for Q4. Part of the reason for the weaker advance in last year’s final quarter was the temporary effects of the government shutdown.

If growth is firming in Q1, the rationale for rate cuts is less compelling, all else equal. Perhaps that’s why Fed funds futures are still pricing in high odds for no change in the central bank’s target rate for the next two policy meetings in March and April. By June, the odds for a rate cut shift to a coin flip.

Policy Tightness Eases as Inflation Cools

TMC Research’s Fed funds model continues to show policy as modestly tight, but far less so than in recent history. The current spread between our model and the effective Fed funds rate has fallen to roughly 30 basis points, or half as much as a month ago and the lowest in nearly a year. The Fed’s hawkish stance, in other words, has faded, primarily due to softer inflation reported for January.

The consumer price index (CPI) rose 2.4% in January vs. the year-ago level, the lowest since May. The current trend for CPI puts it close to the Fed’s 2% target rate.

The combination of expected firming in economic activity and the latest downshift in CPI inflation lays the foundation for anticipating steady Fed policy for the near term.

A market-based profile also points to a stable Fed funds rate for the near term, according to several key interest rates that are sensitive to policy-bias expectations. Note the 1-month Treasury yield, which is holding in the upper half of the channel (relative to the effective Fed funds rate), implying that the market isn’t pricing in a change of policy to the downside.

Fed Officials Urge Patience

Although inflation has eased lately and may be set to move closer to the Fed’s target, some Fed members remain cautious on further cuts. Chicago Federal Reserve President Austan Goolsbee, a voting member of the Federal Open Market Committee this year, said on Tuesday that it was still premature to start a new round of cuts until there’s more evidence that the recent downshift in inflation will hold.

“People express that prices are one of their most pressing concerns. Let’s pay attention. Before we cut rates more to stimulate the economy, let’s be sure inflation is heading back to 2%,” he remarked at a conference yesterday.

In a sign of the times, Federal Reserve Governor Christopher Waller, who recently dissented from the majority and recommended cutting interest rates, has turned cautious lately. In a speech this week he said that, while the January payrolls report surprised with a stronger-than-expected increase in hiring, “One month of good news does not constitute a trend, but a year does, and the year of 2025 was an extraordinarily weak one for job creation.”

Waller is still leaning toward cutting, but he’s become open to keeping policy unchanged. That’s a subtle shift to a casual observer, but it may reflect how the broader Fed policy bias has changed lately. As he explained:

“Before the next meeting of the FOMC on March 17 and 18, we will get employment and inflation data for February, as well as more data on job openings and retail sales. If these data support the idea of an improvement in the labor market in January that continued in February, along with additional progress toward 2 percent inflation, that could result in my outlook turning a bit more positive and my view of appropriate monetary policy may tilt toward a pause at our upcoming meeting.”

If growth is firming and inflation easing, the path of least resistance appears to tilting toward patience—and the Fed seems ready to take it.

• The S&P 500’s trailing 10-year return remains well above the average forecast of our models

• Bulls see AI, growth, and Fed cuts keeping the party alive, but valuations suggest the market’s fully priced

• The gap hints at mean-reversion risk while optimists counter that a new regime is emerging

The S&P 500 Index’s trailing ten-year return has edged up since our previous performance outlook in November, but today’s revised forecast for the decade ahead is still holding in the mid-5% annualized range.

That’s a modest estimate of future performance relative to the double-digit returns in recent years. The current ten-year gain clocks in at a 13.5% annualized total return, more than a percentage point higher compared to when we ran the numbers in late-November.

Although the market has turned relatively sedate so far in 2026 (the S&P is roughly flat year to date through Feb. 13), the rear-view mirror continues to highlight a roaring bull market. Consider: the trailing 13.5% ten-year gain is nearly double the market’s 7.4% average annualized return since 1960.

Will the market’s turbocharged performance continue? The bulls offer several scenarios for expecting the party to endure, including an AI-fueled rise in corporate profits and productivity, a resilient US economy, and expectations that the Federal Reserve will provide more liquidity support through ongoing rate cuts this year.

The question is whether the market’s fully valued and already pricing in those and other best-case-scenario assumptions? In other words, is this as good as it gets?

The future’s always uncertain, but it’s useful to run the numbers on several models to review changes in expectations vs. how the current outlook compares with history. TMC Research updated the five models that we routinely monitor and the results indicate that the S&P 500’s expected return for the decade ahead still looks relatively modest next to the sizzling run in recent history.

The average performance forecast for the ten years through 2036 is 5.6% annualized. That’s a tick above November’s forecast and (still) far below the market’s 13.5% trailing return over the past decade.

Forecasts should always be viewed cautiously, but the large gap between ex ante and ex post performance suggests some degree of mean reversion may be brewing. All of which boils down to the age-old question: Is it different this time? If so, why?

The future isn’t a slave to the past, but with a market outperforming so dramatically, the burden of proof is increasingly on the bulls to justify why lofty return expectations are still a reasonable forecast.

Here’s a quick review of each of the five models used to generate the forecasts above:

CAPE Ratio Model: this stock market valuation indicator, maintained by Professor Robert Shiller, is calculated using real earnings per share for the S&P 500 based on a rolling 10-year window. TMC Research uses the CAPE ratio to generate an implied return for the stock market.

Earnings Yield Model: the stock market’s implied ex ante performance is derived from the S&P 500’s earning yield, defined as the inverse of the price-to-earnings ratio.

ARIMA Model: In contrast with the two models above, which use valuation to infer future return, this estimate uses statistical analysis to generate a forecast. An autoregressive integrated moving average (ARIMA) model is a type of regression analysis that’s run on rolling window of the market’s return history to estimate future results.

Bayesian Model: This statistical model uses lags as a basis for updating so-called “prior beliefs” on a rolling basis to estimate the effects of previous effects on the S&P 500 to forecast return.

Average Historical Return Model: This naïve estimate is a simple average of all the rolling 10-year returns since 1960.

• CBO sees the federal budget deficit widening in 2026 and beyond

• Deficit-to-GDP ratio is projected to climb from 5.7% today to 6.7% by 2036

• Markets aren’t stressing yet, but fiscal pressures could lift market risks in the years ahead if the deficit continues to rise

The Congressional Budget Office (CBO) this week revised its budget outlook for the federal government and the results (still) look worrisome. In line with recent updates, the US deficit remains on track to deteriorate further. The forecast may not be surprising in the red-ink-drenched post-pandemic period, but the new estimates remain concerning by highlighting the government’s deteriorating fiscal profile.

CBO projects that the shortfall will deepen in 2026 to $1.853 trillion, slightly more than 2025’s $1.775 trillion deficit. Looking further down the road offers a similarly concerning trajectory. Over the coming decade, the non-partisan budget office predicts that the US deficit-to-GDP ratio will steepen to 6.7% in 2036 from the current 5.7%.

Policy analysts warn that the size of the deficit is especially troubling because the current level of red ink is unusual for a peacetime economy that’s growing. Presumably during the next recession, if history’s a guide, the fiscal hole will deepen as tax revenue retreats and demand for government spending rises, which is typical for periods when the economy contracts.

The projection for “sustained large deficits are historically unusual, given that the unemployment rate is projected to remain below 5%,” CBO Director Phillip Swagel said in a statement.

A key impact of the growing debt will be reflected in projections for rising interest costs. “Net outlays for interest go from $1.0 trillion in 2026 to $2.1 trillion in 2036, rising from 3.3% of GDP to 4.6%,” Swagel added.

Baseline assumptions

Forecasts are subjective, of course, and so reasonable minds can debate how the future will unfold. CBO’s modeling includes the projection that economic growth will pick up in 2026 (real GDP is expected to rise 2.2% this year, up from 1.9% in 2025), and then downshift to 1.8% for 2027 through 2036. Change the prediction for economic growth and the budget forecast will change, for good or ill, depending.

The White House paints a brighter outlook, claiming that CBO tends to lowball economic growth. “Smaller deficits and higher growth thanks to President Trump’s economic policies are going to slash, not grow, America’s deficit-to-GDP rate,” said White House spokesman Kush Desai.

No matter who’s making the forecast, one constant remains: the future is uncertain. That’s a reminder that the CBO’s forecast can, and probably will, vary from reality, depending on many factors.

What is clear is that the government is running an unusually hefty budget deficit and it’s not obvious that Washington is set to muster the political to meaningfully trim the red ink. Left unchecked, the deepening shade of red carries non-trivial implications for the years ahead on several fronts, including economic growth, interest rates and inflation.

The Fiscal Risk Index

A crucial task is trying to figure when (if?) the red ink crosses a red line for financial markets. That’s challenging due to the multiple factors that go into the analytics. Behavioral economics is part of the mix: At what point do investors cry “uncle” and demand higher risk premiums?

For some initial perspective on how a short list of relevant factors stack up, TMC Research monitors the ebb and flow via our Fiscal Risk Index (FRI). The current reading is 0.3 (per the chart below). That’s up from recent history, but still below the previous peak set during the pandemic-related surge of government spending and far below the 1.0 mark, which indicates extreme risk.

Among FRI’s ten inputs (see table below), three are flashing warning signs, relatively speaking, based on our assumptions for modeling the data: dollar weakness, surging gold prices, and a hefty increase in total government debt over the past year.

To be fair, this is one approach to modeling fiscal risk, and it comes with several caveats. First, there are additional inputs that may be relevant to compliment the ten used in FRI.

Perhaps more importantly, for any mix of variables and a set of parameters, no one knows where a critical threshold lies that, if crossed, financial markets become dramatically less tolerant of government profligacy.

The main value of FRI is comparing how fiscal risk evolves for a given, if imperfect, measure of fiscal risk vs. history. On that basis, the FRI chart above is useful for comparing how a set of indicators and parameter assumptions have changed and tracking how those conditions shift, or not, in the months and years ahead.

FRI isn’t flashing a crisis today, at least by its own standards, but that could change for the worse, assuming the CBO’s forecast is correct.