Stock market plunges by 54%, stagflation on the horizon? Fed simulates AI bubble bursting in extreme scenario.

Notice that every year the Federal Reserve will formulate a "severely adverse scenario" to stress test the financial system. The severe adverse scenario for 2026 is as follows: The severe adverse scenario for the Federal Reserve in 2026 is set as follows: due to a sudden decrease in risk appetite, a global severe economic recession is triggered, leading to a significant drop in risk asset prices, a decrease in risk-free rates, and highly volatile financial markets. In the first three quarters of this scenario, the stock market drops by about 54%, while the U.S. market volatility index (VIX) surges, reaching a peak of 72% in the second quarter. These conditions also lead to an expansion of corporate bond spreads to a level of 5.7 percentage points. The resulting chaos suppresses household demand for goods and services, prompting businesses to significantly cut employment and investment, with economic and asset prices recovering slowly. The U.S. unemployment rate will rise by 5.5 percentage points from the starting point of 4.5% in the fourth quarter of 2025, reaching a peak of 10% in the third quarter of 2027. The sharp contraction in economic activity leads to a collapse in real estate prices, including a nominal house price drop of 29% and a commercial real estate price drop of 40%. Essentially, the Federal Reserve implies that a "sudden decrease in risk appetite" could lead to a severe recessionits transmission pathway seems to be through the negative wealth effects generated by the bursting of the stock market bubble, with the unemployment rate soaring to 10% and subsequently triggering a systemic credit event, thereby leading to the bursting of the housing bubble. This essentially echoes the outlook of some pessimistic analysts for 2026a recessionary bear market accompanied by the bursting of the AI bubble. It is worth noting that the Federal Reserve formulates both a severely adverse scenario and a baseline scenario every year. In almost all cases, the baseline scenario has been proven correctexcept for 2000 and 2008; in those cases, the severely adverse scenario ultimately became a reality. Unfortunately, the macro situation in 2026 seems very similar to the scenarios of 1999-2000 and 2007-2008. Baseline Scenario Firstly, the Federal Reserve's baseline scenario for 2026-2029, which is essentially moderate economic growth, stable unemployment rates, and gradually declining inflationin other words, the "blonde girl" scenario. According to this "blonde girl" scenario, the Federal Reserve predicts that: 1) The 3-month Treasury bill rate will drop from 4.0% at the end of 2025 to 3.1% at the end of 2029; 2) The 10-year Treasury bond yield will gradually decline, dropping to 3.9% by the end of 2029; 3) The stock market will rise by 4.3% annually until 2029; 4) Nominal house prices will decrease before the first quarter of 2027, then gradually increase until 2029; 5) Commercial real estate prices will rise by 4.3% annually. Even in the Federal Reserve's "blonde girl" baseline scenario, there is not much comfort; the stock market is expected to perform poorly over the next three years, with an annual growth rate of only 4.3%. The Federal Reserve is likely aware of bubble-like Schiller P/E ratios, and while the baseline scenario does not predict a bubble burst, it does forecast a very mild performance that barely outperforms 3-month Treasury bills. Severely Adverse Scenario The Federal Reserve's severely adverse scenario predicts a severe recession, with the unemployment rate rising to 10% and the inflation rate dropping to 1.1this looks like a typical deflationary recession. Correspondingly, in this scenario, the Federal Reserve would cut rates to near zero, the 10-year yield would drop to 2.3%, the stock market would plummet by 54%, and real estate prices would collapse. Credit spreads would widen sharplysimilar to the 2008 scenario. Global Stagflation and Dollar Appreciation However, the characteristic of the Federal Reserve's 2026 global severely adverse scenario is commodity-driven stagflation. The characteristic of the global market shock in 2026 is rising inflation expectations, while last year's global market shock showed decreasing inflation expectations. In the current global market shock, bond yields of all maturities are rising, whereas last year saw yields decline, with short-term yields falling more than long-term yields. In the global market shocks of 2025 and 2026, the U.S. dollar appreciated against most major currencies. In the current global market shock, due to inflationary pressures, prices of commodities like gold, oil, and natural gas are rising, while in last year's global market shock, commodity prices fell. In the global market shocks of 2025 and 2026, credit spreads widened, and stock prices dropped. How likely is the Severely Adverse Scenario? The trigger for the U.S. adverse scenario is a "sudden decrease in risk appetite." So, what could cause investors to seek safety in 2026? Additionally, the trigger for the global adverse scenario is inflation driven by commodities. What could lead to an increase in oil and gold prices in 2026? Firstly, the market is currently facing an unfolding AI bubble burst, temporarily masked by the rotation of funds to "value stocks." The unfolding AI bubble burst is dual-sided: 1) Giant corporations are exhausting cash flows and borrowing to finance AI capital expenditures, while investors are questioning the return on this investment; 2) AI applications are disrupting many industries, including software. Eventually, both will lead to a credit event, with Blue Owl's current situation unfolding. The Federal Reserve's adverse scenario predictions suggest that the bursting of the AI bubble could trigger a recession through negative wealth effectsand this is actually highly likely. Secondly, investors are facing geopolitical tensions, possibly leading to an imminent U.S.-Iran war, which could trigger a surge in oil prices, fund flight to gold, and ultimately lead to a global recession. Based on current information, Iran is not willing to completely abandon uranium enrichment, so this scenario is also very likely to occur. Therefore, the likelihood of the Federal Reserve's severely adverse scenarios for the U.S. and global markets is deeply unsettling. Impact Despite the S&P 500 index nearing historical highs, the VIX index is close to 20, indicating that market participants are preparing for increased volatility. Keep in mind that the trigger for the Federal Reserve's severely adverse scenario is simply a decrease in risk appetitemeaning that even a benign initial adjustment could escalate into a recession and a stock market crash comparable to that of 2008.