The Federal Reserve conducts an annual "severely adverse scenario" to stress-test the financial system. The following outlines the severe adverse scenario for 2026: The scenario is predicated on a sudden decline in risk appetite, triggering a deep global recession. This leads to a sharp drop in risk asset prices, falling risk-free interest rates, and highly volatile financial markets. In the first three quarters of this scenario, equity markets plunge by approximately 54%, while the CBOE Volatility Index (VIX) soars, peaking at 72% in the second quarter. These conditions also cause corporate bond spreads to widen to 5.7 percentage points. The ensuing turmoil suppresses household demand for goods and services, prompting businesses to drastically cut jobs and investment. The recovery for the economy and asset prices is slow. The U.S. unemployment rate rises by 5.5 percentage points from a 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 causes a real estate crash, with nominal house prices falling 29% and commercial property prices declining 40%. Essentially, the Fed implies that a "sudden drop in risk appetite" could precipitate a severe recession. The transmission mechanism appears to be the negative wealth effect from a stock market bubble burst, leading to a housing bubble collapse as unemployment surges to 10% and subsequently triggers systemic credit events. This outlook aligns with the predictions of some pessimistic analysts for 2026—a recessionary bear market accompanied by the bursting of an AI bubble. It is important to note that the Fed formulates both a severely adverse scenario and a baseline scenario each year. In almost all instances, the baseline scenario proves accurate—except for the years 2000 and 2008, when the severely adverse scenarios ultimately materialized. Notably, the macroeconomic landscape for 2026 appears strikingly similar to the periods of 1999-2000 and 2007-2008.
**Baseline Scenario** First, the Federal Reserve's baseline scenario for 2026-2029 projects moderate economic growth, stable unemployment, and gradually declining inflation—in other words, a "Goldilocks" scenario. Under this "Goldilocks" scenario, the Fed anticipates: 1) The 3-month Treasury bill rate will decrease from 4.0% at the end of 2025 to 3.1% by the end of 2029. 2) The 10-year Treasury yield will gradually decline, reaching 3.9% by the end of 2029. 3) Equity markets will rise by 4.3% annually until 2029. 4) Nominal house prices will decline until the first quarter of 2027, followed by a gradual increase through 2029. 5) Commercial real estate prices will increase by 4.3% per year. Even within the Fed's "Goldilocks" baseline, there is little cause for significant optimism; equity markets are projected to underperform over the next three years, with annual gains of just 4.3%. The Fed is likely cognizant of the bubble-like Shiller P/E ratio. While the baseline does not predict a bubble burst, it does forecast very subdued performance, barely outperforming 3-month Treasury bills.
**Severely Adverse Scenario** The Fed's severely adverse scenario predicts a deep recession, with unemployment rising to 10% and inflation falling to 1.1%—characteristic of a typical deflationary recession. Consequently, in this situation, the Fed would cut interest rates to near 0%, the 10-year yield would drop to 2.3%, the stock market would crash by 54%, and real estate prices would collapse. Credit spreads would widen sharply—a scenario reminiscent of 2008.
**Global Stagflation and Dollar Appreciation** However, the Fed's 2026 global severely adverse scenario is characterized by commodity price-driven stagflation. The 2026 global market shock features rising inflation expectations, whereas last year's shock involved declining inflation expectations. In the current global shock, Treasury yields rise across all maturities, contrasting with last year's scenario of falling yields, where short-term rates declined more than long-term rates. In both the 2025 and 2026 global shocks, the U.S. dollar appreciates against most major currencies. In the current shock, commodity prices such as gold, oil, and natural gas rise due to inflationary pressures, whereas they fell in last year's shock. Credit spreads widen and stock prices fall in both the 2025 and 2026 global market shocks.
**How Likely is the Severely Adverse Scenario?** The trigger for the U.S. adverse scenario is a "sudden decline in risk appetite." What could cause investors to seek safety in 2026? Furthermore, the trigger for the global adverse scenario is commodity-driven inflation. What could cause oil and gold prices to rise in 2026? Firstly, the market is facing an unfolding AI bubble burst, temporarily masked by a rotation of funds into "value stocks." The unfolding AI bubble collapse is twofold: 1) Megacap companies are depleting cash flow and borrowing to finance AI capital expenditures, while investors question the return on this investment; 2) AI applications are disrupting many industries, such as software. Ultimately, both factors could lead to credit events, as currently unfolding with situations like Blue Owl. The Fed's adverse scenario predicts that an AI bubble burst could trigger a recession through negative wealth effects—a possibility that appears highly plausible. Secondly, investors face a geopolitical situation, potentially an imminent U.S.-Iran war, which could trigger a spike in oil prices, a safe-haven rush into gold, and ultimately a global recession. Based on available information, Iran shows reluctance to fully abandon uranium enrichment, making this scenario also quite probable. Therefore, the likelihood of the Fed's severe U.S. and global adverse scenarios materializing is disturbingly high.
**Implications** Even as the S&P 500 trades near all-time highs, the VIX index hovering around 20 indicates that market participants are bracing for volatility. It is crucial to note that the trigger for the Fed's severe adverse scenario is merely a decline in risk appetite—implying that even an initially benign market correction could potentially spiral into a recession and a stock market crash comparable to 2008.
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