Non-Linear

17 September 2025

A key feature of our macro framework is that business cycles tend to be non-linear. The non-linearity exists because of a pro-cyclical or reflexive feedback loop and the intimate link between liquidity, leverage, and volatility. Our framework, following Karl Popper, contrasts with general equilibrium theory. When a positive feedback loop develops between an underlying trend and a misconception relating to that trend, it sets a boom-bust process in motion. The boom-bust process is then amplified by credit and leverage.

In most of the period since 2008 the US and the global economy have been supported by a positive feedback loop of low rates, forward guidance (the promise to keep rates low), QE and large fiscal easing since 2020. In turn that contributed to a rise in credit and leverage. Stated differently, long phases of stability lead to episodes of instability due to the pro-cyclical build up in leverage. The contrast since 2020 was that leverage has been built up in the public sector and the consequence has been higher inflation (on average) ever since.

The US Federal Reserve is likely to cut the funds rate at the September FOMC meeting today by at least 25 basis points. Our bias is for a 50-basis point cut. Although the projected path of rates over the cycle is probably more important than today’s decision. The lower expected path of rates has already relaxed broad financial conditions and might support a stabilisation or even a re-acceleration in economic activity, earnings revisions, and liquidity. Large AI capital spending and positive contribution from the fiscal impulse (tax cuts) has also likely supported cash flow. However, it would be unusual for the current deterioration in labour market conditions and consumer confidence to end in a “soft landing.”

As we have consistently noted in this episode, the “good outcome” for the bond markets would be a growth shock or recession that might reduce inflation pressure and allow governments to fund large and growing liabilities. A few observers have noted that the current US public debt accumulation might be America’s “Liz Truss” moment. The damage to the UK markets in the 2023 episode was via the gilts (sovereign bonds) and the currency. The unexpected or hidden leverage that emerged was the LDI (liability driven investment) funds that were forced to sell gilts. In that episode, the Bank of England had to bail out pension funds to allow an orderly resolution of risk. If you want to know where the future risk is; follow the leverage. 

The United States is still in the fortunate position as the global reserve currency. More debt is issued in US dollars than any other currency. The dollar also remains dominant in central bank reserves capital flows and trade. It is also important to remember that currencies are always a relative price. Hence the ultimate diversifier in this episode has been gold and precious metals, rather other major fiat currencies. To be fair, the dollar index has depreciated by over 10% so far this year.

Whatever your view is on the stage of the business cycle, what we do know is that risk compensation in equity and credit is extremely poor. Indeed, investment grade credit spreads are now tighter than in the period leading into the 2008 episode (chart 1). A long position in credit and carry strategies (in all forms) are inherently short volatility or short convexity. From an empirical perspective credit spreads tend to widen when cyclical conditions, profits and cash flows deteriorate. Debt is repaid out of cash flow.

Chart 1

Source: Bloomberg

For the reasons we noted above, the process also tends to be non-linear due to the reflexive or self-reinforcing feedback loop and the intimate link between liquidity and leverage. In the current episode, leverage is also evident in exchange traded funds (BDCs for example). They create a negative gamma like downside accelerator. The big picture point is that the Fed and the US administration might extend the cycle in the near term. However, risk compensation is historically poor on credit and equities. Stated differently, the cost of protection or insurance is cheap.

We are sympathetic to the positive feedback loop extending into next year if capital spending from the hyper-scalers continues. However, as we noted recently, AI spending has created a spiraling cost model. From a big picture perspective, if AI becomes cheaper, requires less power than previously thought, proliferates faster, or does not generate a sufficient return on capital to meet investor expectations existing capital spending outlays could be very wrong. Euphoric non-linear price action combined with heroic valuation is a warning signal that the trend is mature. From a macro perspective the deterioration in the labour market is also comparable to pre-2001 and 2008 and a red flag for US domestic final demand. We are not convinced that aggressive Fed rate cuts will be enough to stabilise growth and corporate profits over the coming months.

20250917_Non_Linear.pdf

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