ROI-AI gloom revives the specter of stagflation: McGeever​

AI skittishness has put the brakes on Wall Street's rally, ​resuscitating demand for US Treasuries as investors seek to protect portfolios, even as surging energy prices stoke inflation. This ​could put the Federal Reserve in an unenviable stagflationary bind. For most of this year, ‌the ​US bond market has been slammed by an inflation-inducing barrage of soaring energy prices, fiscal fears, and the AI boom. Two of those forces remain very much in play, yet bond yields are no longer on a one-way path higher, with the 10-year falling below 5% for the first time in over a month last Thursday.

Investor sentiment around AI is souring. While there ‌has been no single obvious trigger, long-held concerns about the vast sums being spent on the technology have been exacerbated by Big Tech earnings reports detailing gargantuan capital expenditure plans. AI debt markets are wobbling too. While this all may prove to be temporary – just another speed bump in the AI race – the mood shift suggests we may be at the point in the cycle where almost any news is bad news. If so, this should spur a rally in “risk-free” Treasuries. If the AI juggernaut is sputtering, Wall Street and ‌Main Street should sputter too, given how fundamental the technology has become to the stock market and economic growth.

But the alarming fiscal outlook hasn't changed, and energy prices are roaring higher again, with US crude futures rising 10% last week to ‌a six-month peak above $110 a barrel, suggesting price pressures and inflation expectations aren't cooling anytime soon. PERSISTENT PRICE PRESSURES

A glance at a chart of the 10-year Treasury yield shows how closely correlated energy prices and the bond market have been this year. The 10-year yield's lowest daily close in 2026 was 3.96% on Friday, February 27, the day before the US and Israel attacked Iran. The subsequent surge in global crude, gas and fuel prices then propelled Treasury yields to their highest levels in more than two decades as investors bet that inflationary pressures would intensify. The 10-year yield reached 5.36% earlier this month. But that relationship has broken ⁠down recently. Oil ​prices eased for a few weeks beginning in mid-September, but the relentless ⁠rise in bond yields continued. Now oil prices have rebounded sharply, yet Treasury yields are in retreat, culminating in last Thursday's steep decline of 20 basis points.

Typically, a global energy shock would be expected to slow economic growth, causing investors to flee to the Treasury market. However, for most of this year, ⁠the tailwind from the AI juggernaut has kept the economy and Wall Street humming. If the AI narrative is turning, bond investors will have to consider the potential valuation destruction and economic fallout from a deflating AI bubble. That appears to be offsetting any fears of "higher-for-longer" energy prices. But the ​move back toward Treasuries may not be a simple switch to flick.

'STAGFLATION' RETURN? That’s because "stagflation" could return to investors' lexicon.

A mix of stagnant growth and sticky inflation would complicate life for the Federal Open Market Committee. While it raised its ⁠policy rate in September, it will almost certainly keep it on hold this Wednesday ahead of next week's midterm elections. Markets still expect it to tighten again in the coming months, but that assumes inflationary pressures outweigh AI wobbles. Last week, one-year market-based inflation expectations climbed to 2.80%, as measured by inflation swaps. That’s the highest since ⁠June, ​though the rise in longer-dated inflation swap rates has been less dramatic, suggesting investors don't believe the energy shock will become deeply embedded in higher goods and services prices.

Fed policymakers will likely be banking on that. But it's a risky bet. Producer prices, often a leading indicator of consumer prices, are rising at the fastest pace in four years. The gap between producer and consumer price inflation is also the widest in four years. And it's worth repeating that consumer price inflation has been above the Fed's ⁠2% target for close to six years.

"All main inflation measures are expected to increase over the next couple of months as base effects from last year's government shutdown in October and November create a low bar for rising inflation," UBS economists ⁠say. "We expect little easing in inflation before the spring of next year," ⁠when the base effects from the start of the Iran war kick in. Can the Fed afford to "look through" the latest spike in energy prices, while hoping that the AI wobbles don't snowball?

(The opinions expressed here are those of the author, a columnist for Reuters) Enjoying this column? Check out Reuters Open Interest (ROI), your essential new source for global financial commentary. Follow ROI on LinkedIn, ‌and X.

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