Stock market plunges 54%, stagflation on the horizon? Federal Reserve simulates extreme scenario of AI bubble burst

The Tongtong Finance APP notes that the Federal Reserve annually develops a “Severely Adverse Scenario” to conduct stress tests on the financial system. Below is the 2026 Severely Adverse Scenario:

The 2026 Severely Adverse Scenario is set as follows: Due to a sudden decline in risk appetite, triggering a global severe recession, leading to sharp declines in risk asset prices, falling risk-free interest rates, and highly volatile financial markets. In the first three quarters of this scenario, the stock market drops about 54%, while the US market volatility index (VIX) surges, reaching a peak of 72% in the second quarter. These conditions also cause corporate bond spreads to widen to 5.7 percentage points. The resulting chaos suppresses household demand for goods and services, prompting companies to significantly cut employment and investment, with the economy and asset prices recovering slowly. The US unemployment rate will rise from 4.5% at the end of Q4 2025 by 5.5 percentage points, reaching a peak of 10% in Q3 2027. The sharp contraction in economic activity leads to a collapse in real estate prices, including a 29% decline in nominal home prices and a 40% drop in commercial real estate prices.

Essentially, the Fed hints that a “sudden decline in risk appetite” could lead to a severe recession—with the transmission pathway seemingly through negative wealth effects from a stock market bubble burst, followed by unemployment soaring to 10%, which then triggers systemic credit events, ultimately causing a housing bubble burst.

This is also partly the outlook of some pessimistic analysts for 2026—a recessionary bear market accompanied by an AI bubble burst.

It is important to note that the Fed develops both a Severely Adverse Scenario and a Baseline Scenario each year. In almost all cases, the Baseline Scenario has proven correct—except in 2000 and 2008; in those two instances, the Severely Adverse Scenario ultimately became reality. Unfortunately, the macroeconomic situation in 2026 appears very similar to that of 1999-2000 and 2007-2008.

First, the Fed’s Baseline Scenario for 2026-2029 envisions moderate economic growth, stable unemployment, and gradually declining inflation—essentially a “Goldilocks” scenario.

According to this “Goldilocks” scenario, the Fed expects: 1) 3-month Treasury yields to fall from 4.0% at the end of 2025 to 3.1% by the end of 2029; 2) 10-year Treasury yields to gradually decline to 3.9% by 2029; 3) the stock market to rise 4.3% annually through 2029; 4) nominal home prices to decline before Q1 2027 and then gradually rise until 2029; 5) commercial real estate prices to increase 4.3% annually.

Even in the Fed’s “Goldilocks” baseline, there is little comfort; the stock market is expected to perform poorly over the next three years, with an annual gain of only 4.3%. The Fed is likely aware of the bubble-like Shiller P/E ratio; although the baseline does not predict a bubble burst, it forecasts very modest performance—barely outperforming the 3-month US Treasury.

Severely Adverse Scenario

The Fed’s Severely Adverse Scenario predicts a severe recession, with unemployment rising to 10% and inflation falling to 1.1%—a typical deflationary recession.

Correspondingly, in this scenario, the Fed would cut rates close to zero, the 10-year yield would fall to 2.3%, stocks would plummet 54%, and real estate prices would collapse. Credit spreads would widen sharply—similar to the 2008 scenario.

Global Stagflation and US Dollar Appreciation

However, the key feature of the Fed’s 2026 global Severely Adverse Scenario is inflation driven by commodity prices, leading to stagflation.

The 2026 global market shock is characterized by rising inflation expectations, whereas last year’s global shock saw inflation expectations decline.

In the current global shock, yields on bonds of all maturities have risen, whereas last year’s saw yields fall, with short-term yields declining more than long-term yields.

In the 2025 and 2026 global shocks, the US dollar appreciated against most major currencies.

In the current global shock, due to inflation pressures, prices of commodities like gold, oil, and natural gas have risen, whereas last year’s shock saw commodity prices fall.

In the 2025 and 2026 shocks, credit spreads widened and stock prices declined.

How likely is the Severely Adverse Scenario?

The trigger for the US adverse scenario is a “sudden decline in risk appetite.” So, what could cause investors to seek safety in 2026?

Additionally, the trigger for the global adverse scenario is commodity-driven inflation. What could cause oil and gold prices to rise in 2026?

First, the market is facing an unfolding AI bubble burst, temporarily masked by capital rotation into “value stocks.” The AI bubble burst is twofold: 1) large-scale companies are depleting cash flows and borrowing to finance AI capital expenditures, while investors question the returns; 2) AI applications are disrupting many industries, including software. Ultimately, both factors could lead to a credit event, as seen with Blue Owl’s current situation. The Fed’s adverse scenario prediction suggests that the AI bubble burst could trigger a recession through negative wealth effects—highly plausible.

Second, geopolitical tensions, such as an imminent US-Iran war, could cause oil prices to spike, capital flight into gold, and ultimately trigger a global recession. Given current information, Iran’s reluctance to fully abandon uranium enrichment makes this scenario quite likely.

Therefore, the probability of the Fed’s global and US Severely Adverse Scenarios occurring is alarmingly high.

Despite the S&P 500 approaching record highs, the VIX index near 20 indicates that market participants are preparing for volatility.

Please note that the trigger for the Fed’s Severely Adverse Scenario is merely a decline in risk appetite—meaning even a benign initial adjustment could evolve into a recession and a stock market crash comparable to 2008.