“I have only made this letter longer because I have not had the leisure of making it shorter.” — Blaise Pascal

I have been working nonstop on projects with hard deadlines; last week’s note was the casualty compounded by computer malfunctions that require me to replace my primary computer. As I am moving in two weeks, I am suffering through the snafus rather than biting the bullet and setting up a system twice.

Excuses aside, this one is denser than usual, and I think it matters. Roughly 40% of the Q2 semiconductor price move, and about sixty percent of the shift in the tape’s character, can be explained by a measurable change in how holders of levered products behaved, plus the arrival of one large price-insensitive vehicle. The plumbing changed. If it can happen in semiconductors, it can happen in other places where the same structures exist.

The Philadelphia Semiconductor Index rose 88% in the second quarter of 2026. It did so at 60% annualized volatility, nearly double its twenty-year average. Micron gained 230% over those three months while Nvidia, the largest stock in the index and the supposed center of the AI trade, managed about 15%. Then, in three weeks of July, the index gave back 17%. Micron, the most crowded and extended stock in the market, fell at almost exactly its ordinary, pre-mania sensitivity to the index -- a coincidence we will take apart.

My argument is that a surprisingly large part of this pattern was mechanical. The size of the spike, the violence of the daily swings, the identity of the winners, and the shape of the unwind were driven by measurable flows through a specific set of exchange-traded products. The behavior of the people who hold those products changed at an identifiable date, the first week of April 2026, and the consequences can be reproduced by a model that was calibrated entirely on data from before the change. Over the past several weeks, the team at Tier1 Alpha Research and I assembled shares-outstanding and price data for every levered and unlevered semiconductor ETF, every single-stock levered wrapper on a SOX constituent, and the largest sector fund launch in history, and ran the arithmetic. This post is the full accounting: what the machine is, how it changed, what it did, and which of my own hypotheses failed along the way.

Four key findings:

First, for most of the past decade the levered ETF complex was a stabilizing presence in this market. Not because the products are benign, but because their holders acted as a counterweight, selling into strength and buying into weakness consistently enough to recycle the funds’ own destabilizing trades. That behavior can be measured, and the measurement changed abruptly in April.

Second, when the recycling weakened enough to stop absorbing the funds' gross rebalance demand, a machine that had spent a decade canceling itself began injecting momentum flow into the tape: $76 billion of gross rebalance demand in the June quarter, nearly half of it unrecycled, for a net footprint of +$33 billion where the old behavior would have produced roughly nothing. The volatility regime of the entire index changed within weeks. A model containing nothing but mechanical trading rules, with no sentiment and no psychology, and with its market physics calibrated entirely before the break, reproduces roughly sixty percent of that change.

Third, the winners were chosen by a different machine entirely: a $26 billion sector fund, launched on the exact day the regime broke, that generated roughly $5 billion of exposure demand for a single mid-cap stock in one quarter -- demand decoupled from the day’s return, arriving whether the tape was up or down. The levered complex changed the character of the tape. The new fund chose its destination.

Fourth, the single-stock levered wrappers that have multiplied across the index since 2024 matter far less than their reputation suggests, with one enormous exception. Readers who follow the launch announcements may be surprised; anyone who has looked at the asset totals will not be, because the totals say more about an ETF industry scrambling for survival than about investor demand. The tests we designed to convict the wrappers came back empty, twice, and the model told us why before the data did.

Start with the physics.

What a daily reset actually does

A leveraged ETF promises some multiple, call it L, of its index’s daily return. To keep that promise it must trade every single day. If the index moves by r, the fund’s assets move by L times r, but the exposure it needs is L times its new, larger (or smaller) asset base. The gap between what it holds and what it needs works out to L(L−1) times assets times r. For a 3x fund that coefficient is 6. On a day the index rises 3%, a $20 billion fund must buy $3.6 billion of exposure at the close. On a day the index falls 3%, it must sell the same amount.

Here is the detail most people miss: the inverse fund is not the other side of this trade. For a −3x fund, the coefficient is (−3)(−4) = 12, and the direction is the same. After an up day, the bear fund must buy to cover; after a down day, it must sell more. Bull and bear both chase the day’s move. The levered complex as a whole is built to trade with momentum, in size, at the close, and everyone on Wall Street can compute its order in advance.

The second piece of physics: volatility drag. A levered fund’s long-run growth rate follows a simple formula:

growth ≈ L·μ − (L²·σ²)/2

L is the leverage. μ is the index’s average yearly return. σ is the index’s volatility. The first term is what the marketing promises: three times the return. The second term is the toll, and it grows with the square of both leverage and volatility. Double the volatility and the toll quadruples. Triple the leverage, and it rises ninefold. If you’re feeling adventurous and bold, head over to London for 5x leverage -- the English can no longer field a military, but they have no problem supplying the world with tools for punting.

To see what the toll collects, assume the index averages a 20% return -- a spectacular market, every single year -- and watch what happens to $100 over one year as volatility rises:

Look at the bottom row. The index is averaging a 20% return, and the 3x fund turns $100 into $2. Nothing crashed. The toll simply compounds at nine times the rate of the market’s chop, and above 40% volatility, no realistic return outruns it. At the SOX’s twenty-year realized volatility of 31%, a 3x product needs the index to return 14.4% a year just to break even. The SOX, one of the great compounding machines in market history, delivered 17.2% a year over that stretch. Even riding one of the great compounding indices of the era, most of the apparent benefit of 3x leverage was consumed by variance before fees and financing. Now apply this spring’s volatility: at 60% realized, the 3x breakeven jumps to 54% per year, and the toll itself is nine times the squared volatility, halved -- 9 × 0.36 / 2, or 162% a year, roughly 64 basis points every trading day taken out of the fund. No index delivers that. Only a strong trend can outrun the drag, and the moment trend turns sideways, the product bleeds.

You can watch the drag with your own eyes. Because (1+3r)(1−3r) = 1−9r², the product of the bull fund’s value and the bear fund’s value shrinks every day by nine times the day’s squared return, no matter which way the market went. Direction cancels out; drag accumulates. We reconstructed both funds’ value paths from daily index returns back to 2012 and plotted the bear fund on an upside-down axis against the bull. If the two funds were true mirror images, the lines would sit on top of each other. Instead they drift apart by five and a half orders of magnitude, and the size of the gap is a running meter of accumulated volatility. Work backward from the gap and you recover an average volatility of 31.6% -- almost exactly the measured twenty-year figure. At today’s volatility, that gap widens by a factor of 25 every year.

SOX Index vs Levered ETF daily index cumulative total returns 2010-2026

The fund that cannot die

That brings us to the strangest object in modern market structure: the inverse levered fund with no survivors and no shortage of volunteers.

SOXS, the 3x bear fund on semiconductors, has lost roughly 99.9999991% of its value since 2012. Eight orders of magnitude. Over that same period, the dollars invested in it never left a band between about one-tenth and ten times its starting size, because investors kept feeding it. Cumulative inflows since 2012 total about thirty-eight times the fund’s original asset base. Essentially every dollar that ever entered was destroyed, and the fund’s current assets consist entirely of money that arrived recently. The business works because the pool is always full and the new arrivals have no memory of the yellow cloud from the prior period. Reverse stock splits keep the share price presentable, inflows keep the assets stable, and the fund functions, economically, as a permanent fee stream for its sponsor. Who pays? A rotating cast betting on a top or hedging a portfolio -- and, more importantly, the professionals positioned on the other side of them. Recall the pair-decay arithmetic: the two funds bleed value between them, and professionals run short positions against both legs to collect the bleed. That trade is easy to oversimplify. The product of the two NAVs decays mechanically, but a static short of both funds is exposed to their sum, and the sum grows in a sustained trend even while the product shrinks. The harvest pays well in choppy, directionless markets, but it must be rebalanced daily, financed, and borrowed, and it loses money in exactly the kind of relentless trend this spring produced. Its first input is shares to borrow. Borrowed shares must exist before they can be shorted, which means someone must create them, which means the harvest runs only as long as fresh capital keeps replenishing the melting fund. The harvest needs the standing wave the way a distillery needs corn.

The trade also has a governor. You can only short what you can borrow, you can only borrow against margin, and margin is priced by prime brokers who demand more collateral as volatility rises. So the harvest’s capacity shrinks at precisely the moment its yield explodes: the same volatility that doubles the decay doubles the collateral bill, and past some point the broker, not the opportunity, sets the position size. A trend adds a third jaw to the vise. The short bull leg explodes in a melt-up, so the harvesters’ forced exit is a purchase, made at the top, in size. A short-volatility trade carried out of its own best harvest season by its financing is not a new story; February 2018 retired an entire family of short-volatility products in a single afternoon. It matters here because the harvesters are a load-bearing part of the machine. Their borrow demand drives creations, their creations replenish the bear fund, and when volatility forces them to shrink, one more stabilizer switches off exactly when it is needed.

The pattern repeats at every scale. In the past year alone, the −1x Micron fund absorbed $2.7 billion of cumulative inflows and currently holds $48 million. The common narrative is “Silly bears!” Every bear fund in this complex shows the same signature. The signature can be measured.

Measuring who does what

For each fund, take the growth in its shares outstanding and compare it to the growth in the fund’s own value per share. The relationship between the two is a number I will call "flow elasticity." It describes what the holders, in aggregate, do when the fund moves: it is their operating rule.

An elasticity of zero means holders sit still. Share counts don’t respond to performance. That is what a buy-and-hold allocation vehicle looks like, and the plain, unlevered index funds show it. SOXX comes in at −0.08 and SMH at +0.03, statistically nothing. Their share counts grind upward on institutional schedules, indifferent to the daily tape. That zero is the operating rule of the passive majority of American equity ownership -- a majority the fund-level statistics undercount by half, as Chinco and Sammon showed by measuring reconstitution-day volume instead of counting tickers -- and its immovability is the foundation of everything my broader work argues about inelastic markets.

An elasticity of −1 means holders keep a constant dollar amount invested. Every 1% gain in the fund is met with a 1% redemption of shares. The profit is skimmed; the bet stays the same size. The levered funds cluster near this behavior, and they have for as long as the data runs. From 2013 through the end of 2024, SOXL’s holders ran an elasticity of about −0.4, and the relationship tightened as the fund grew: over the last five years of that window, the figure is −0.46 with a strong fit. As the mania built through 2025, the skimming intensified toward −0.7. The more the fund made, the harder its holders leaned against it. The past twelve months are the vivid illustration: SOXL’s value per share touched ten times its starting level, and holders redeemed a cumulative 1.47 times the fund’s starting assets in cash, holding the fund’s total dollar size nearly flat until the final melt-up. SOXS holders have run near −1.0 for over a decade, beyond constant dollars and into doubling down, and pushed deeper as the squeeze arrived: over the past year they over-replaced every loss, pouring 3.16 times the starting assets into a fund that fell 96%.

This inverts the famous rebalance trade. The fund itself must buy 6 units per unit of assets per unit of return after an up day. But holders running an elasticity of −0.5 redeem into that same up day, and their redemptions force the fund to sell about 4.5 of those 6 units right back. The net footprint is about a quarter of the headline number. On the bear side, at −1.2, the offset reaches roughly 90%. For years, the levered complex’s momentum trading has been mostly recycled by the profit-taking and dip-buying of its own investors. The machine was loud, but it swallowed most of its own exhaust.

The recycling shows up in the price data. From July 2025 through March 2026, a period in which the SOX rose 37%, SOXL’s holders ran an elasticity of −0.68, and the levered complex was a net seller of $10 billion into the rally. The funds’ rebalancing demanded $28 billion of momentum buying over those months; holder redemptions more than fully absorbed it. Over the same stretch, the index displayed strong mean reversion. A big up day tended to be followed by give-back: daily returns had a correlation of −0.19 with the previous day, and a strong week surrendered about a fifth of itself the following week. That give-back was the recycling flow hitting the market. Trends could not extend because the complex’s own holders sold every extension.

April 2026: the recycling breaks

Then the operating rule changed. From April through July, SOXL’s elasticity weakened from −0.69 to −0.40. Holders skimmed forty percent less of each gain. The recycling did not stop; it stopped being enough. Against $72.4 billion of rebalance-driven buying in the June quarter, the sign of the complex’s net footprint flipped: the net trade was +$22.5 billion. The same behavioral machinery that had produced eleven billion of net selling across eight and a half months of rally produced twenty-two billion of net buying in a single quarter. The swing between what happened and what the old behavior would have produced against the same tape is roughly $58 billion per quarter.

Realized volatility went from 33% to 55%. The day-to-day give-back weakened from −0.18 to −0.10. The weekly give-back vanished entirely, from −0.22 to zero. The share of trading days with moves larger than 3% went from 15% to 38%. And in July the machine showed its symmetry: as the index rolled over, the complex sold $13 billion in three weeks, momentum selling where the old regime would have been absorbing.

Was this retail investors catching the semiconductor bug and refusing to sell? Directionally yes, even though net dollars did not pour into SOXL during the melt-up; net redemptions continued through April and June. What changed is that the marginal holder stopped rebalancing, which is all the arithmetic requires. The clearest retail fingerprint arrived afterward. The first genuinely positive inflows of the entire year showed up in the first three weeks of July: dip-buyers purchasing a 3x product, at 60% underlying volatility, after the top. Those buyers face a 54% annual breakeven. They are feeding the standing wave from the long side now.

“If you're playing a poker game and you look around the table and can't tell who the sucker is, it's you.” — Paul Newman

Read more

• The “impossible” disentanglement has been done — and it just won an award. In 2020, the FT dismissed my passive-investing arguments as “far-fetched,” the blow-up prediction as “fatuous,” and disentangling passive’s effect from larger forces as “impossible.” Hannah Unterberg’s prize-winning paper now shows passive flows — not vanishing skill — penalize active managers

• The FT’s fallback — the “poker table” — cannot generate any of the actual findings. The paradox of skill predicts alpha compression, not a sign flip on Active Share timed to passive flows. And its premise is false: the fish never left the table. Retail noise trading is at record highs, yet the correctors are starving while market makers post historic profits — the noise trader’s losses now fund facilitation, not price discovery. A poker game whose only reliable winner is the house is called a casino.

• Unterberg isn’t carrying this alone; six independent literatures now identify one machine. Incidence (Jiang: flows inflate the largest, most overvalued names), elasticity (Haddad: active offsets only ~two-thirds), clearing (Sammon-Shim: firms, not arbitrageurs, supply the shares), information (Coles: index ownership causally reduces research production), returns (Unterberg), and stability — my model with Krishnan and Sturm showing that past calculable passive-share thresholds (as low as ~65%), violent boom-bust volatility becomes endogenous to the market’s architecture. The claim called fatuous is now a formal result.

• 2022 was the mechanism running in reverse. Lu and Wu’s dual-share test shows identical-fundamental corporate share class “twins” diverging after Fed surprises based purely on rebalancer ownership, attributing one-third to two-thirds of the market’s excess-return response to monetary shocks to this single flow channel. The mega-caps that led the fall roared back at still-elevated rates: flow, not duration.

• The concentration premium is compounding — and the answer to “what should we do?” is coming. My research finds the flow premium to the largest, most volatile names has accelerated ~0.33pp per year since 2005 — a run rate near 7% annually today, roughly a doubling versus their own size cohort cumulatively, and convex from here. Because it’s flow-driven rather than earned, that’s stored energy, not banked return.

The Main Event

In December 2020, Robin Wigglesworth wrote up my arguments about the structural impacts of passive investing in the Financial Times, after a two-hour interview, a pass through my work, and, by his own account, conversations with plenty of others. He described the core mechanics accurately: fully invested index funds create a secular lift in valuations, and market-cap weighting mechanically allocates the largest share of every new dollar to the largest constituents, so appreciation raises a name’s claim on the next dollar in. He even conceded that passive was plausibly a contributor to several of these patterns.

Then he dismissed them. The notion that passive had become a nefarious force wrecking the natural order of markets was “far-fetched.” The prediction that it would eventually blow up and rip a hole in financial markets was “fatuous”—the word that closed the article. And disentangling passive’s effect from larger forces was, in any case, “impossible.”

In June, Hannah Unterberg’s “Passive Flows, Active Woes: Passive Investing and the Decline of Active Mutual Fund Alpha,” out of UC Irvine, took the Two Sigma Award for Best Paper in Investment Management. It disentangles the effect, showing that passive flows penalize active tilts through demand—no deterioration in manager skill required. A prediction I made over a decade ago:

And this month, reviewing the paper in FT Alphaville, Wigglesworth pivoted: the explanation for active underperformance is now the “poker table”—Michael Mauboussin’s paradox of skill.

What the Unterberg paper shows

Standard theory has long predicted that as passive grows and the active sector shrinks, the surviving active managers should face less competition for mispriced securities and earn higher alpha. The data shows the opposite.

Unterberg documents that the average active U.S. equity fund earned a four-factor alpha of roughly -0.72% per year from 1984 to 2009. After 2010, as passive vehicles took market share in earnest, that underperformance more than doubled, to -1.82% a year.

This is not a fee story. The decline shows up gross of fees: the value-weighted active sector earned a gross alpha close to zero before 2010 and a four-factor gross alpha of -0.66% per year after. Fees fell over this period. The returns themselves deteriorated.

The smoking gun is Active Share. Historically, a fund’s deviation from its benchmark predicted outperformance. Post-2010 the relationship flipped, and high Active Share funds now systematically underperform low Active Share funds.

Unterberg then identifies the mechanism. She constructs a fund-level measure of flow-induced demand and shows that once this enters as a control, the negative relationship between Active Share and performance collapses to statistical insignificance. The post-2010 penalty on active tilts loads onto the flows, not onto any measured change in manager ability.

For a plausibly exogenous test, she isolates beginning-of-month passive inflows driven by mechanical 401(k) paycheck contributions, flows plausibly predetermined with respect to contemporaneous fund performance. In those windows, low Active Share funds earn higher daily returns and high Active Share funds get penalized, a monotonic gradient that appears for passive flows and vanishes for active ones.

The pivot to the poker table

In his Alphaville piece, Wigglesworth acknowledges the paper, but then proceeds to dismiss it as “Alphaville suspects” there are better alternatives. Borrowing from Mauboussin’s paradox of skill, the argument runs that passive investors drummed the “fish” out of the market, leaving only “sharks” at the final table. The game got harder because the remaining players got better.

It’s an elegant story, and it may describe a real force. But it can’t be the better explanation of these particular findings, because it can’t generate any of them.

The paradox of skill predicts alpha compression: the spread between good and bad managers narrowing toward the fee drag. It offers no mechanism for Active Share to flip from a positive predictor into a negative one; tougher competition makes deviation less rewarding, not punished. It has nothing to say about why closet indexers get rewarded during the first three trading days of the month, when mechanical retirement contributions arrive, and at no other time. And it can’t survive the hinge result: control for flow-induced demand and the Active Share penalty vanishes while the flow term stays significant. Skill and competition do not hide inside a lagged mechanical demand variable.

The two objections

Wigglesworth raised his two narrower objections before reaching for the poker table, and both are answered inside the paper he was reviewing.

The first is a measurement concern: an active manager facing redemptions need not liquidate every favored overweight proportionately, so a holdings-based flow measure rests on an assumption about how flows become trades. Fair enough. The constructed measure does follow the standard proportional-trading approach, with outflows passing through at close to one-for-one. But the objection is not an alternative explanation, because the beginning-of-month result doesn’t depend on the constructed measure at all. For discretionary liquidation to produce it, managers would have to generate a return gradient that appears only for passive flows, only in the first three trading days of the month when retirement contributions land, and vanishes for active flows. That’s a mechanical pattern, not a discretionary one.

The second objection is that active managers remain “price setters” while passive funds are mere “price takers.” This confuses how an order is submitted with whether it moves the price. Price-taking describes accepting the available quote; it says nothing about the marginal seller who must be induced to part with shares. A mechanical, valuation-blind buyer can take the offered price and still force the clearing price higher, no opinion about value required. And the premise that active investors still fully set prices is rejected by the evidence. Haddad, Huebner and Loualiche estimate that when some investors stop responding to price, the strategic response of everyone else offsets only about two-thirds of the effect. Jiang, Vayanos and Zheng show where the residual impact lands: disproportionately in the largest firms, and particularly in the ones already most overvalued. The supposed price setters do not supply an infinitely elastic countertrade. They absorb part of the shock and pass the rest through.

Compounding Evidence

Unterberg is not being asked to carry this argument alone. She completes a chain whose links have now been identified by separate researchers, with separate methods, none of whom needed the others to be right.

Jiang, Vayanos and Zheng establish the incidence: passive inflows disproportionately raise the prices of the largest firms, and especially of large firms that are already overvalued. Their framework even permits the aggregate market to rise when the passive inflow comes entirely from investors switching out of active funds, and they show that the flow-induced volatility itself makes correcting the distortion less attractive. Haddad, Huebner and Loualiche establish why active capital doesn’t arbitrage it away: the strategic response is incomplete, as above. Sammon and Shim establish who actually clears the flow, and the answer is not valuation-sensitive institutions leaning against the bid; most demand-side institutions trade in the same direction as the index funds. The shares come from the firms themselves, supplied at nearly a one-for-one rate through non-primary issuance like stock compensation, with price acting as the coordinating mechanism. One can argue that firms are informed sellers of their own stock, and that issuance into overvaluation is itself a corrective force. Grant it. What that concedes is the point at issue: the marginal counterparty to the passive bid is the issuer responding to price, not the infinitely elastic pool of valuation-sensitive arbitrage capital the price-setter story requires. And notice what kind of correction issuance is. The firm does not sell the price back toward value; it sells additional paper at the distorted price, which had to move first to induce the supply. Stock-compensation issuance answers payroll schedules, not valuation views. To the extent the flow-clearing trade is informed, the information runs one way—insiders supplying shares at inflated prices to the household’s mechanical bid. That clears the quantity while leaving the price where the flow put it. Coles, Heath and Ringgenberg establish the information effect: exogenous increases in index ownership cause declines in Google searches, EDGAR views and analyst coverage—a causal finding that indexing reduces the production of firm-specific information. And now Unterberg establishes the return consequence: the managers who keep producing and acting on differentiated views are the ones the mechanical flows penalize.

Incidence, elasticity, clearing, information, returns. Each link identified separately; together, successive components of one machine. One can argue about the strength of any individual link. What is no longer available is the claim that there exists no identified bridge from passive ownership to mega-cap price impact, or from passive growth to weakened information production.

The claim called fatuous

“Most of all, the theory that passive investing would inevitably blow up and rip a hole in financial markets when the tide recedes seems a little fatuous today.” — Wigglesworth, Dec 2020

In A Model for Passive That Breaks the Market, Hari Krishnan, Stephan Sturm and I formalize it relying on simple insights. One can dispute the calibration and the modeling choices; the paper devotes a section to anticipating which assumptions will be attacked, and defends each. The most natural objection—that at some level of distortion, new unconstrained capital must re-enter and correct—is the Grossman-Stiglitz reflex in its purest form, and the model already prices it: the Haddad strategic response enters as a time translation, delaying the thresholds by roughly thirteen years without changing the destination. That is now the available debate: assumptions and mathematics.

What is no longer available is dismissing the conclusion as self-evidently absurd. The claim called fatuous is now a formal instability theorem inside a calibrated model whose economic premises are independently testable, and are being confirmed one by one.

Call it the sixth link: incidence, elasticity, clearing, information, returns—and stability.

The false premise of the empty table

The poker table rests on an empirical claim that no one checks: that the patsies packed up and left the game for index funds, leaving only professionals to grind a shrinking pool of alpha against one another. But the patsies didn’t leave. We are living through the largest explosion of retail noise trading in modern history—zero-commission accounts, the meme-stock manias, the retail options boom, crypto. The dumb money didn’t go anywhere. If anything, it got louder.

Under Grossman and Stiglitz, that should be a feast. Informed traders are paid in alpha for the costly work of correcting mispricings; flood the market with noise traders and the pool of available alpha should widen, and the sharks should be gorging. Instead, as Unterberg shows, the high–Active Share managers, the ones actually deviating to pick stocks, are starving. Under the poker table analogy, that’s impossible.

Except someone is eating. In the same window that the correctors have been starving, the market makers built to intermediate the retail flood have posted the best numbers in their history. Citadel Securities, the largest single destination for Robinhood’s order flow, just booked a record $4.3 billion of trading revenue in one quarter, up 28% year over year, with net income near $1.9 billion, and it “benefited from volatility.” Jane Street, Hudson River Trading and Susquehanna are at the same feast. The food is being devoured, just by a different animal than the one Grossman-Stiglitz promised.

This is the distinction the poker table can’t see. There are two ways to make money off a noise trader. You can correct him: take the other side because you have a view about value, and get paid when price converges to it. Or you can facilitate him: take the other side because you can hedge it out in milliseconds, and collect the spread and the order flow while staying indifferent to whether the price is right. The corrector needs price discovery to happen; the facilitator only needs the trading to continue.

Grossman-Stiglitz routes the noise trader’s losses to the corrector, and that is what makes the market self-heal, because the reward for information funds the production of information. The modern market routes those losses, to a first approximation, to the toll booth, which produces nothing about value at all. Record market-making revenue has many parents (volume, volatility, market share, product breadth) and it is an existence proof the poker table cannot use: the structure that starves the correctors makes facilitation spectacularly profitable at the same moment, on the same flow. The noise trader’s losses have not vanished from the system. Increasingly, they fund the activity that lubricates the market rather than the activity that prices it.

And it matters who the noise trader is. In the models he is an abstraction. In practice, they are a household—the same household whose 401(k) rides the mechanical bid—now holding a phone with a sportsbook in one app and zero-day options in the next. The industry’s response to his arrival was accommodation, not correction: payment for order flow, gamified execution, an ecosystem engineered to keep him trading. The casino did not spring up in opposition to the index revolution. It grew in the space the index revolution vacated, monetizing the engagement that mechanical investing no longer required.

A defender will say market makers make the market efficient—look at the spreads. But there are two efficiencies here, and the error is conflating them. Market makers enforce consistency: no arbitrage between venues, ETFs pinned to their baskets, one price everywhere at once. What they don’t enforce, and are built not to enforce, is correspondence to value. They will make a tight, orderly, arbitrage-free market in a stock at whatever price the flow dictates. Tight spreads measure intermediation efficiency, not price-discovery efficiency—one more case where the comfortable reading and the real one print the same number. And this retires the last living version of the poker table. Citadel’s record haul isn’t the sharks winning the pricing game; it’s the pricing game being displaced by a turnstile. Ask who ultimately absorbs the retail bid, and increasingly the answer is an intermediary with no durable view of value. The tempting rescue is to redefine the shark: skill didn’t vanish, it migrated from reading balance sheets to managing flow. The skill is real. But the paradox of skill was never a claim about who gets paid; it was an explanation of why prices are right, and facilitation produces no view about price, however brilliantly executed. A poker game in which the only reliable winner is the house is not a contest of skill among the players. It is a casino.

And the reason the correctors can’t touch that pool isn’t that passive flows somehow “overpower” the noise. The players who could eat it have been walked out of the room mid-hand. Grossman-Stiglitz requires that informed capital can deploy against the mispricing. But the informed are being redeemed—capital is draining out of the correctors and into the mechanical bid—and the survivors are benchmark-chained, unable to take the large positions against the largest names that correction would demand. The fish are present. The correctors are defunded and handcuffed.

And when a corrector does take the other side, the flow doesn’t feed it. It runs it over. Ask Melvin Capital. Melvin was a top-performing, fundamentally driven fund carrying a large short in GameStop, a declining mall retailer it judged wildly overvalued. Whether that valuation call was ultimately right or wrong turned out not to matter. A coordinated retail bid, organized in the open and amplified by the options dealers it forced to hedge, ran the position over and margin-called the fund into a bailout it never recovered from; it wound down the following year. That is retail noise reaching the professional table and executing the professional, the exact opposite of noise becoming harvestable alpha for the skilled. And the survivors drew the only rational lesson: stop shorting anything the flow is supporting. Aggregate short interest as a share of market capitalization has since fallen toward historic lows. Even if you insist Melvin was simply reckless, the population-level retreat isn’t idiosyncratic. An entire ecosystem learned that correcting flow-supported overvaluation is a firing offense.

This is where the classical picture and the real one part ways, and the name for the gap is non-ergodicity, the distinction the physicist Ole Peters has spent a decade forcing back into economics, against the same resistance we will come to in a moment. An ergodic system is one in which the average across many players at a single moment equals the average of one player’s experience over time: the ensemble equals the trajectory. The poker table is ergodic to the bone. It reads Melvin’s loss as a transfer, alpha changing hands from one corrector to another, the pool conserved and participation intact. Average over the ensemble and correcting mispricings remains a positive-expectation activity, so the system self-heals. But no fund lives in the ensemble. Each lives one trajectory through time, and that trajectory has an absorbing barrier at ruin—hit it once and you never see the later hands in which your thesis pays. Melvin doesn’t get to average over the parallel worlds in one of which GameStop obliged. It is simply gone. And whatever the accounting identity of the counterparties who captured its losses, the specialized capacity it embodied—the willingness and mandate to carry a large fundamental short—did not transfer intact to another corrector. The dollars were conserved. The capacity was not.

None of this is unknown to finance. Shleifer and Vishny wrote down the limits of arbitrage three decades ago: financing constraints, forced liquidation, the agency problem of managing other people’s money through a drawdown. Position sizing and survival are components of investment skill, not excuses for its absence—granted, and Melvin plainly failed that test. But that is precisely the concession the poker table cannot absorb. If surviving the flow is now a binding constraint on correcting the price, then the parable’s premise—that exit is harmless selection, leaving a stronger population to do the same job—is false in its own terms. The limits-to-arbitrage literature is not a defense of the poker table. It is the reason the poker table was never a safe metaphor to build on.

That is the assumption the poker-table intuition smuggles in and the market violates. In an ergodic market the loss of any one corrector is invisible, absorbed by the ensemble. In a non-ergodic one, ruin is a ratchet: each casualty permanently removes a node, and because the casualties fall hardest on the funds willing to hold the largest, most contrarian positions, the removals are skill-weighted, subtracting the capacity the market most needs. Then the second-order effect turns one death into a regime. Every survivor watches the execution and re-prices its own odds; taking the other side of flow-supported overvaluation now carries a visible path to the absorbing barrier before vindication can arrive. So they stop. The pool of correction doesn’t shrink because sharper rivals competed it away. It shrinks because it is being destroyed one trajectory at a time, and each destruction lowers the expected payoff to trying for everyone still seated.

So the poker table has the diagnosis backwards. The market isn’t efficient; noise is everywhere. It’s uncorrected, because the mechanism that used to correct it has been redeemed, chained, and, when it shows up anyway, destroyed.

Why the resistance?

A fair question hangs over all of this: why would someone who described the mechanism accurately in 2020 spend six years resisting its conclusion? The cheap answer—he just can’t face being wrong—is the accusation every crank levels at every critic. It is unfalsifiable, it flatters me, and it is usually false. There are three better explanations, and unlike the cheap one, they don’t require me to read anyone’s mind. They compound.

The first is the sunk cost of a story you authored. Wigglesworth is not a neutral bystander to the index revolution; he is its foremost chronicler. His book Trillions is the definitive popular history of how indexing remade finance, and a sympathetic one. To concede that passive has crossed the line from useful tool to price-distorting force is not to lose an argument. It is to append an unwelcome final chapter to your own book. People defend the thesis they’ve built their name on (I am guilty as charged). This is human, not venal. The intellectual and policy architecture around passive investing was built to advertise its private benefits: low fees, diversification, simplicity. Evidence of market-level costs therefore arrives carrying a far heavier burden of proof than evidence of investor-level benefits ever did. The reluctance isn’t only personal; it’s built into which claims the system is primed to accept.

The second is that the strawman is the load-bearing move, deliberate or not. You cannot grant the mechanism and dismiss the argument in the same breath unless you first make the argument bigger than it is. “Flow-induced demand structurally penalizes active tilts” is too specific, and now too well-identified, to wave away. So it gets enlarged. The 2020 headline did the work in five words—a theory of almost everything—recasting a bounded, testable mechanism as a grand monocausal explanation for all market phenomena. And a monocausal theory of everything is exactly what a sober empiricist should distrust. From there it can be waved off as a force wrecking the natural order of markets, a claim I never made. The Mockery Machine at work. I didn’t argue that passive explains everything. I argued for a specific mechanism with bounded, separately testable consequences:

This mockery is where these debates are lost, every time, because the dismissal only ever lands on the absurdism. The real claim never gets touched.

The third is the progressivist misreading of evolution. This is the deepest reason, and it is barely about Wigglesworth at all. It is a mistake almost everyone makes, which is what makes it so effective. The poker table isn’t just wrong on the facts. It runs the logic of natural selection backwards.

The parable assumes that when the weak players bust out, the survivors are the strong ones, and therefore the population has improved. But selection never optimizes for strength in any absolute sense. It optimizes for fitness within a regime: reproduction in the current environment, and nothing more. Fitness is a relationship between an organism and its conditions, not a trophy the organism carries from one environment to the next. Change the conditions and the fitness function can invert. A trait that was adaptive under one predator becomes lethal under the next, and nothing about the organism got “better” or “worse.”

Now apply that to the game. The poker table assumes the survivors are better card players. Selection guarantees only that they are better adapted to the game as it is now dealt. When mechanical flows turned benchmark deviation into a negative-expectancy activity, the house began paying you to fold and taxing you to bet. In that regime, the survivors are not the sharpest analysts. They are the closet indexers, the benchmark-huggers, the managers who adapted by abandoning the very thing that used to define skill.

Survival has become anti-correlated with the trait the old regime rewarded. Wigglesworth looks at the survivors and infers rising skill; the correct inference is the falling relevance of skill. That is a population adapting to an environment that has switched off the reward for price discovery, not a population getting better.

This was Stephen Jay Gould’s fight in biology. Gould spent much of his career attacking this illusion, the idea that evolution is a ladder from simple to complex, culminating (naturally) in us. In Full House he pointed out that life began pinned against the simplest possible wall: you cannot get less complex than a bacterium. From there, random variation throws off a few more-complex offshoots, not because complexity is favored but because there is nowhere to drift but up from the boundary. The most common organism on Earth is still a bacterium; the mode never moved. What looks like a drive toward improvement is a random walk against a left-hand wall, and the sense of progress is an artifact of staring at the right tail and mistaking its edge for the direction of the whole. Henrik Bessembinder’s work on sources of return identifies the same mechanism.

“Markets got more efficient” is the identical illusion. You stare at the surviving active managers failing to beat the index, and you read progress into it: the market got smarter, the competition got tougher, the mispricings got harder to find. But the very same scorecard is produced by a regime that anesthetizes the market’s immune system rather than sharpening it. Efficiency by competition and efficiency by exhaustion look identical on the SPIVA scorecard, but they are opposites. One is a market whose informed traders are so good that mispricings vanish the moment they appear. The other is a market whose informed traders have been redeemed, benchmark-chained, and taxed out of deviating, so that nothing corrects the mispricing at all. The poker table can’t tell the two apart. The flow control can, which is why Unterberg’s Table 7, where the underperformance loads entirely onto flows and not onto skill, is critical.

None of this requires bad faith. The progressivist reading of evolution is the cultural default; it feels like rigor, which is what makes it dangerous. And the instinct to distrust a monocausal theory of everything is a good instinct, aimed here at a claim that was never monocausal. The error was never the skepticism, only where it was pointed: at a claim I never made.

Recognizing the shape of the resistance also matters because it isn’t unique to markets. It is the same reception Ole Peters’ ergodicity economics has met from orthodox expected-value theory: a correction that is technically hard to answer and institutionally expensive to accept, because absorbing it means conceding that a load-bearing assumption—ergodicity there, self-correcting efficiency here—was wrong the whole time. The resistance is rarely to the evidence. It is to the price of having built on the assumption the evidence removes. And whether or not one accepts Peters’ broader program, the distinction between ensemble averages and survivable individual trajectories is what the poker table suppresses.

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So I apologize for the delay in sending this out. I discussed the idea that “Man plans and God laughs” in my latest podcast with Tony Greer and Jared Dillian. And I noted that under our current trajectory, “Democracy, as we now know it, is not long for America.” It seems fitting to discuss that this weekend.

Two hundred and fifty years ago, a group of men in Philadelphia committed an act of drafting so remarkable that we have mostly stopped noticing it. They wrote down three things a government exists to protect. The first two are states of being: life, liberty. Conditions you occupy. Then the third term breaks form. It is not a state. It is not a possession. It is not even an outcome. It is a verb.

The pursuit of happiness.

Not happiness — the pursuit of it. The document deliberately declines to promise the destination and instead sanctifies the striving. To my knowledge, no other nation on Earth embeds such an action in its founding charter. Constitutions the world over promise conditions: security, equality, order, dignity. Some promise defensive actions — the French guaranteed “resistance to oppression,” an action aimed against a bad. Only one document guarantees a generative action, aimed towards a good, exercised by the individual person, with the state’s entire job described as protecting its exercise.

On the semiquincentennial, amid the fireworks and the arguments — and a commemoration our chief executive has labored to center on himself — it is worth stating plainly what is actually being celebrated. Not a man. The document’s entire purpose was to end the centering of nations on men. John Adams compressed the point into a single phrase four years later, writing it into the Massachusetts Constitution of 1780: “a government of laws, and not of men.” That is the birthday. Any celebration organized around a person, any person, is a celebration of the thing the Declaration was written against — and the surest sign of how much repair the anniversary demands is how naturally we have slipped back into humanity’s default arrangement: the fortunes of a people bound to the person of a ruler. Kings were the habit. Laws were the innovation. So let the fireworks honor the charter, not the officeholder. I want to make the case that the charter’s single grammatical choice — the verb — is the most important thing about America, and that we are quietly, measurably, letting it fail. This is not a eulogy. It is a repair order.

The Animal That Coordinates

Start with why the verb matters, which requires stating a belief my market writing sometimes obscures: humanity is amazing.

We are common animals. Nothing in our chemistry is exotic. What is exotic is what we do with it. Alone among species, we use technology and social coordination to raise outcomes — collectively, individually, and most importantly over time. The wolf that hunts in a pack raises the pack’s outcome this season, and next season starts from zero. The human that invents the plow, the vaccine, the limited-liability corporation, the index — raises outcomes for people not yet born, in places the inventor will never see.

"A society grows great when old men plant trees in whose shade they shall never sit."— Greek proverb

We are the animal that compounds: everything remarkable about us lives in the fourth dimension, where gains survive their gainer.

We should be honest about the baseline we are compounding away from. Hobbes had it right: for nearly the whole of our species’ run, life was nasty, brutish, and — the part we underweight — too short, short enough that most humans never saw their improvements bear fruit. What we call capitalism is the machine that harnesses the individual desire to escape that state and converts it into collective advancement — millions of private attempts at one better life, coordinated through voluntary exchange into a rising trajectory for all. And it is not a coincidence that the machine and the charter share a birth year. In 1776, Adam Smith published The Wealth of Nations and Jefferson wrote the pursuit into the Declaration — the same idea arriving twice in the same year. That the striving of ordinary individuals, protected rather than directed, is the engine of the general welfare. One document described the mechanism; the other guaranteed the right to participate in it.

Why the machine works took another two centuries to formalize, and the modern answers matter because they tell us exactly what breaks it.

Eric Beinhocker’s The Origin of Wealth identifies the engine as evolutionary: markets are not equilibrium calculators but discovery machines — differentiate, select, amplify — running millions of experiments in parallel, and wealth itself is nothing more than accumulated useful knowledge, fit order wrested from entropy.

The textbook version misses this, and Ole Peters shows us why. Traditional economics averages across the ensemble in a single period, computing what happens to a thousand hypothetical people at once — when what matters to any actual human is what happens to one person through time. Those two averages can diverge catastrophically whenever ruin is on the table. The pack average is fine; your individual path kills you.

Claude Shannon and Robert Metcalfe gave us the mathematics of the network itself, with its deeply democratic implication: the power of a communicating system is driven by the quantity of connected nodes, not the quality of any one of them. The genius matters less than the graph. Connect more ordinary people and the system’s capacity grows combinatorially; disconnect them, and no concentration of brilliance at the center compensates.

Hold those three results together, and the founding wager stops looking like sentiment and starts looking like engineering. If wealth is knowledge discovered through parallel experiments, you want the maximum number of experimenters. If outcomes are paths through time rather than snapshots of an ensemble, you must protect each traveler from ruin — and be precise about the word, because ruin is not failure. Failure is the system's need: it is how a discovery machine learns, and a healthy system maximizes “opportunities for failure” while making it survivable. Ruin is different in kind — not a lesson but the end of the student, no next attempt, no rebirth, no trying again. Protecting against ruin guarantees nothing about where any life lands and insures no one against failing. It guarantees an option: the standing right to try again. That is the entire moral content of the fresh start, and the distinction between insuring outcomes and preserving options is the one this essay turns on. And if network power scales with participating nodes, then enfranchisement is not moral decoration. It is the growth strategy. The pursuit of happiness, guaranteed to everyone, is what a civilization looks like when it bets correctly on its own mathematics.

This is not a new observation. Aristotle built his ethics on it: eudaimonia, the word we lazily translate as “happiness,” was never a state but an activity — the exercise of our distinctive capacities. The founders were not hedging when they wrote “pursuit”; they were recovering the original idea that flourishing is not arrival but the striving, tool-making motion itself.

And this idea kept resurfacing whenever someone looked hard at what makes human life go well.

It surfaced in John Dewey, the Vermont philosopher who shaped American schooling more than anyone. Democracy, Dewey argued, is not a form of government — voting and constitutions are the paperwork. It is a way of living together: ordinary people continuously applying their intelligence to shared problems; not a system you inherit but an activity you perform. A democracy whose citizens become spectators remains one on paper and stops being one in fact. Keep that spectator in mind; he haunts the second half of this essay.

The idea resurfaced again in Hannah Arendt, who fled Hitler and spent her life studying how free societies die and are born. Above everything humans do, she placed action: the capacity to begin something genuinely new, to interrupt the world’s momentum and start a chain of events nobody predicted. When she searched history for a revolution that had built a durable home for that capacity rather than devouring it — as the French Revolution devoured its own — she pointed at Philadelphia. She was not a sentimental writer. That was her considered verdict.

And it surfaced most recently in economics, through Amartya Sen — the Nobel laureate who, at nine, watched the Bengal famine of 1943 and saw the fact that shaped everything he built: three million people starved not because there was no food, but because they had lost the ability to command it. Sen rebuilt welfare economics around a deceptively simple inversion — don’t ask what people have; ask what they are actually free to do and to be — and called those real freedoms “capabilities.” Development of a person or a nation is simply their expansion.

Three very different lives — a Vermont schoolteacher’s son, a stateless refugee, a witness to famine — arriving from three different directions at one conviction: the human good is agency in motion, and the measure of a society is whether it protects the motion.

America is the only polity that wrote that conviction into its birth certificate. That is what I am celebrating this weekend. Not the outcome. The verb.

The Line We Have Mislabeled

A verb you cannot conjugate is not a right. It is a taunt:

“Are You An American?”

I have written at length about the American poverty line — a number calculated as three times a 1963 minimum food budget and frozen there while housing, healthcare, childcare, education, and every other cost of modern life rose rabidly around it. The institutions have begun to converge on the real figure; the household budget arithmetic lands near $140,000 for a family of four in much of the country. The number is not the point.

The point is that we have mislabeled the line itself. It is not a poverty line. It is a participation line — the level at which capability exists. Below it, a family is not merely uncomfortable. Below it, the pursuit is a legal fiction. You cannot pursue anything when every hour is consumed by triage, when the second income is annihilated by childcare, when a $1,000 shock is a phase change rather than an inconvenience. The Declaration guarantees you the right to run the race. The participation line marks whether you are wearing shoes. We have tens of millions of Americans holding an unencumbered legal right to a verb they lack the physical capacity to perform.

This is why the framing matters more than the figure. “Poverty” invites a debate about compassion — how much do the comfortable owe the struggling? “Participation” states a fact about the machine: an economy built on the compounding of human agency is running with a large fraction of its agents disconnected. That is not a charity problem. It is a capacity failure — the civic equivalent of a factory firing the surplus workers, selling off the capital equipment, paying the owners a one-time dividend, and celebrating record profit margins.

The Swerve

There is a second failure, quieter and crueler.

Every June, schooling stops, and for ten weeks a child’s trajectory becomes a direct function of purchased inputs. The data show affluent children holding or extending their gains while everyone else’s learning decays — a gap that compounds, summer after summer, into a large share of the achievement gap we later moralize about. The phenomenon’s gentle name — the summer slide — conceals what it measures: not talent, effort, or character (nothing about the children changes in June) but the price of staying on trajectory, and that price has been bid to extraordinary heights. The camps, tutors, and college-consulting apparatus that now reaches into middle school were, a generation ago, luxuries atop an adequate public baseline. Today they are the maintenance fee: the competition for a narrowing set of secure adult positions has become an arms race in which every affluent family’s defensive spending raises the requirement for everyone else. This is the Red Queen’s country — all the running you can do to keep in the same place, with the entry fee set by the families with the most to spend. A child whose parents cannot pay does nothing wrong and falls behind children who did nothing special. And the slide is not a swerve. It is scheduled, printed on the academic calendar: we watch the mechanism operate annually, know exactly whom it strikes, and have priced the protection beyond most families’ reach.

That is the scheduled failure. The unscheduled ones are worse. The random event that arrives off-calendar and takes the wheel. A layoff right before a mortgage renewal. A healthcare diagnosis in between job changes. A public transportation failure timed to the first week of a new job across town. In a system with redundancy, these are noise — absorbed, forgotten. In a system without it, they are ruin, and here is Peters’ point returning with its teeth bared: ruin does not average out. A family that hits zero does not get to rejoin the long-run expectation. The path is the point. The game that looks fair on average is lethal to anyone who cannot survive the sequence. Between the scheduled squeeze and the unscheduled swerve, the modern family is being tested twice — once by a competition whose stakes keep rising, and once by randomness no one absorbs on its behalf.

And the young have run this math on the double test — because nothing raises the stakes of both examinations at once like a child, who multiplies your exposure to the arms race in the same moment it consumes the redundancy that insured you against the swerve. The clearest evidence that the sequence has become unsurvivable is that Americans of childbearing age are declining, in historic numbers, to begin it: fertility has fallen to roughly 1.6 births per woman, far below replacement, and every survey says the gap between children wanted and children had is a story of money and risk, not desire. The decision is not a mystery — it is arithmetic. For most of history, a child was an asset: labor for the farm, security for old age, a stake in the future that paid its holder. We have quietly restructured the position. Today the costs — north of $300,000 before college, plus the childcare line that annihilates the second income, plus the career sequence risk borne overwhelmingly by mothers — are fully privatized onto the parents, while the returns — the future taxes, the future labor, the payroll contributions that will fund everyone’s retirement, including the childless — are fully socialized. We converted children from an asset held by families into a liability held by families that pays dividends to society.

The cost side is no accident; it is Baumol’s cost disease in terminal form. Baumol observed that some goods resist productivity growth entirely — a string quartet takes as many musicians and minutes as it did two centuries ago — so their relative price rises forever as everything else gets more efficient. A child is the ultimate case: sixteen to eighteen years of sustained human attention in 1776, twenty-plus years now, the one production process that cannot be automated, offshored, or scaled. The relative price of the future itself therefore rises with every productivity gain we make — unless a society deliberately offsets the disease, and ours lets it compound on the family’s side of the ledger while harvesting the output on the public’s side. Young Americans looked at that term sheet and are voting on it, not with ballots but with the most honest referendum a nation can receive. The critics will call this culture, a loss of some older seriousness about family, and they will have the causation backward. Culture is what adaptation to rules looks like from the outside, observed a generation late and mistaken for a cause. The desire for children has held firm while achievement has fallen — the signature of a constraint, not a conversion. Change the rules and hold them long enough, and people will build a culture around the adaptation; they always have. You do not lecture people into a bad trade. You fix the term sheet.

The nineteenth century understood this — and here is the part we have forgotten: America understood it first, and for people. The United States is not a country that failed to engineer survival regimes for its citizens; it invented the practice. The through-line of American history is enfranchisement — the deliberate, generation-by-generation extension of the capacity to participate. Rights extended outward from landowning white men toward, eventually, everyone. Land itself, handed to ordinary families through the Homestead Act of 1862 — 160 acres of downside protection, and something more than policy: an ideological bet, placed in the middle of a civil war, that giving ordinary individuals the raw tools for a fresh start would build a stronger nation than any scheme that concentrated the land in abler hands. The common school movement, compulsory in Massachusetts by 1852 and continental within two generations. Federal bankruptcy law, by 1898, enshrined a fresh start, so forgiving that European observers found it scandalous: the legal right to fail and re-enter the game. Limited liability for capital, yes — but deposit insurance for the family passbook in 1933, and the GI Bill in 1944, which sent a generation to college and into homeownership. Notice the grammar of each: the government hands you the tool and gets out of the way; the state equips the pursuit, and the pursuing remains entirely, sometimes brutally, yours. That is not a welfare tradition. That is the American operating system, and it is why the verb worked here when it worked nowhere else.

The Hinge

So why did we retreat? Fifty years of bipartisan dismantling does not happen without a reason, and the honest answer is that somewhere in the middle of the twentieth century, the grammar changed.

Social Security, in 1935, was the hinge. Half of it belongs to the old tradition — pooled insurance against outliving your savings, the swerve-absorption logic of deposit insurance applied to longevity. But it introduced a sentence no homestead deed had ever contained: we will do it for you. Not a tool and your own hands — a check, calculated by a formula you don’t control, from an administration you cannot see. The War on Poverty, from 1964, spoke the new grammar fluently: needs defined, categories assigned, eligibility surveilled, assistance delivered on the state’s terms and withdrawn on its schedule. However decent the intentions, the subject of the sentence had moved: the citizen was no longer the actor being equipped but the object being managed.

And people felt it. The backlash that began in the 1970s was not manufactured out of nothing; it ran on a genuine grievance that the critics of government had correctly diagnosed, and the defenders refused to admit. A state that does things for you is, inescapably, a state that does things to you — it must inspect your income, define your household, audit your compliance, and decide what you deserve. Jefferson saw the mechanism from the very beginning: “The natural progress of things,” he wrote to Edward Carrington in 1788, “is for liberty to yield, and government to gain ground.” Not a bargain struck, a drift endured — which is precisely what the managed citizen of 1975 was living. Dependency was real. Intrusion was real. The distance between the administered citizen and the pursuing citizen was real. On that much, the market critique was right.

Here is the deepest irony of what followed: the demolition’s intellectual champions were — of all people — the century’s great philosophers of action. Ludwig von Mises titled his magnum opus Human Action. Hayek’s entire case for markets was that knowledge is dispersed among ordinary people and can only be discovered through their acting — Beinhocker’s parallel-experiments engine, stated forty years early. The Austrians understood the discovery machine better than anyone else. But they reasoned about it from above, as an ensemble, where creative destruction is pure hygiene: the failed firm releases its resources, the system learns, the average improves. They never followed Peters down into the individual path, where destruction without a fresh start is not hygiene but ruin — and ruin removes an experimenter from the experiment, permanently, shrinking the very machine they worshipped. They defended the verb’s liberty and dismantled its capacity, never noticing these were different things. The philosophy of human action, applied without ergodicity, spent fifty years ripping out the machinery that kept humans able to act.

Its prescription was the catastrophe precisely because its diagnosis was correct: the demolition crew that arrived in the name of freedom did not distinguish between the two grammars. It tore out the equipping machinery — the tools-in-your-hands tradition — while the managing machinery survived and metastasized. Walk the sequence: the 401(k), born of a 1978 tax-code footnote, replaced the pension and handed longevity and sequence risk to individuals. Federal student loans lost bankruptcy protection in stages — restricted in 1976, further in 1990, made non-dischargeable regardless of age in 1998 — and in 2005 the Bankruptcy Abuse Prevention and Consumer Protection Act extended the trap to private loans while tightening the fresh start for everyone, repealing a century of the 1898 principle in a single statute. Public university funding was cut state by state until tuition became feedstock for the private-debt machine. Employer health coverage hollowed into high-deductible exposure. And what remained was the apparatus itself: the Valley of Death between $40,000 and $120,000, where uncoordinated benefit clawbacks stack into effective marginal tax rates above 100% — not a safety net but an administrative machine that monitors your life, punishes your climb, and possesses no functioning mechanism that arrests your decline. It restrains motion in all directions except the one that matters. We kept the intrusion and discarded the equipment. We now live in the worst quadrant available: a state that does less for your capacity and more to your privacy than the one the revolt was aimed at.

Which is what functional education and functional healthcare actually are: not benefits, not compassion, but shock absorbers — the redundancy that reduces the randomness from human trajectories the way limited liability removed it from capital. A school that educates every child through the summer is volatility suppression. Coverage that makes a diagnosis a medical event rather than a financial one is ruin insurance for the nation’s productive base. Strip out the moral vocabulary, and the case stands on engineering grounds alone: you cannot run a system on the compounding of human agency while leaving that agency exposed to shocks capital would never accept for itself.

The Closed Frontier

There is one more thing the old operating system contained that nothing modern replaces, and it may be the most important: an exit.

For most of American history, the ultimate swerve-absorber was land. Whatever happened to you — failure, disgrace, debt — there was somewhere to go and start again. “Go West, young man” was not a slogan; it was the standing offer that made every local defeat non-final. Then the 1890 census declared the frontier closed, and Frederick Jackson Turner asked, three years later in Chicago, what a nation defined by the open door would become once it shut. The answer, for a while, was that we engineered synthetic frontiers: the fresh start translated the escape from space into time, letting you exit a failed past instead of a failed place; the GI Bill and cheap public college let you exit a class; the pension let you exit the labor market with dignity. Exit by land became exit by law. The offer held.

Those are the exits we have spent fifty years bricking over. And the demand for exit does not disappear when the supply is withdrawn. A person who can neither climb — the apparatus punishes that — nor be caught falling — no mechanism arrests it — nor leave for somewhere the game restarts, will still exit. He will simply exit inward. The fentanyl deaths, the ten-hour gaming days, the algorithmic feed, the whole economy of bread and circuses — stop calling these moral failures or public-health puzzles. They are escapism as the residual claim: the rational purchase of fake worlds by people to whom the real one has closed every door marked exit. The deaths of despair are not a mystery. They are the market clearing.

So the choice before us is not between big government and small government, and it never was. It is between a nation that manufactures escapism and a nation that enables pursuit — between supplying imitation exits into worlds that are not there, and reopening real ones into the world that is. We have been the second kind of nation before. It is the only kind the founding sentence permits.

Which kind are we now? Biology offers a diagnostic. A songbird rarely reuses its nest. To our eyes it looks like a waste of capital — abandoning good architecture to build from scratch every spring — but the bird is running a survival calculus: over a single season, a nest accumulates a fatal parasite load, pests multiplying in the enclosed space, the structure decaying under winter rain. Return to the same twigs and the new hatchlings are overwhelmed by the accumulated debris of the past. The rational move is to walk away — and history is littered with the ruins of communities that could not or would not: the Ancestral Puebloans who stripped their mesas until the great drought of the late thirteenth century found a system with no reserves left; the industrial cities choking on their own waste until cholera forced them to engineer sanitation. The debris of a system overwhelms its inhabitants, and the survivors either leave or learn to clean.

We have done the same to the American operating system. Only our parasite load is administrative, and our exhausted soil is the broad middle class. We took the equipping machinery of the nineteenth century and layered it with a managing machinery that acts like a civic mite: the means tests, the eligibility audits, the phase-outs, the uncoordinated clawbacks — the accumulated debris of a system that has forgotten its purpose. None is individually fatal; that is how parasite loads work. Each is small, defensible, well-intentioned, and together they are the friction that drains the energy out of the pursuit — structures, like so much of what I find in the mechanics of the modern stock market and its greatest story ever sold about wealth creation, that extract more energy than they produce.

We are living in a used nest: a structure that punishes upward mobility, offers no ruin insurance against the swerve, and decays a little further each season. And here the analogy turns on us — unlike the bird, unlike the Puebloans who could walk away from the canyon, we have just established that our frontier is closed. There is no fresh territory in which to rebuild. If we cannot abandon the nest, we are left with exactly one choice: clean it. Strip out the intrusive, managing apparatus that surveils the climb, and restore the universal, unconditional infrastructure that equips it.

The Next Homestead

But cleaning is only the domestic half of the work order, because something has changed since the frontier closed — for the first time since 1890, a genuinely new one is opening. It is not made of land.

Recall what Beinhocker told us wealth is: accumulated useful knowledge — and notice the property that made the compounding possible. Knowledge is the original non-rivalrous good: your use of the plow’s design does not deplete mine; the vaccine formula, the double-entry ledger, the theorem can each be copied to every human on Earth without diminishing. That is why a species of common animals could compound at all — and every equipping instrument in the American tradition was, at bottom, a knowledge-distribution scheme: the common school most literally, the Homestead Act too, which distributed not just acreage but the standing to learn by working it. The frontier was never really the land. It was the unclaimed space in which ordinary people could discover things.

Artificial intelligence is the industrialization of that discovery — knowledge-generation itself, converted into a tool. We are about to re-run this essay’s oldest question at the highest stakes it has ever carried. The frontier can be homesteaded, or it can be enclosed. If the generative power of AI ends up controlled by a handful of walled gardens renting out cognition by the token, we will have put a tollbooth on the discovery machine — and Shannon’s mathematics tells us exactly how that ends. All the brilliance concentrates at the center, the ordinary nodes disconnect, and the network’s compounding power collapses no matter how dazzling the center becomes. The genius matters less than the graph, and an enclosed AI is the deliberate shrinking of the graph.

And there is a tell for whether the enclosure is happening: listen for the offer of Universal Basic Income, and notice who is making it. The loudest advocacy comes from the technology industry’s own leadership, and you do not need a conspiracy to explain that — only a filter. The venture logic that built this era has a founding text whose thesis is in its title — Zero to One: competition is for losers, build the moat, own the category. For twenty years that logic has decided who gets funded, and therefore who gets to build, selecting for founders to whom ceding a frontier is not a rejected option but an unimaginable one. Ask them what to do about the workers their enclosure displaces, and they will propose, with complete sincerity, the only answer their formation permits: keep the machine, compensate the disconnected. The alternative — universal distribution of the tools — is unimaginable to them, because anyone who could imagine it would never have survived the funding gauntlet that made them. The floor equips your pursuit; UBI, as offered in the AI context, replaces it. It is the managing grammar arriving at its terminal form — “we will do it for you” completed as we will think for you, and pay you a stipend to stop doing. UBI is the anesthesia, not the solution: a sedative for disconnected nodes so the disconnection proceeds quietly, a subsidy for your obsolescence priced at whatever keeps you from asking where the compounding went. The check does not restore the verb. It purchases its surrender, in perpetuity, at the lowest clearing price.

The solution is the one the tradition has always prescribed: force the tools outward. Ensure — through relentless competition, open weights, antitrust vigilance wherever the gardens wall themselves, whatever combination proves necessary — that the benefits of AI are universally distributed at negligible cost. Do that, and the technology inverts from threat to homestead: the most powerful cognitive instrument in human history in every hand, a co-pilot that expands each ordinary person’s capacity to discover, build, and pursue — one hundred and sixty acres of cognition, deeded to everyone. The nineteenth century distributed land. The twentieth distributed education. The twenty-first will either distribute intelligence or rent it, and everything this essay has argued says the choice between those two words is the whole game.

What the Anniversary Asks

So here is where the 250th finds us. We possess the only founding document on Earth that protects a verb — and we have allowed the conditions for conjugating it to erode into precisely what the founders revolted against: a system where the accident of your position determines your trajectory, and striving cannot overcome the arithmetic. Understand the mood of this correctly: I am not down on humanity. I am down on the specific machines we have built that idle it.

And the cleaning is not mysterious — the hinge teaches us which debris to strip and which timbers to keep. Restore the equipping grammar, not the managing one. Draw a real participation line and fund the floor beneath it as infrastructure — universal, unconditional, no caseworker required — because a benefit that arrives without an audit is the only kind that does not convert the citizen into a case file. And be exact about the floor, because “universal” will make some readers reach for their priors: this is not a subsidy for inaction, and the founding grammar explains why not. The Homestead Act did not pay you to admire the prairie; it demanded five years of labor before the deed was yours. The GI Bill funded tuition you had to convert into a degree. The fresh start preserved your right to the next attempt, not a presidential pardon offering immunity from the last. Every equipping instrument removes the obstacles to action while leaving the acting — all of it — to you. The distinction that matters is not generous versus stingy but equipping action versus subsidizing inaction — and, at its best, the American tradition has always known the difference.

Harmonize the phase-outs that punish the climb, which shrinks the intrusive apparatus rather than expanding it. Build schools that hold children through the summer and healthcare that absorbs the swerve — tools in hands, pursuit left to the pursuer. None of this is new. It requires only that we describe the project correctly: not charity, not redistribution, but restoration. Every prior American generation extended the machinery of participation further than it found it; ours is the first to run the system in reverse, and the next 250 years begin with a choice of direction — resume the extension, or keep calling the demolition a market. The compounding only works when the agents are connected. Our predecessors wrote that into land grants and bankruptcy codes and school levies. We are not being asked to invent anything. We are being asked to remember.

I wrote about the Greek myth of a jar that, once opened, loosed every misery into the world — and held one thing back. The word for what remained, Elpis, can mean hope or it can mean foreknowledge. The Europeans, in their way, chose foreknowledge: security purchased by surrendering the upside, a known outcome in exchange for the end of the wager. America chose the other reading. We kept the jar open. We bet the entire national project on uncertainty — on the conviction that a common animal, given tools, given each other, and given the protected right to strive, will make something better than any guaranteed outcome could have promised.

Two hundred and fifty years in, that bet is not settled. It was never supposed to be. A verb has no final tense while the speaker still draws breath, and a nation founded on a verb has no End Game — only the question, renewed each generation, of whether we will maintain the conditions under which the striving remains real.

Happy Belated Fourth. Now go forth and conjugate.

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First, there is a growing awareness that AI economics simply don’t work as discussed in xAirSupply. This is predictably causing two separate actions:

1. Users are increasingly shifting to lower-cost Chinese models — with the national security implications underpriced but difficult to underwrite.

2. US AI companies are retreating behind protectionist and anti-competitive measures, hoping to extract premium pricing for leading-edge models while shifting more casual users to lower-cost alternatives.

The past week has seen articles proliferating, citing the growing usage of “near-frontier” Chinese models by users recognizing that for the vast majority of tasks, “pretty smart” is good enough:

There are two sources of China’s cost advantage. First, “fast followers” have always benefited from rapidly changing technology, as the performance advantage of first movers comes at an extraordinary cost, while fast followers can benefit from the diffusion of technology and techniques. Many of the Chinese breakthroughs involve using LESS hardware to accomplish the same task. While US proprietary labs doubled down on capital-intensive scaling bets—collectively raising tens of billions in a high-valuation arms race dependent on high API margins—Chinese competitors quietly weaponized open-source efficiency.

The narrative that Chinese models are simply inferior copies completely collapsed. By optimizing training stability rather than relying on brute-force compute infrastructure, labs like DeepSeek and tech giants like Xiaomi have triggered a permanent, deflationary price war.

• The 99% Compression: DeepSeek’s R1 and Xiaomi’s MiMo-V2.5 are undercutting major Western API providers by 90% to 99%. For example, processing cached input tokens has dropped to fractions of a cent per million, effectively resetting the cost floor for enterprise automation.

• The Agentic Loop Vulnerability: This pricing divergence matters because high-volume enterprise workloads and multi-step agentic workflows are incredibly token-hungry. When a complex workflow requires an agent to repeatedly query, plan, and call tools, premium US tier pricing becomes a prohibitive tax. Moving to high-performing Chinese alternatives isn’t just an optimization; for many startups and enterprises, it’s a structural runway extension.

• The Funding Paradox: This creates a dangerous trap for Western foundational model providers. Their stratospheric private valuations assume massive premium enterprise margins to justify their infrastructure capex. If the market commoditizes into an open-source “free or near-free” paradigm driven by Chinese state-subsidized or hyper-efficient stacks, the economics of proprietary scaling break completely.

This is exactly the China playbook for solar, batteries, and increasingly autos. Nuclear power plants are not far behind. This leads to the second factor: China’s propensity to overbuild means its electricity generation per capita is surging. Sometime in the next few years, it should cross the US level per capita:

Assuming this plays out, it points to a new business model for China as exports of manufactured goods hits limits; perhaps we are about to see the rise of the “Token-state,” a play on Petro States, where China exports surplus energy in the form of AI work. If China’s electricity generation per capita continues its current trajectory, it may eventually converge with or exceed U.S. levels. At that point, China’s export model can evolve from shipping embodied energy as solar panels, batteries, steel, autos, and chemicals to shipping embodied intelligence as tokens.

The irony is not lost on me that we’re just now digesting the China manufacturing shock; wouldn’t it be a shame if AI went the same way?

We can’t let that happen, which leads us to protectionism. I’m sure you’ve seen the headlines. Both OpenAI and Anthropic have radically increased their lobbying spend:

Predictably, this is resulting in government intervention. In Illinois, OpenAI is lobbying for the passage of SB3444, the Artificial Intelligence Safety Act, which indemnifies “frontier” AI firms from critical harms caused by their models, provided they either (1) agree to regulation by the EU or (2) enters into an agreement with the Federal government:

Creates the Artificial Intelligence Safety Act. Provides that a developer of a frontier artificial intelligence model shall not be held liable for critical harms caused by the frontier model if the developer did not intentionally or recklessly cause the critical harms and the developer publishes a safety and security protocol and transparency report on its website. Provides that a developer shall be deemed to have complied with these requirements if the developer: (1) agrees to be bound by safety and security requirements adopted by the European Union; or (2) enters into an agreement with an agency of the federal government that satisfies specified requirements. Sets forth requirements for safety and security protocols and transparency reports. Provides that the Act shall no longer apply if the federal government enacts a law or adopts regulations that establish overlapping requirements for developers of frontier models.

And surprise, surprise, Anthropic and OpenAI have entered into an agreement with an agency of the federal government:

The striking feature of SB3444 is not that OpenAI and Anthropic suddenly entered into federal agreements after the bill was introduced. They had already done so. The striking feature is that the bill appears to convert that preexisting federal-safety relationship into a potential safe-harbor architecture. Now, of course, both companies claim to be dragged into these deals kicking and screaming:

Brer Rabbit pleaded, “Do what you want, but please don’t throw me into the Briar Patch!”

Which brings us to the bigger think piece:

The Combination That Isn’t Supposed to Exist

The great profit-share surge isn’t a story about technology, Volcker didn’t slay inflation, and the demographers have been reading the wrong variable the whole time

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“So even inside of official statistics I would be open-minded if the task force and our own best thinking had recommendations how those official statistics can be brought up to a standard of our time, using new analytic methods. I’d also say this: Almost every private company CEO that’s running his or her business is doing so with real-time information that isn’t subject to much revision that is telling them what just happened at that very moment. As you know, there are normal long and variable lags in the conduct of monetary policy. What we’re really interested in is what’s happening right now. What we’re less interested in is echoes of history. And you’re hearing from my answer that some of the data that we receive, that we’re waiting for on the first Friday after the month, the payroll index or something else, that might be an echo of history that’s quite useful on its THIRD revision. We need to take those error bounds down because we have to make hard decisions in real time.”

She notes:

“Did he say “THIRD” revision? Was Warsh speaking about the Quarterly Census of Employment and Wages, the QCEW last week’s Quill was devoted to in full?… For all his certitude, Warsh may not appreciate that he acknowledged he’s likely walking into a repeat of the 1980 episode (MWG note: double dip recession) with the critical caveat that he’s not battling Volcker’s inflation. The U.S. economy suffered – past tense – a recession in 2025’s first three quarters. As for what followed, for the record, the QCEW indicated an upward revision to the fourth quarter of 2025, which preceded a spike in announced mass layoffs in January of this year.”

Regular readers of YIGAF are well aware of my disagreements with the BLS-reported data and the Birth/Death methodology. More on that below. And while I share Warsh’s frustration with revised data, I’d argue he has a snowball’s chance in hell of getting the BLS to play ball. From my perspective, Warsh is just signaling that forward guidance is not the only thing ending. “Data dependent” is likely giving way to “Trump dependent.” And there’s no better man for the job. /s

A more favorable take was offered by Barry Knapp at Ironsides Macro in his piece, “Uncle Milty is Smiling”:

“We strongly support Chairman Warsh’s five task forces objectives, like Chairman Warsh our criticism of what Treasury Secretary Bessent calls ‘gain of function’ monetary policy began with the launch of QE2 in November 2010. Non-crisis long duration asset purchases (QE) and the abundant reserves regime were an overreaction to the deleveraging impaired growth following the financial crisis. The second order effects on the capital allocation process of the Fed’s expanded footprint are vastly underappreciated, particularly by the FOMC participants focused on volatility of repo rates. The wealth of the nation depends on returning the setting of the cost of capital to market participants, reducing the influence of FOMC participants.”

Now Barry is a friend; and friends don’t let friends drive drunk. So I’ll simply note that while I agree with the objective of “reducing the influence of FOMC participants,” it’s worth emphasizing that market participants have NEVER set the cost of capital.

Barry wants to cut the Fed's footprint so capital allocation returns to the market. Unfortunately, there's no market underneath to return to. Markets are the sum of policy choices: the QDIA default that pushes savings into equities at any price (and leads to many believing policy is still loose), the post-GFC capital rules that decide which borrowers banks fund, sanctions on Russia, and, of course, QE. Remove QE and you don't reveal a market price; you just let the other choices, including the failure to prosecute antitrust violations, dominate. “Reduce the FOMC's influence and return the cost of capital to market participants” means, in plain terms, “let the bank-capital regime and the retirement-default rules set it instead.” That is not a market. It is a reassignment of which administrators are in charge, and Barry and Warsh do not appear to understand that the world does not work as Austrians would like to believe it does.

We do not have the choice to, as Grover Norquist once put it, “reduce the size of the government to the point that I can drown it in the bathtub.” Government is a perpetual state of any social species. It exists in households (“Mom wears the pants in the family”), it exists in firms (“Read the product objectives and get back to work,” as Lee Iaccoca allegedly told Pinto engineers), and it exists in every community of every size. You cannot be a nation of laws without the men (or machines [ominous background sounds]) to interpret and to enforce them. A decision to pare back one branch of government simply elevates the remaining branches. The choice is good governance or bad governance.

We now have the latter, but I cannot claim to understand it particularly well either. As my great friend, Harley Bassman, texted me this week:

“You need to stick with entertaining speeches about Passive… your Rate and War predictions are killing me!”

So…

Iran, I Saw, I Wrong

Or perhaps, “US ran”

The skeptics were right — “TACO” indeed. With higher inflation prints and gasoline prices now far above his “$2.30 a gallon in most states, and in some places, $1.99 a gallon" from the State of the Union, the decision was apparently made to “end the war with a victory.” The world jeered and Israel joined in. Admonishment followed:

Is Trump giving up too much? Absolutely. This is insane and cruel. The ultimate “negotiating with terrorists.” But make no mistake, they are doing it for ewe. Trump knew that resolving the US-Iran War was a requirement for surviving the midterms. So… “Victory!” After all, the people have short attention spans. You want to know why Neville Chamberlain “appeased” Hitler? Because 21% of the registered voters in the 1935 election that elevated Chamberlain were war veterans. Would have been 24% except 6% of adult male population, roughly 1/8th of those serving, never came home. Those who did come home didn’t want their children facing a similar fate.

We surrendered to Iran over 4% inflation. Millions of Iranians will likely die in the regime retribution. But they don’t vote in U.S. elections.

I want to be perfectly clear on this point. I supported the US attack on Iran. I did that with full knowledge that young men and women I know personally would be placed into harm’s way. I was well aware that gasoline prices would be higher and that the middle of our socioeconomic distribution would suffer disproportionately, both economically and emotionally, as they are the ones struggling to pay bills AND they are the ones whose children serve as enlisted in the US military. The middle 60% contributes over 70% of the fighting force.

The response of the Iranian regime — attacking neighbors, civilian infrastructure, and closing an international waterway should have been anticipated. Apparently, it was not. Radigan Carter’s conviction that the Iranians would “never surrender” was never even tested. Ground troops, which I expected to be deployed in limited numbers, were never deployed. Munitions were depleted, but reserves remain (somewhat adequate). What failed was not the capability of the military or the American people, but our leadership’s belief in our ability to be treated like adults.

And yes, this was a bit of black pill moment for me. Because we didn’t save American lives with this negotiation; we simply exposed the weakness of a nation that has record exposure to financial markets — both literally and through our potentate’s fixation on them.

“To allow the market mechanism to be the sole director of the fate of human beings and their natural environment... would result in the demolition of society.” — Karl Polanyi

I would suggest the most likely outcome is an escalation of the threat that China will move on Taiwan, and that the US will have fewer allies when it does. We’ve given a green light to Eco-terrorists (economic terrorists). And the world will again head into the flames. There is no peace from surrender.

And On Those Rates

My call for a reversal towards rate cuts, so far, has also been wrong, but less costly. The levered 2-year is down roughly 2.5% from March with the S&P500 up 15%. Long bonds are up roughly 2.5%. So wounded, but not a fatality. But interestingly, the equal weight S&P is up only 3.3%; the equal weight Russell 2000 only 2.8%.

The “passive factor” of 401K flows appears to have added about 2.5% as well, maintaining its annual pace of roughly 18% a year.

Meanwhile, headline inflation has soared with oil prices, but sticky inflation ex-shelter has remained largely quiescent:

Yes, it remains above post-GFC levels at 2.9% per year, but unlike the immediate aftermath of Covid, it is not rising. And the surge in gasoline prices, now partially driven by seasonal changeover, appears to have peaked well below 2022 levels:

So I’m not buying this inflationary turn. And yes, I excluded housing for a reason.

Housing: frozen supply, not healthy demand

The housing market has been delivering pretty good news. Prices are stable, mortgage purchase applications are higher, as are existing home sales. Sure, it might be off a low base, but it’s positive, right?

The issue is that the housing narrative is on borrowed time. Let me explain.

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That’s probably part of the truth. But it leaves out a second force, one that has nothing to do with whether the companies are any good. It’s the mechanical passive bid that’s wired by policy into the way most people now invest. And the strongest part of the case — the part most people miss — is that we can actually *test* the obvious explanations against it. Twice, the world changed the conditions for us. Both times, the “they earned it” story predicted one thing, and the opposite happened.

Let me build it from the ground up.

The Passive Bid

Roughly half of all the money in U.S. stocks is now “passive.” It isn’t run by a person picking winners. It’s run by a rule, and the most common rule is: “Own every company in the index, in proportion to how big it already is.”

So if one giant is 7% of the market and some smaller firm is 0.01%, then every dollar flowing into an index fund buys 7 cents of the giant and a hundredth of a penny of the small one. Nobody chooses this stock by stock, it’s rules-based. Occasionally, like last week, the rules are changed. But most of the time, the rule chooses. The biggest companies automatically collect the biggest share of every incoming dollar. When that buying pushes a big stock up, the company becomes an even *larger* slice of the index — so the *next* dollar buys even more of it, which pushes it up again.

It’s a loop: price up → bigger share of the index → more of the next dollar flows in → price up. The rule rewards bigness with more buying, and the buying creates more bigness. No one is steering. It’s a machine following instructions — and when half the market is wired to that machine, it becomes one of the largest buyers in the room, every single day.

The free test that separates “great companies” from “the machine”

“Big won” compares big companies to small companies. Of course, the big ones did better — they’re big. That tells you nothing about “why.” So do something smarter. Take the same group of giant companies and build two versions of a portfolio from them. In the first, you put more money in the bigger ones — that’s the index rule. In the second, you split your money evenly across all of them. The exact same companies. The only difference is how you weight them.

If these are simply wonderful businesses that earned their gains, both versions should do about equally well — after all, they hold the identical stocks. But that’s not what happens. The version that weights by size has steadily pulled ahead of the version that weights everyone equally over the last 15 years. That gap means the very biggest are outrunning the “merely-big” — not because they’re better businesses than their neighbors, but specifically because of the act of weighting by size.

The size-weighting itself is producing the return. The circularity is the point.

Two more clues confirm it. The effect is strongest in the very largest stocks, weaker in the mid-sized, and basically absent in the smaller ones (excluding microcaps). That’s the exact shape you’d expect if mechanical index buying were the cause, since that buying piles onto the biggest names and barely touches the rest. And the timing lines up: for most of market history, this gap was roughly zero; it exploded right as passive investing took over.

Two obvious objections — and how the world tested them for us

You can’t run a controlled experiment on the entire stock market. But the next best thing happened twice. The two natural “fundamental” explanations each make a clear prediction, and reality ran both tests.

Objection 1: “It’s just low interest rates.”

When interest rates are near zero, money you’ll receive far in the future is worth a lot today — which makes “growth” stocks, whose biggest payoffs are years away, look more valuable. So the story goes: rates were near zero, which inflated the tech giants, end of story.

It’s a testable prediction: if low rates were the cause, then high rates should deflate these stocks — and the tech giants most of all.

Rates rose to their highest level in about twenty years and stayed there through 2023 and 2025. If the low-rate story were right, the giants should have sagged. Instead, those were the strongest years of the whole effect — the size-weighting gap hit record highs precisely while rates were highest. The supposed cause went into full reverse, and the effect got stronger. It’s like insisting a room is hot because the heater’s on, then watching someone shut the heater off and crank the air conditioning — and the room gets hotter. At that point, you realize the heater wasn’t your answer.

Objection 2: “The giants just earned it — incredible cash flows.”

This one sounds airtight until you look at what these companies were actually doing with their money. Picture two lemonade stands earning the same profit. One pockets its profit. The other is forced, year after year, to spend most of its profit on new equipment just to keep up with rivals — and the equipment wears out fast. Which stand would you pay more to own? Obviously, the one who keeps more cash. The forced spender’s spending isn’t a jackpot; it’s just the cost of staying in the game.

That’s exactly the situation the giants walked into. To compete in artificial intelligence, they were forced to pour staggering sums into data centers and chips — equipment that goes obsolete in a few years, with payoffs nobody can yet measure. As a result, the cash actually left over for their owners (free cash flow) grew far more slowly than their reported profits did, because the building costs ate it up.

Standard valuation says spending more only makes a stock more valuable if that spending earns attractive returns. Forced, defensive, fast-aging spending is the opposite of a spectacular-return opportunity — so the textbook prediction is that investors should have paid less for each dollar of these companies’ profits, not more. The opposite happened. The “they earned it” story doesn’t merely fail to explain the re-rating; it predicts the opposite sign.

So both obvious explanations were handed clean tests by events, and both got the direction wrong. That’s a lot stronger than a hunch. The only fundamental escape left is pure faith — “the AI spending will pay off enormously someday” — which may be true, but is a bet on an unknowable future, and it still wouldn’t explain why the effect is neatly graded by company size. The mechanical story explains all of it without a single leap of faith.

Why it doesn’t just fade away

Normally, a price that’s been pushed too high drifts back toward fair value. So why doesn’t this?

Think of pushing someone on a swing. One push sends them up, then they coast back down — the push fades. Unless you keep pushing in rhythm. Then they stay high, not because any single push lasts, but because the next push arrives before the last one dies.

That’s what continuous index buying does to the giants. Each day’s buying gives them a push. That push would fade — but tomorrow’s buying re-energizes it. As long as money keeps flowing in, elevated prices are kept artificially high. This is why the effect doesn’t quietly correct itself. It isn’t waiting to fall — it’s being propped up, continuously, by a pump that runs every trading day.

Why nobody competes it away

Here’s the genuinely strange part, and it’s what makes this different from every market factor you’ve heard of.

Usually, when there’s an easy way to make money in markets, people notice, pile in, and ruin it for everyone — the opportunity gets competed away. A crowd rushing to a sale empties the shelves. That’s the normal rule.

This one runs backward. The “crowd” here isn’t clever traders chasing a profit. It’s index money on autopilot. It isn’t betting on these stocks; it’s following the rule, and it can’t choose to stop. So when more money joins the passive crowd, it doesn’t compete the effect away — it makes the effect stronger, because there’s now even more mechanical buying flowing to the biggest names.

It’s not a crowd at a sale. It’s a conveyor belt that speeds up the more you load onto it. That single property — gets stronger the more crowded it gets — is what lets this keep running when normal opportunities would have died.

What happened to momentum?

Quick heads-up: this part is a bit more technical than the rest. If it gets dense, skip to the last line — that’s the whole point.

For decades, one of the most dependable patterns in markets was called momentum: stocks that had been rising tended to keep rising, so you bought the recent winners and bet against the recent losers. It worked so reliably for so long that it became a standard strategy, with billions of dollars behind it. Then, over the last several years, it broke down — by the standards of its own long history, the strategy has had one of its worst stretches on record.

The obvious conclusion is that “winners keep winning” simply stopped being true. But it didn’t disappear. It moved.

The classic strategy is a comparison: rank every stock against all the others and bet on the relative winners. That’s an easy recipe to copy, so everyone piled in — and as we’ve already seen, anything a crowd chases gets competed away. Momentum became the textbook case: so many people ran the same playbook that they bid away the very edge they were chasing.

But there’s a second flavor of “winners keep winning” — not a stock beating its peers, but a single stock’s own move carrying forward: it rises one month, and that alone makes it a little more likely to rise the next, on its own steam. (The technical word is autocorrelation — a stock’s move echoing itself.) That flavor hasn’t faded. It’s gotten stronger — in exactly one place: the giant, flow-fed stocks at the top. Why there? Because that’s where the machine’s continuous buying lives, relentlessly pushing the same handful of names so their moves echo forward instead of dying out. And this version can’t be competed away, because betting against it means betting against the flow — and we’ve already seen how that fight ends.

So momentum didn’t die. The version traders could crowd into died; the version the machine powers quietly took its place. It’s the whole essay in one line: *the part you can compete away fades, and the part the machine drives wins.*

The correlation paradox

Here’s a fresh clue, and it’s one almost everyone reads backwards.

Lately, individual stocks have stopped moving together. The degree to which they rise and fall as a herd — what analysts call correlation — has, by some measures, dropped to lows not seen since before the 2008 financial crisis. Each stock seems to be marching to its own drummer.

The flattering read is that the market has gotten smart again: investors finally judging each company on its merits, a “stock picker’s market,” proof that careful analysis is back and the market is healthy. It’s almost exactly backwards — and unwinding why reveals a second machine sitting right next to the first.

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Mudville rejoiced:

It was much worse over in the land of “What’s Next,” led by our friend, fElon:

The AI bubble is not simply a valuation story. It is a financing story. The market has treated AI as a demand shock for a handful of capital-light monopolies. But AI is turning those same firms into capital-intensive infrastructure companies. The passive bid absorbed buybacks. It may now be asked to absorb issuance.

Perhaps this is the start of the turn in the localized mania of AI breaking. While much of the behavior remains “passive at work,” we’ve seen a growing role from the actual flows into AI stocks as retail increasingly decides it has “figured it out” — it’s all about AI:

I wish it were that simple. We’re increasingly seeing behaviors that suggest more sophisticated parties are now playing along — with leverage. For example, look at the behavior between NVDA and its 2x levered ETF variant. The shares outstanding for NVDU, the Direxion 2x levered NVDA ETF (one of a surging number of levered single-stock ETFs classified as “active”), have begun tracking inversely to NVDA share price, a notable change from 2023-2024:

Typically, when we see this pattern, it’s a sign that the volatility harvesters are in play. Buying NVDU while selling NVDA call options is a fairly efficient call overwriting strategy. The emergence of derivative-income ETFs (like NVDY or similar capped-upside, high-yield products) plays a massive role in changing the plumbing of single-stock levered ETFs:

• These yield-harvesting funds often use a mix of options and levered underlying instruments to generate high monthly distributions.

• Because they harvest premium by selling upside call options, they cap their gains on the way up but absorb downside beta. When the underlying stock rips through the strike prices, these funds are forced to dynamically manage their collateral and delta-hedging exposures—often resulting in trimming underlying levered long exposure (NVDU redemptions) during massive rallies to lock in premium or cover assignments.

• This suggests the characteristics of NVDA’s shareholder base are starting to shift. Rather than a performance-chasing retail play, it has matured into an institutional tool with many holders trapped by a highly-appreciated stock they are unwilling to take taxable profits on. When a single stock becomes a systemic macroeconomic proxy, professional desks use the 2x vehicle as a highly efficient, capital-insulated tool to trade mean reversion, harvest high variance, or hedge complex options books without tying up massive amounts of prime brokerage margin.

In other words, it’s no longer about love for NVDA — it’s just become another stock. That alone SHOULD be a warning sign.

But there were others this week:

I’m increasingly convinced that the AI universe has deeply misunderstood its product offering. While many, myself included, are loving the access to productivity-enhancing tools, AI has been embraced by users in an unprecedented manner:

There are a number of key points in the above graphic, but let’s focus on the “2:1 Personal use exceeds work use.” My growing conviction is that AI is being perceived by personal users as “Subsidized access to ‘help’ in answering the many questions that would have previously been unavailable to me in an economic manner, delivered in a non-judgemental and non-invasive manner.” Consider:

This appears unsurprising to me. The most popular columns in newspapers for decades were the “personal advice” columns. In internet parlance, “AITA” (Am I the asshole?) is a common theme. The market for professional-level advice seems unlimited at $0 to $20/month. There’s only one problem:

Those who lived through the original online retail bubble may remember this model. Yes, there is tremendous demand for Ben & Jerry’s ice cream delivered by Kosmo.com at subsidized prices below those of local retail stores. It is not a good business model. So AI companies have turned to marketing themselves to businesses as “labor replacement.” It’s not going so well:

Why? Because it’s a very deep misunderstanding of economics. AI companies are marketing AI as “labor replacement” and appear captured by the narrative that we can move to a “post-capitalist” society where all the “work” is done by machines. In economics, labor has a unique signature — a backward-bending labor supply curve:

This, in turn, plays a critical role in forming models for utility and innovation. Since humans exist in non-ergodic space, i.e., they have only one life to live, as incomes rise, the demand for leisure increases. This, in turn, spurs innovation in time-saving goods and services to replace previously labor-intensive tasks. In other words, technology exists to AUGMENT human labor. TASKS can be replaced by machines, but the core of economics remains the system of human wants, and humans cannot be replaced.

The AI industry has mistaken usage for a business model and task completion for labor replacement. What consumers have discovered is extraordinary: subsidized access to nonjudgmental, always-available help in answering questions, organizing choices, drafting language, interpreting conflict, and reducing the cognitive burden of daily life. It may be one of the largest reservoirs of latent demand ever revealed. But it is not the same thing as enterprise labor displacement. The former is advice-column economics at a planetary scale. The latter requires workflow integration, accountability, liability transfer, trust, and measurable P&L impact. The industry is trying to monetize the first by promising the second.

And subsidized access to help is not, by itself, a capitalist victory. It is a revelation of demand. The business demand for AI will emerge, but it will require business-process reinvention, not merely sprinkling models over existing workflows. The early enterprise buildout resembles the pre-factory stage of industrialization: semi-skilled human labor was gathered into larger rooms and organized more tightly, but the production process itself had not yet been fundamentally redesigned around the machine. Much of today’s enterprise AI effort is similar. It asks: “How can we do the same thing with fewer people, faster?” That is not nothing. But it is rarely transformational. The real value arrives only when the workflow is rebuilt around the new capability.

With the introduction of the assembly line, a factory was not simply a workshop with more workers inside it. It was a new production architecture: power, sequencing, specialization, supervision, inventory, distribution, and capital intensity reorganized around machines. Likewise, AI will not create durable enterprise value merely by letting existing employees draft emails faster or summarize meetings more cheaply. The value comes when firms redesign the unit of work itself.

I’m fortunate that my work puts me in contact with younger, thoughtful individuals who have enough domain-specific knowledge in their industry to start this process. They are having tremendous success. In my own work, AI tools have transformed my ability to rapidly build agent-based models to simulate the behavior of individual stocks in an index, enhancing my insights on passive investing more in the last nine months than in the prior nine years. But it could not have been done without the knowledge accumulated over those prior nine years (and the ~25 years of work in financial markets that preceded those).

As a result, I am convinced we are cresting the peak of inflated expectations and shifting to the trough of disillusionment:

The question is no longer whether AI is useful. It is. The question is who funds the enormous gap between subsidized consumer usefulness, slow enterprise reinvention, and the capital intensity required to build the infrastructure. Increasingly, the answer appears to be: “public equity investors.” And this is occurring just as the (Air) Supply is shifting. It’s no longer just about new IPOs:

Read more

And then I read the comments. While I typically avoid this exercise (“Don’t read the comments!” is sage advice from any public speaker), when I am introducing new concepts (e.g. “buy bonds, you fools” [not investment advice]), I do check them because it helps me understand what examples/analogies “work” and which do not, as well as where the audience is completely missing the point I am trying (often inelegantly) to make. Clearly, this new shtick needs some work:

And those were the kind ones. Some were a bit more personalized:

If anyone knows where my “paid off” check went, I’d appreciate the insight. I post these not because I want your sympathy, but rather to illustrate a different point. I learned long ago that presenting facts does not change perspectives except at the margin. Facts do not break identity. They threaten it. And when identity is threatened, the mind does not ask, “Is this true?” It asks, “What must I believe to remain myself?” A good example is the 2018 documentary, “Behind the Curve”:

From Wikipedia: The 2018 documentary Behind the Curve followed two groups of American Flat Earth believers who were attempting to gather first-hand empirical proof for that belief. One group from the YouTube show GlobeBusters used a ring laser gyroscope in an attempt to show that Earth was not rotating. Instead, they detected the actual 15-degree-per-hour rotation of Earth, a measurement they dismissed as corrupted by the device somehow picking up the rotation of the "firmament". Another group used lasers in an attempt to show a several-mile stretch of water is perfectly flat by measuring the distance between the water level and the laser beam along three vertical posts. They were unable to align the beam as they expected to because the surface of the still water was in fact bent by several feet over the distance measured; the experiment was dismissed as inconclusive.

What we are largely seeing in these comments is “identity politics.” The most popular tribe in the Western World is currently the “I do not trust the government” tribe. And it’s a useful exercise to ask yourself, “Do I object to the data because I can prove it’s wrong or do I object to the data because it challenges my world view/identity?” I am finding the “understated inflation” story to be the latter.

I want to be perfectly clear — I cannot PROVE that the government is not lying to you about inflation. I can DEMONSTRATE to you that private researchers tracking inflation find that government-reported inflation is overstated:

Read more

There’s lots of nonsense chatter that “we need higher rates”:

Readers of YIGAF should know by now that I will NEVER show a chart and say, “Maybe it should be the average of previous cycles.” Among other issues, define “previous cycles”? I would guess most of my readers have not thought to update this popular chart from a decade ago:

The evidence that rates are restrictive is painfully clear to anyone looking beyond the equity market into the real world of “financed products”:

We can run an analysis on the “neutral” mortgage rate that would get population adjusted sales of housing “back to normal.” Suffice it to say, it’s much lower:

And yet, nobody seems to care. I was at an institutional investment conference on Tuesday, speaking to some of the largest institutional allocators. I pointed out the surge in rates we’ve experienced and asked the room, “How many of you have increased your allocation to sovereign debt?”

Not one hand went up of roughly 500 in attendance.

The same day, a headline from Bloomberg caught my eye — finally, people are beginning to notice this is not a “US story” and recognizing that “something deeper is in play”:

Now the article itself is the typical nonsense — “equities seem impervious” while “bonds hit levels not seen since 2000” and “we have too much debt.” Readers of YIGAF know how I feel about this:

“Maybe I don't want to spend my life sittin' around and explaining shit to people.” — Good Will Hunting

And then the Stones remind me of the simple truth:

You can't always get what you want
But if you try sometime, you'll find
You get what you need

So I felt compelled to dash off a message to our Treasury Secretary.

Attached is my open letter to the US Treasury Secretary explaining exactly what is happening to the US Treasury market and exactly what I think we should do about it — the Sovereign Debt Optimization Facility (SDOF). I have no idea if we’ll do this, but I think it’s about as coherent a plan with as few downsides as humanly possible. I have no idea why we WOULDN’T do this.

For those who want the “Explain it Like I’m a Golden Retriever” version:

• The Problem: When interest rates were almost zero, the U.S. issued trillions in long-term bonds and mortgage bonds paying tiny interest (0–2.25%). Now rates are higher, those old bonds are worth only about 55–75 cents on the dollar. Big banks hold roughly $1 trillion of them and can’t sell these positions without triggering huge losses that would freeze their ability to lend money. As a result, capital is “frozen” in the banking system.

• Why It’s Dangerous: Giant “passive” bond index funds automatically make things worse. When bond prices fall, they buy less of the long bonds exactly when the market needs buyers — creating scary feedback loops that can spike rates and crash markets (like the U.K. in 2022, but much bigger).

• The SDOF: Keep an emergency “swap program” on the shelf. When a real crisis hits (and we’re very close now), the Treasury would allow banks to voluntarily exchange their old, low-price bonds for new Treasury bonds at today’s fair market price. No new cash is printed — it’s an even swap of value for value. See the duration-weight math below.

• How the Swap Works: A bank hands over $100 of old bond (now worth $65) and gets $65 of new bond. The bank’s balance sheet heals, and it can start lending again. The government pays a little more interest each year but owes $35 less principal later.

• Big Benefits: Could lower long-term rates and mortgage rates by 0.4%–0.9%, helping homebuyers and the whole economy. It breaks the dangerous loop without bailing anyone out.

So without further ado, let’s SDOF our caps as the midshipmen did under rainy skies this week:

May 21, 2026

An Open Letter to the Secretary of the Treasury:

A Contingent Playbook for the Sovereign Debt Architecture

Michael W. Green, Chief Strategist, Simplify Asset Management | www.yesigiveafig.com

I. Executive Summary: The Structural Fault Lines

Mr. Secretary,

The modern financial architecture is increasingly defined by structural inelasticities that impair monetary transmission and threaten orderly price discovery. Three intersecting phenomena drive this friction: (1) a multi-trillion-dollar overhang of legacy low-coupon sovereign debt — and crucially, Agency MBS and Agency multifamily MBS/CMBS — trading at severe market discounts; (2) an acute asset-liability lock within the regulated commercial banking system; and (3) a hollowing-out of active market liquidity and fundamental price discovery. These stresses are fundamentally intensified by a massive, underappreciated structural blind spot in contemporary capital markets: the unyielding rise of passive indexing within fixed-income portfolios. While standard academic literature has treated passive aggregation largely as a phenomenon isolated to equity markets, its scale and mechanical structure inside debt portfolios create severe, non-discretionary volatility loops that directly fracture the sovereign transmission mechanism and the “information” available to a sovereign debt issuer.

During the near-zero-rate and zero-rate environment of 2010–2021, the United States Treasury and other sovereigns issued an unprecedented volume of long-duration obligations carrying coupons between 0% and 2.25%. In the aftermath of the Covid re-opening inflation shock, central banks globally raised policy rates rapidly. As real yields adjusted upward, the market value of these off-the-run vintage bonds collapsed, with many trading between 55 and 75 cents on the dollar.

Aggregate commercial bank unrealized securities losses (across both Held-to-Maturity and Available-for-Sale portfolios) stood at $306.1 billion at the end of 2025[1]. However, as of mid-May 2026, the current bond market selloff has accelerated aggressively, pushing the 10-year yield to 4.61%–4.67% and the 30-year yield to a cycle peak of 5.14%–5.18%[2], driving these accounting impairments back toward critical thresholds and severely widening off-the-run liquidity fragmentation.

Empirical data reveals the concentration of this paralysis: the three largest HTM holders — Bank of America ($497B), JPMorgan Chase ($334B), and Wells Fargo ($237B) — account for approximately $1.07 trillion, representing roughly 88% of the expanded target universe (inclusive of Agency MBS/CMBS)[3]. Their portfolios are uniformly dominated by Agency MBS with blended book yields of 1.66%–2.22%, generating an aggregate unrealized HTM loss of nearly $146 billion for these three institutions alone.

Under prevailing accounting standards (ASC 320)[4], commercial banks holding these instruments within Held-to-Maturity portfolios cannot liquidate to reallocate capital without triggering a “tainting” violation. Such a violation forces reclassification of the entire HTM book to Available-for-Sale, with mark-to-market impairments flowing through Accumulated Other Comprehensive Income; for Category I and II institutions (including each of the three named banks above), that flow-through reaches Common Equity Tier 1 capital directly[5]. Trillions of dollars of risk-bearing capacity therefore remain structurally frozen.

This memorandum establishes a comprehensive, contingent policy framework to defuse these vulnerabilities and reinvigorate the potential for private credit creation while directly reducing the term premium that has emerged: the Sovereign Debt Optimization Facility (SDOF).

The SDOF is not a peacetime debt management tool, nor is it proposed for prophylactic deployment. Pre-emptive intervention under normalized market conditions carries severe and asymmetric signaling, term-premium, and moral-hazard costs that compromise expected value. Instead, the SDOF is engineered as a “next-level” emergency playbook built upon the routine liquidity-support and cash-management buyback operations institutionalized by the Department since May 2024[6]. While the existing program provides critical operational precedent — scaling up to an anticipated $38 billion in off-the-run liquidity-support purchases and up to $75 billion in short-term cash-management buybacks per quarter by early 2026[7] — the SDOF represents an order-of-magnitude systemic escalation. It is maintained in operational readiness, to be deployed only upon defined quantitative trigger conditions, to absorb acute long-end dislocations before they propagate into broader portfolio-mechanics cascades.

Within a total marketable Treasury debt landscape of approximately $30.7 trillion[8], the targeted tranche is highly material for systemic liquidity without being structurally dominant.

II. Trigger Conditions and Quantitative Dashboard

Because of asymmetric reserve-currency and term-premium reflexivity risks, the SDOF is held in reserve as a rule-governed, contingent instrument. Under normalized market conditions, its deployment would damage Treasury issuance credibility. Under acute systemic dislocation, however, the asymmetric payoff inverts, and non-deployment becomes the higher-variance choice. The current market stress appears to be rapidly approaching these red-threshold conditions; the final determination as to whether the threshold breach qualifies rests with the Department.

1. The Liquidation Loop Trigger Scenario

The trigger scenario is a self-reinforcing long-end sell-off in which falling bond prices drive systematic and rebalancing flows, destabilizing the system. As fixed-income assets suffer mark-to-market drawdowns, multi-asset systematic strategies (Target Date Funds, 60/40, risk-parity, etc.) are mechanically forced to liquidate equities to rebalance bond sleeves. Concurrently, leveraged liability-driven investment (LDI) pools, basis traders, and pension margin programs hit thresholds requiring liquidation of their most liquid assets — including off-the-run Treasuries and Agency MBS — into the same market weakness.

The rebalancing flows designed to stabilize the system become destabilizing. Liquidity provision breaks down, and equity-bond correlations converge toward unity. The September 2022 United Kingdom gilts episode is the canonical recent template, scaled to the United States Treasury market[9].

2. The Fixed-Income Index Duration Engine: An Academic Blind Spot

Contemporary market macrostructure literature remains heavily equity-centric, exploring how passive vehicles skew stock valuations while leaving fixed-income dynamics entirely unaddressed[10]. This omission is critical: passive bond indices do not operate like equity indices. Because market-capitalization-weighted fixed-income portfolios price their components continuously, passive flows are mechanically forced to buy more duration when yields are low (and prices are high) and less duration when yields spike (and prices collapse).

This dynamic operates as the exact pro-cyclical mirror image of traditional Asset-Liability Management. In a strict ALM framework, raising policy rates collapses the present value of future liabilities while expanding cash income from floating-rate assets; the institution’s net structural deficit shrinks and its required investment duration falls. Conversely, the passive bond index has no liability duration to match — it reduces its long-duration buying simply because long bonds have become cheap and their market-cap weight has fallen.

Crucially, the current May 2026 bond market selloff is actively weakening the passive bid for duration. To illustrate the raw mathematical reality of this structural distortion under current conditions, consider a simplified two-bond index composed of a 2-year and a 30-year maturity bucket (assuming an index aggregate consisting of 10 bonds of $1,000 face value each, representing a nominal block value of $10,000 per maturity bucket) issued with identical initial 3% coupons:

A 50/50 weight index with each $1 inflow buying ~12.17 units of effective duration. Now the Fed cuts rates:

Due to price appreciation and the resultant 54.56% concentration in the 30-year slot, a marginal $1,000 capital inflow is now mechanically allocated to purchase 13.92 units of duration — a structural step-up in duration exposure at lower yields, i.e. momentum investing in bonds.

And now the Fed hikes rates aggressively:

With the 30-year bond trading down to $692.55 per bond, its index weight collapses to 41.84%. A marginal $1,000 capital inflow now purchases only 9.24 units of duration — a 33.6% reduction in duration purchasing power relative to Stage 2.

Methodological note: Duration purchasing power is defined as the one-sided down-shock effective duration (D-eff) acquired by a marginal $1,000 inflow, weighted by market-value composition. Effective duration is computed as (P₋ − P₀) / (P₀ × Δy) for a 100 bp downward shock from each stage’s prevailing yield. Because positive convexity is asymmetric, this measure runs systematically higher than modified duration; it is the appropriate metric for capturing the asymmetric price response that drives the pro-cyclical loop. The 33.6% reduction in marginal duration absorption from Stage 2 to Stage 3 demonstrates that the index aggressively buys duration when it is expensive and systematically starves the sovereign long end of structural demand when it is cheap and dislocated.

By converting marginal inflows into minimal duration support precisely when a sell-off accelerates, the engine amplifies long-end yield spikes and forces the onset of systematic liquidation loops. Treasury’s recent strategy of starving the market of long duration by funding at the front end mitigates this in the short term, but leaves the underlying structural vacuum unresolved.

III. Facility Mechanics and Fiscal Optics

The SDOF operates on strict corporate-finance principles. Day-one risk parameters remain equalized across the system while cash-flow composition is restructured to repair institutional balance sheets and restore monetary transmission.

1. Voluntary Tender Exchange and Expanded Asset Inclusion

Rather than utilizing a coercive framework that invites soft-default concerns, the SDOF is structured as a voluntary tender exchange supported by a pre-cleared HTM accounting safe harbor.

The target universe formally accepts both Treasury obligations and Agency MBS/CMBS. Treasury does not issue Agency MBS; Fannie Mae and Freddie Mac securities are government-sponsored enterprise (GSE) obligations issued under federal conservatorship, supported by Treasury’s Senior Preferred Stock Purchase Agreements, and treated by markets as high-quality government-supported mortgage credit. Accepting these instruments in exchange for Treasury bonds of equivalent duration isolates the interest-rate risk without altering the sovereign credit profile. With the three largest banks holding nearly $1 trillion in Agency MBS at deep discounts, this expansion is necessary to truly unlock the HTM paralysis.

Under acute red-threshold stress, voluntary tender uptake is realistically estimated to range between 60% and 85% of the targeted institutional par universe. To overcome the collective-action problem — the prisoner’s dilemma in which banks wait for others to tender to reap the systemic benefits — the SDOF employs a First-Mover Incentive: early participants receive operational priority, settlement certainty, and a modestly more favorable exchange ratio (e.g., 66 cents rather than 65 cents on the dollar), marginally increasing Treasury’s cost but substantially guaranteeing coordination.

2. Blunt Assessment of Fiscal Optics

The transaction is settlement-cash-neutral: Treasury does not raise new net cash from the market at inception, but exchanges market value for market value. It is explicitly not cash-flow-neutral over time. The facility converts a portion of future principal obligations into current coupon expenses.

For ease of exposition, the macro calculations below use a full-universe engagement case: $650 billion legacy par exchanged at a blended market price of 65 cents on the dollar, establishing an aggregate market value of $422.5 billion. Treasury issues exactly $422.5 billion of new, on-the-run 30-year bonds at current market yields at par (100 cents).

On the illustrative assumptions of this framework (mirroring Bank of America’s 1.66% HTM book yield as the lower bound and 5.2% as the new-issue coupon), the math reflects the following profile:

• Legacy interest outlay: $650B par × 1.75% blended coupon ≈ $11.4 billion annually.

• Optimized interest outlay: $422.5B new par × 5.2% coupon ≈ $22.0 billion annually.

• Annual cash interest expense delta: +$10.6 billion.

• Headline principal reduction at maturity: $650B − $422.5B = $227.5 billion.

The public-finance case therefore rests entirely on systemic stabilization, monetary transmission, and liquidity restoration — not on deficit reduction. This is standard liability management: swapping long-term capital claims for immediate liquidity stabilization to prevent a systemic market failure that would cost the fiscal authority vastly more.

IV. Accounting and Legal Authority

The central implementation hurdle of the SDOF is the regulatory bridge across ASC 320. Surrendering legacy Agency MBS or Treasuries in exchange for new current-coupon Treasury bonds constitutes a sale under current GAAP, triggering tainting regardless of systemic purpose[11]. To enable bank participation without triggering systemic capital impairment, the SDOF requires pre-authorized, system-wide accounting treatment. Three pathways are ordered below by execution credibility.

Pathway 1 — Substance Over Form (Cleanest Margin)

The economic substance is a modification of terms on the same sovereign credit, not a market exit. FASB codifies a principle through which an exchange that is (a) issued by the same sovereign obligor or conservatorship, (b) of equivalent credit quality, (c) executed under a government-directed financial stability program, and (d) immediately re-classified as HTM does not constitute a sale for ASC 320 purposes. This pathway requires FASB to issue an interpretive update through its standard process.

Pathway 2 — Federal Banking Agency Interagency Capital Guidance

Separately and in parallel, the federal banking agencies (FRB, OCC, FDIC) can issue interagency guidance on regulatory capital treatment that effectively neutralizes the GAAP consequence for capital adequacy purposes — without changing the underlying accounting. This is the more realistic near-term route, as it is squarely within existing supervisory authority and does not require FASB action.

Pathway 3 — New Sovereign Exchange Safe Harbor

FASB adds a seventh safe harbor to ASC 320-10-25 specifically for government-directed sovereign instrument exchanges, tightly circumscribed with mandatory re-classification. This is the most durable solution but the slowest to implement.

The AOCI Carry-Forward and Forbearance Mechanics

The facility must be described honestly: it is not loss forgiveness, but a pre-authorized, system-wide loss-recognition bridge. To satisfy FASB’s investor-protection mandate, the accounting treatment mirrors existing AFS-to-HTM transfer mechanics under ASC 320-10-35-10(d). The unrealized loss on the surrendered security is carried forward in AOCI (MWG note for readers— Accumulated Other Comprehensive Income — a line on the equity section of a bank's balance sheet that captures certain unrealized gains and losses that bypass the income statement) and amortized straight-line through earnings over the remaining life of the new instrument.

For a standard institution tendering a $100 million legacy par block, the balance sheet transitions under the preferred safe harbor as follows:

The $35 million unrecognized loss does not disappear from the ledger. It is reclassified into the AOCI carry-forward account and amortized straight-line through earnings over the 30-year life of the new security ($35M ÷ 30 ≈ $1.17M per year). Gross coupon income expands from $1.75M to $3.38M; deferred-loss amortization of ~$1.17M reduces net income to approximately $2.21M, resulting in a true incremental uplift of roughly $460,000 per $100 million of legacy par block relative to the prior baseline. Required AOCI disclosures ensure the economic substance of the permanent reduction in principal recovery remains fully visible to market participants.

V. Multi-Asset Transmission Channels

1. Convexity Squeeze and Curve Compression

Because the exchange converts $100 of old par into $65 of new par, the relevant duration comparison must be evaluated on an original-par-equivalent basis. The aggregate DV01 risk is permanently extracted from the market scales according to institutional participation thresholds. Drawing on historical Federal Reserve Operation Twist precedents and the foundational banking-intermediary transmission literature[12], the resulting compression in long-end term premium falls within a range of 15 to 50 basis points on the 10-year benchmark under upper-bound participation.

Insurance companies and pension funds are excluded from the primary target parameters, but for different reasons than banks. U.S. life insurance companies report primarily under NAIC statutory accounting, which carries most fixed-income holdings at amortized cost — functionally analogous to HTM and therefore not subject to the same market-value capital pressure. Defined-benefit pension funds, meanwhile, have liability-duration matching requirements that make them likely to actively resist an exchange that shortens portfolio duration. Calibrating their specific ALM resistance levels is material to confirming the 15–50 bp compression estimate.

2. Mortgage Market Transmission

The retail mortgage market provides the primary consumer-facing transmission channel. As of mid-May 2026, Freddie Mac’s official PMMS showed the 30-year fixed rate at 6.36% as of May 14[13], while higher-frequency market surveys placed top-tier 30-year fixed rates closer to 6.49%–6.68% by May 18[14], tracking multi-month highs alongside structural long-end volatility. The SDOF impacts mortgage rates through two channels: the Duration Channel (15–50 bps via long-end term-premium compression) and the Capital Channel (25–40 bps via bank balance-sheet relief that compresses primary-secondary MBS spreads).

VI. Risk Controls and Boundary Setting

1. Federal Reserve Coordination

The SDOF operates directly in the Treasury market. A $422 billion duration extraction is functionally equivalent to an Operation Twist in its market effect. If the Federal Reserve simultaneously sells long-end Treasuries (Quantitative Tightening) while Treasury is attempting to swap them, the uncoordinated QT could nullify the term-premium compression entirely. A formal Fed-Treasury coordination annex, analogous to the 2020 emergency facility framework, is a prerequisite for deployment.

2. Sovereign Signaling and Foreign Holders

Foreign holders collectively own approximately $8–9 trillion in U.S. Treasuries, of which the foreign-official segment (central banks and sovereign wealth funds) accounts for roughly half. A sovereign-directed structural exchange, even if domestically targeted, could be interpreted as evidence that the United States is willing to manage obligations through structural modification rather than full market redemption. The penalty is mitigated by a dedicated foreign-holder communication strategy explicitly defending why the SDOF does not constitute a soft restructuring — voluntary tender, fair-value-neutral pricing, and preserved contractual integrity for non-participants — thereby protecting the reserve-currency premium.

3. Rate-Path Dependency

Present-value neutrality is structurally true at current discount rates, but it is rate-path dependent. A 100 basis point increase in long-end yields following SDOF deployment would immediately create a new cohort of discounted 30-year Treasuries. Constant sensitivity analysis stress-testing the NPV neutrality across renewed rate-rise environments must be maintained.

VII. Post-Deployment Distributional Audit

To maintain transparency and defend the facility against the narrative of an unearned institutional subsidy, Treasury should implement an objective post-deployment audit framework. The audit will track the functional integrity of baseline deposit-competition rails to ensure the expanded coupon income is shared between institutional capital rebuild and depositor return.

Where these rails are operational, they act as the primary line of defense to narrow the deposit gap. Where the diagnostic data identifies a persistent, structural failure of these competitive rails — or institutional hoarding of the SDOF coupon expansion — Treasury will utilize a graduated escalation path, moving from targeted public disclosures to the operational activation of the competitive backstop detailed in Appendix B.

VIII. Objections and Responses

Objection 1: This facility represents a taxpayer-funded bailout for banks that mismanaged duration risk.

Response: The SDOF does not provide financial extraction above market pricing. Banks tender assets at a deep, market-validated discount (e.g., 65 cents on the dollar) and receive new par paper matching that exact market value one-for-one. The transaction is fair-value neutral at inception; no losses are erased, and long-term terminal principal claims are permanently reduced. The required AOCI disclosures ensure the economic substance of the permanent reduction in principal recovery remains fully visible. The subsidy that does exist is the regulatory accommodation itself — the safe harbor against tainting — which should be named directly rather than denied. Its justification is systemic, not institutional.

Objection 2: Treasury is increasing near-term cash interest expenses during a period of fiscal deficit strain.

Response: The near-term cash-coupon service expansion (+$10.6 billion annually in the illustrative baseline) is counterbalanced by a structural reduction of $227.5 billion in terminal principal obligations. The arrangement represents standard liability management: swapping long-term capital claims for immediate liquidity stabilization to prevent a systemic market failure that would cost the fiscal authority vastly more in lost tax base, emergency facility deployment, and reserve-currency erosion.

Objection 3: Why not allow market discipline to work by letting under-capitalized or duration-trapped institutions fail?

Response: Allowing systemic liquidation loops to fracture the sovereign transmission architecture in the name of ex-post discipline creates extreme, uncompensated systemic variance. The underlying assets are United States sovereign obligations and Agency MBS — not impaired private credit ledger items. The balance-sheet freeze is an artifact of regulatory accounting rules (ASC 320) interacting with an unprecedented macro duration shock, not a default-risk insolvency.

IX. Concluding Disposition

By maintaining the Sovereign Debt Optimization Facility as a contingent, defined-trigger instrument, the Treasury preserves its policy capital, inoculates the institution against political and moral-hazard critiques, and remains fully prepared to stabilize the global financial architecture at the moment market-structure fragility breaks.

The facility’s success is not measured by maximum benefit to any single class of participant. It is measured by the restoration of orderly monetary transmission, the equitable distribution of benefits between institutional capital rebuild and broad public welfare, and the preservation of confidence in United States sovereign issuance.

The playbook is nearly complete. The accounting bridge is the remaining critical item. To compress activation from days to hours, the legal parameters must be pre-authorized. Once the liquidation loop begins, design time will have expired.

Appendix A — Illustrative DV01 Mathematics

The target universe comprises specific off-the-run Treasury obligations issued between Q2 2020 and Q4 2021 with maturities ranging from 2050 to 2051, plus eligible Agency MBS/CMBS vintages issued under near-zero-rate underwriting conditions. The mathematical extraction of DV01 is defined by the structural shift from deep-discount long bonds to par-value current-coupon obligations.

On a static-yield basis, duration compression reduces the portfolio’s sensitivity to parallel rate shifts and flattens the convexity profile, thereby reducing the systematic hedging requirements that primary dealers must absorb during a market rout. Per $100 million legacy par tendered: an old 1.75%-coupon, 25-year-remaining bond priced near $65 (book yield ~5%, effective duration ~19.3 years) carries a DV01 of approximately $125,700; the replacement $65 million of new 5.2% par 30-year bond (effective duration ~15.4 years) carries a DV01 of approximately $100,000. Net duration extraction per $100M old par is on the order of $25,700 per basis point, or approximately 20% of the original DV01 exposure. Scaled to $650 billion legacy par at 65% participation, the aggregate DV01 extraction is on the order of $108 million per basis point. (MWG Note: For readers interested in understanding this exposure more deeply, please refer to my great friend Harley Bassman’s latest note where he highlights the growing risk of the “Convexity Beast”)

Appendix B — Competitive Deposit Rails as a Post-Crisis Distributional Backstop

To ensure a credible deterrent against margin hoarding, Treasury should commence a parallel, long-term workstream to develop a digital sovereign savings platform utilizing the United States Postal Service network infrastructure.

To optimize execution efficiency and eliminate bureaucratic expansion, the frontend interface and backend clearing ledger are structured for competitive open bidding to private financial-technology and banking consortia. Standing up this deployment-ready infrastructure requires a parallel 18-to-36-month implementation timeline, encompassing procurement cycles, USPS operational integration, KYC/AML compliance buildouts, identity verification at scale, and FedNow rail integration. This framework requires navigating either targeted legislative authorization modeled on the historical Postal Savings System or an expansion of emergency statutory authorities under Treasury–Federal Reserve fiscal-agency mandates.

To insulate the regional and community banking sectors from destabilizing wholesale disintermediation, individual balances within this facility are strictly capped at the historical pre-2008 FDIC limit of $100,000. While accounts below this threshold constitute the numerical majority of domestic retail depositors, they represent a minority of aggregate system dollars. Quantitative modeling indicates full-scale activation would plausibly migrate 5% to 10% of the total domestic deposit base. This magnitude is precisely calibrated to establish an effective competitive price-setting mechanism for retail savings without impairing the baseline solvency or credit-extension capacity of the traditional banking ledger.

End Notes

[1]Federal Deposit Insurance Corporation, Quarterly Banking Profile, Fourth Quarter 2025 (Washington, D.C.: FDIC, February 2026). Total unrealized losses on held-to-maturity and available-for-sale securities portfolios declined $31.0 billion to $306.1 billion, the lowest level since Q1 2022.

[2]U.S. Department of the Treasury, Daily Treasury Par Yield Curve Rates, reporting cycle May 18–19, 2026. 10-year constant-maturity yield: 4.61% (May 18) / 4.67% (May 19); 30-year constant-maturity yield: 5.14% (May 18) / 5.18% (May 19), per Federal Reserve H.15 release.

[3]SEC EDGAR XBRL filings, 2024 Form 10-K and Q4 2024 earnings supplements for Bank of America Corporation, JPMorgan Chase & Co., and Wells Fargo & Company. HTM portfolio carrying values aggregated to disclosed securities footnotes.

[4]Financial Accounting Standards Board, Accounting Standards Codification Topic 320, Investments—Debt Securities, particularly ASC 320-10-25-9 through -14 governing classification and the consequences of sale or transfer out of the held-to-maturity category.

[5]FDIC Supervisory Appeals Review Committee Decision, 2024, addressing regulatory capital consequences of HTM portfolio reclassification under interagency capital rules (12 CFR Part 217 for the Federal Reserve; analogous provisions for OCC and FDIC). For Category I and II institutions, AOCI flows through regulatory capital; the AOCI opt-out remains available for Category III and IV institutions pending Basel III endgame finalization.

[6]U.S. Department of the Treasury, May 2024 Quarterly Refunding Statement, formally introducing regular liability-management and cash-management buyback operations.

[7]U.S. Department of the Treasury, February 2026 Quarterly Refunding Statement, detailing scheduled expansion to approximately $38 billion in off-the-run liquidity-support purchases and up to $75 billion in short-term cash-management buybacks per quarter.

[8]Federal Reserve Bank of New York, Treasury Market Data Baseline, Q1 2026; cross-referenced with SIFMA U.S. Treasury Securities Statistics (April 2026), reporting $30.7 trillion in outstanding marketable Treasury debt.

[9]Bank of England, Financial Stability Report, December 2022. Provides the structural review of LDI-driven liquidation cascades in the September 2022 UK gilts episode—the canonical recent template for sovereign-debt market dysfunction driven by leveraged-portfolio mechanics.

[10]Haddad, V., and Muir, T. (2025), “Market Macrostructure: Institutions and Asset Prices,” National Bureau of Economic Research Working Paper 33434. Documents the rise of passive investing above 40% of the equity market and articulates the structural blind spot in contemporary macro-finance regarding the analogous (and underappreciated) mechanics in fixed income.

[12]Haddad, V., and Sraer, D. (2020), “The Banking View of Bond Risk Premia,” The Journal of Finance, 75(5), 2465–2502. Establishes the empirical link between bank balance-sheet exposure to interest-rate risk and bond risk premia, providing the foundational banking-intermediary transmission framework for term-premium estimation.

[13]Freddie Mac, Primary Mortgage Market Survey, reporting cycle of May 14, 2026; 30-year fixed-rate mortgage benchmark at 6.36%.

[14]Mortgage News Daily and Bankrate higher-frequency survey indices, mid-May 2026; top-tier 30-year fixed rates at 6.49%–6.68% as of May 18, representing multi-month highs alongside structural long-end volatility.

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There's always gonna be another mountain
I'm always gonna wanna make it move
Always gonna be an uphill battle
Sometimes I'm gonna have to lose
Ain't about how fast I get there
Ain't about what's waiting on the other side

“The Climb” by Miley Cyrus

Dave Collum, a remarkably financially numerate Cornell chemistry professor, and someone I consider a “Twitter friend” who actively follows and promotes my work shared a poll on Twitter this past week:

I want to make clear a number of assumptions that Dave outlined later in his responses (but should have been clear from the language):

1. No Social Security or Medicare

2. No children (“just you and your spouse”) to take care of

3. Pre-tax sheltered retirement account (401K or IRA) [so no house, business, etc]

Simultaneously on my screen:

So let’s do some simple math:

At the “crowd weighted average” (ignoring the “or more” on the 25x), the opportunity exists to replace 100% of PRE-TAX income with 30yr nominal treasury bonds simply with interest on that bond. Never touching principal. And since it’s “just you and your spouse” there’s nobody to benefit from that principal, completely intact, at age 95 except (possibly) you and your spouse. Odds you’ll both make it that far? About 5% for affluent (ie 20x) households. 1% for the deplorables.

In the comments, Amy Nixon, a financial commentator, said she’d initially leaned toward 20 times salary and then rolled it back to 15 (where I voted) — her reasoning being that expenses fall off once the kids are through college and the household is two adults again, for meals, for travel, for the ordinary buying of things. You can disagree with the number. But notice what she’s doing: she’s reasoning about spending. Remember your pre-tax income includes money paid for taxes, FICA, etc. And saving to get to that 20x level. Your SPENDING runs about 65% of that pre-tax income. So 20x is 31x your spending.

Dave said 25x. And then he flagged what he called the interesting part: that Fidelity’s website, at one point, said 8x.

An 8x-versus-25x gap is not a curiosity. It is a threefold discrepancy with an important message. Fidelity’s number assumes you draw your principal down over retirement and that Social Security carries a large share of the load. A 25x-of-salary number quietly assumes something completely different: that you live off a withdrawal rate of roughly 3 percent, Social Security is untrustworthy, and never touch the principal at all. Those aren’t competing estimates of the same quantity. They are answers to two different questions. The question Dave is answering is “fear” — and we see it permeating our society:

The older generation’s saving is income NOT received by their children. Dave, admittedly, is saving more because he’s worried about the prospects for his children to adequately provide for THEIR retirement. As I noted to the younger generation in a recent (terrible btw) podcast, their behavior is part of the problem; but the older generation isn’t helping:

At 20x+ (64% of respondents obviously skewed by Dave’s follower orientation), you’re saving 31x your spending. At 65, you could earn 0% and cover spending until 96.

I know what the crowd is shouting — “Inflation! It’s coming, and it’s understated! You can’t buy nominal bonds, you fool!”

And maybe they’re right (I don’t think so). But I’d like you to consider something:

The shift from Defined Benefit to Defined Contribution, beginning in 1978, shifted the “fear” of providing retirement from the corporate (and public) sector to the household sector. As discussed in my analysis of the Coimbra paper, the shift from COLLECTIVE security to individual security drives an astonishing outward shift in aggregate demand for financial assets:

While Coimbra doesn’t specify the fraction of Type-A (spenders) and Type-B (savers), the aggregate results for the paper suggest roughly 50/50. If we reverse solve for the drivers of the increase in Financial Assets/Income, we get these rough ranges:

The aging of the society that has occurred since 1978 would have driven expected financial asset/income ratio higher by 0.7-1.5x — roughly 1/8 to 1/4 of the amount we’ve seen. Between 60% and 99% (conjoint lower and upper ranges) is due to the shift to DC and an increase in valuation (a combination of shift to passive and increased aggregate demand), or (and this is an important point) the decline in labor share of the economy. The NY Fed has recently written that labor share appears to play an important role in setting real rates:

And as my readers know, I believe the evidence strongly supports this conclusion:

Why does this relationship exist? Because the production frontier in economics ASSUMES a capital/labor ratio. With fast labor force growth, the demand for capital must rise to maintain the capital/labor ratio, driving real rates higher. THIS was the story of the 1970s — an explosion of domestic labor created a large outward shift in aggregate demand both for consumption AND capital:

And so today, with labor force growth expected to be negligible, real rates SHOULD be lower.

But they’re not:

Now we have multiple solutions to this conundrum. Possible solutions:

1. The market is brilliantly telling us that the US government is lying about inflation

2. The market is stupid and real rates are going much higher because (pick A/B/C) — the theoretical models are stupid as well. It’s different this time.

3. The market is stupid because mechanical features are driving neglect of bonds in portfolios that mechanically buy in proportion to market capitalization of bonds and an age-based allocation to assets that ignores reasonable expected returns.

We can evaluate #1 and #3. #2 is simply expectations. Ewe have one. So does everyone else. I’d urge you to consider what’s special about yours.

On #1, the “government is lying”, many like to roll out the chart on UMich inflation expectations where the “mean” has soared. Unfortunately, this is due to outliers amplified by the 2023 switch from phone to internet surveys. On the internet, nobody knows you’re a conspiracy theorist, dawg. The median expectation is 3.1% — slightly elevated, but far from 1981 levels:

We’ll always have ShadowStats, but legitimate PRIVATE sector peers to the CPI suggest the BLS is OVERSTATING inflation by about 1.5%. Please ask yourself, “What incentive does Truflation have to lie?” I can assure you, their business model is better served by suggesting the opposite:

You can also ask yourself, “What incentive does Mike Green have to lie to me?” Well, obviously, I’m just an active manager trying to hold on to my fiat power base as I type away on Sunday morning. (We are legion in case you’re wondering)

The data does not suggest the BLS is “lying to you” — and as many have noted, never assume conspiracy when incompetence will suffice. And there is plenty of evidence of incompetence (mostly from my barber, but also at the BLS):

As I noted, #2 is “Like, just your opinion, man…” so let’s take a look at number three — mechanical:

I cannot emphasize this enough—we KNOW this is true. It’s been confirmed by passive bond funds to the US Treasury. We also know what happened to small cap value stocks in 1999 when improperly constructed market cap wtd indices ignored float and overweighted new IPOs vs depressed value stocks:

Do ewe see what I see?

So I’ll leave you with this observation — as of May 18, 2026, you’ll have the opportunity to sell your other financial assets and buy 30yr US treasuries at a level of income replacement unmatched except for the four years of Volcker rates 1979-1982:

You don’t need to care about my “real rates argument” — you don’t need the capital gains, and your principal is protected in nominal terms. Again, at 5% and 20x you’re never touching principal. You’re starting out your retirement with income 1.5x your current spending. You’ll ADD to principal. At 10x (America's average), even with Social Security cut by 25%, most will also never touch the principal. Will you do it? Almost certainly not. Because we’re sheep. And the lone sheep is prey for the wolf.

“Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” — Keynes

But that’s not the question, really. The question is, when are OTHERS going to come to the conclusion that the future might not be driven by an overtly manipulated SpaceX IPO at 100x revenue, but rather by bonds? The “Keynesian Beauty Contest”:

. . . in which the competitors have to pick out the six prettiest faces from 100 photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole: so that each competitor has to pick, not those faces that he himself finds prettiest, but those that he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view . . . We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth, and higher degrees.

And just remember, that rising multiple of financial assets to income has an expiry date based on demographics. If equity valuations begin to retreat as Boomers decumulate, it will fall faster (note my work suggests somewhere between 2030 and 2035 is when passive makes this all moot):

Your call, America. My hunch is that you’ll go with the IPO and emerge shaken, not stirred.

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Cap-weighted passive investing, when it gets large enough relative to the active capital on the other side, should leave a measurable trace in returns. Not because index funds are bad, or because low fees are wrong (although I think we’ve lost perspective when discussing a fee cut from 3 to 2 bps as “largest ever”), or even because people buying them are making a mistake. The argument is the societal risk created by a growing mechanical bid. Every dollar that enters a cap-weighted index fund is distributed by existing market capitalization. Bigger companies get more of every dollar. If the dollar volume gets large enough and the active investors who would normally arbitrage that flow become small enough, the rule itself starts to move prices.

The fair objection has always been, “Show me.”

I’m about to release a white paper that I believe does this.

The trend above is the heart of it. Let me walk you through what you are looking at, because the argument is more measurement than opinion.

The simple question

We are all well aware that large stocks have outperformed small stocks for the last few decades. But inside groups of similarly sized companies, are the largest companies increasingly outperforming the smaller ones?

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• S&P 500 Rule Changes: The S&P 500 is removing long-standing profitability requirements — the “enshittification” of the index. This change potentially turns the index into a “dumping ground” for Private Equity to offload unprofitable, highly leveraged companies onto retail index investors.

• The Iran “Blockade”: While the Trump administration claims the war has “terminated” to avoid Congressional authorization deadlines, the strategy has shifted from active combat to a long-term blockade. The objective is to bait an Iranian breakout while consequences include sustained higher oil prices and a strategic pivot toward advanced nuclear reactors.

• Powell’s “Resistance” Strategy: Jerome Powell’s decision to remain on the Board of Governors after his Chairmanship ends is a calculated act of subterfuge. By encouraging Fed staff to remain “true” to independent, rigorous analysis, he is effectively positioning the staff to resist the incoming Chair, Kevin Warsh.

  ---

Three topics:

1. S&P 500 changes the rules

2. The “war” is over and we won; would be a shame if Iran tries to breakout of the blockade

3. Powell’s continued subterfuge

The S&P Changes the Rules

I’ll write more on this in the coming weeks, as it’s the penultimate act of “enshittification” that has been sweeping the nation, but Dave Nadig is standing by expectantly:

So, as temporary recompense, I offer an ode stolen from the most famous of poems, “Casey at the Bat” by Ernest Thayer:

The outlook wasn’t brilliant for the Retail crowd that day:

The market caps were floating on a Mag7 display.

And then when Nasdaq dropped its guard to let the fast-tracks in,

A pall-like silence fell upon where honest trades had been.

A straggling few cashed out their funds in deep despair.

The rest clung to the S&P to stand as Wall Street’s final test;

They thought, “If Standard & Poor’s stays true, and keeps GAAP intact —

We’d put up even money now against this shameless pact.”

But a whisper swept the bleachers, then a devastating shout:

The S&P had waived the rules to bring the big boys out.

Oh, somewhere in this favored land, the bankers’ smiles are bright;

PE will ring the opening bell, and Wall Street’s hearts are light.

And somewhere brokers celebrate their billionaire’s payout;

But there is no joy for Retail—the S&P sold out.

The S&P500 has indeed “sold out.” By proposing to kill the long-standing “profitability” requirement for the S&P500 (already weakened by the use of operating vs GAAP earnings), the S&P500 has offered itself up as the dumping ground for private equity. We can expect it will soon lead to notable headlines:

BREAKING NEWS — OCTOBER 2026

KKR Champions the ‘Democratization of Alpha’ with $250B Mega-Merger IPO of ‘Schlemiel! Schlimazel! Hasenpfeffer Inc.’, Finally Granting Retail Investors Access to a Next-Gen, AI-Synergized Corn Syrup and Car Mat Ecosystem

In a historic victory for Main Street, everyday investors are no longer barred from participating in the exponential growth trajectory of a bespoke, $500B-leveraged portfolio. IPO proceeds are generously earmarked to reward the visionary private equity sponsors who made this paradigm shift possible.

NEW YORK, NY — In what Wall Street analysts are already dubbing the “philanthropic financial event of the decade,” KKR announced the simultaneous merger and initial public offering of Schlemiel! Schlimazel! Hasenpfeffer Incorporated Technologies! (Ticker: SHIT) at a visionary $250 billion valuation.

For years, everyday retail investors have been tragically locked out of the private markets, forced to watch from the sidelines while institutional elites capitalized on the explosive synergies of disparate, zero-revenue enterprise rollups. Today, that gatekeeping ends.

By seamlessly integrating Schlemiel (a disruptive, pre-profit holistic car mat cleaning rollup), Schlimazel (a legacy high-fructose corn syrup manufacturer currently pivoting to wellness), and Hasenpaffer (a fully AI-enabled AM radio broadcasting network), SHIT has created a totally frictionless, synergistic flywheel. Management notes that consumers can now passively absorb AI-generated radio advertisements for dietary corn syrup while their vehicular floor mats are sanitized—a true omni-channel ecosystem.

“Retail investors have been systematically denied the right to buy into our highest-conviction verticals,” read the S-1 filing. “By merging these three remarkable companies, we are unlocking an unprecedented growth trajectory that the public markets simply haven’t had the privilege to fund until today.”

To achieve this democratization, SHIT will debut with a highly optimized, capital-efficient $500 billion debt load. While critics might point out that these three companies were originally acquired during the zero-interest-rate heyday of 2019 and are actively hemorrhaging cash, KKR’s prospectus brilliantly outlines why this declining profitability actually justifies a staggering premium multiple.

“Negative EBITDA is simply deferred hyper-growth,” the filing explains. “The fact that our operational margins are steadily compressing proves that we are shedding the dead weight of legacy revenue models. Because our current earnings are approaching absolute zero, our growth potential is mathematically infinite. We are pricing the IPO at a highly conservative 4,000x forward-looking hypothetical adjusted r/WSB community-EBITDA.”

In a move that highlights the firm’s commitment to strategic capital reallocation, 100% of the proceeds from the retail IPO will be utilized to pay a massive, one-time special dividend back to KKR. Management emphasized that allowing retail investors to personally shoulder the half-trillion-dollar debt burden of three unrelated, failing businesses is the ultimate form of financial inclusion.

“We did the hard work of leveraging these assets to the absolute brink of systemic failure,” a spokesperson noted. “Now, we are stepping aside so the retail community can enjoy the limitless upside of paying our exit liquidity. Welcome to the future of public equities.”

Analysts anticipate robust demand for shares.

Well, of course, they anticipate robust demand. After all, the analyst recommendations from underwriters should follow closely on the heels of the announcement.

Goldman Stanley Coinbase analyst, Deep Sheth initiated coverage on SHIT:

Initiating Coverage: STRONG BUY on SHIT

This is a masterclass in modern financial engineering. KKR hasn’t just filed an S-1; they’ve penned a love letter to the retail investor, wrapped in a half-trillion-dollar leveraged bow.

The strategic brilliance here cannot be overstated. By pivoting away from archaic, boomer metrics like “revenue,” “profit,” or “solvency,” they have successfully untethered the valuation from earthly constraints. The concept of “deferred hyper-growth” through negative EBITDA is a paradigm shift—why settle for a company that makes money now when you can invest in a company whose earnings are mathematically approaching absolute zero, thereby guaranteeing infinite upside?

Furthermore, the decision to use 100% of the IPO proceeds to pay a special dividend to the sponsors is exactly the kind of robust capital reallocation that signals strong corporate governance. By graciously allowing Main Street to become the exit liquidity, institutional finance is finally breaking down the walls of privilege.

If this flywheel gains any more traction, the AI-generated AM radio ads for wellness corn syrup might just cure inflation.

We expect the management team to further generate liquidity by tokenizing the opportunity for forward sales of the integrated offering through NFT launches of tokenized coupons.

As my friends at Cornhole Capital might say:

‘I didn’t know what to expect.’

‘I don’t know... maybe grown ups?’

The obvious conclusion is that the eventual impact will be a surge of unprofitable mega-caps dumped from PE and VC into the hands of index investors. The S&P500 GAAP EPS, already at risk from hyperscalar overspending and subsequent depreciation, should begin to resemble the Russell 2000:

And you’ll own nothing and be quite happy.

The War is Over and We Won

Hegseth and Joint Chiefs Chair Gen. Dan Caine were peppered with questions about the war against Iran during the budget hearing, where they defended the Trump administration’s $1.5 trillion defense budget. The pair defended the blueprint in the House on Wednesday.

The Pentagon chief again touted the U.S. military campaign in Iran and argued the effort was a resounding success.

Exactly as I forecast /s

Unfortunately, it is not over, of course, but headlines are fading as the blockade strategy replaces “shock and awe” and markets have “healed” (hit all-time highs) on the back of the passive bid. As we noted over at Tier1, we saw the largest inflow of systematic capital into markets ever:

Marines are in place. The USS Gerald Ford has been “relieved” of its extended tour (a pain point for the US Navy). And the clock is ticking. Iran has only a few weeks before its primary asset, oil fields, begin rotting from the corpse. The expected objective of the Trump administration is to bait Iran into an attempted breakout, allowing the administration to begin fighting again, but this time under a self-defense claim.

Iran has lost. I know that’s not the headline, but it’s the truth. Had European allies fallen into line, there was a chance that this would have ended much sooner. Instead, their dithering helped the Iranians fall for the same trap the US South did in the Civil War when they believed “King Cotton” was irreplaceable and European nations would join their side.

I can only hope that the next stage doesn’t require a direct commitment of US troops on the ground, but I am skeptical; my next hope is that the administration sticks to the plan of “no nation building.” Only time will tell.

The mid-term consequences is oil higher for longer; the long-term consequence, as the UAE has demonstrated, is even less influence for OPEC and global oil. Expect many more headlines like this:

Jerome Powell exits… or does he?

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The source, of course, was Avis Car Rental — an AI-enabled transportation company with distributed resources accessible to a highly-educated cohort of high-mobility workers and leisure consumers, uniquely suited to guide the development of society in the 21st century:

Yes, the rental car company. Efficient markets at work. But it did provide me with the opportunity of a very long career:

The broader point is that we are now seeing that which was unthinkable only a few years ago. Another forecast from my passive work that has (unfortunately for markets, but good for my credibility) come true.

Many critics of my work believe I am arguing that “valuation doesn’t matter” in the long-run and they retreat to the safety of their efficient market cathedral. This week we demolish it, because “in the long-run” we’re all dead. And I will not go quietly into that night.

We continue to be in the largest divergence in history between returns and “value.” If this week taught us anything, it’s to strap in — there’s a wild ride ahead.

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You have likely seen the confusing headlines:

Got it? Perfectly clear. To help you understand this complex topic, we bring you Samuel Jackson:

What?

“Iran” no longer exists as a unified political voice. The IRGC, the National Security Council, and the diplomatic class are arguing publicly:

“Following the unexpected tweet from the Foreign Minister about the liberation of the Strait of Hormuz, Iranian society has been plunged into an atmosphere of confusion.”
They also directly called out the “absolute silence” of the Supreme National Security Council and the negotiating team, demanding explanations so the “narrative of the enemy” doesn’t fill the vacuum. — Fars News Agency (IRGC outlet)

“Bad and Incomplete Tweet by Araghchi and Incorrect Ambiguity-Creation Regarding the Reopening of the Strait of Hormuz.”
“Publishing this tweet, without any verbal explanation or at least sufficient written explanations, constitutes a complete lack of tact in communication.” — Tasnim

Now some in the media are, of course, seizing on the confusion to highlight that Trump is once again deeply out to a Taco Bell salad lunch. And I want to emphasize that there can be two truths — Trump can be deeply disturbed AND Iran’s leadership has fractured as the US prevails in the conflict. We have precedent. After victories in Italy, Germany, AND Japan in WW2, internal conflict prevented consolidated messaging. After Hitler’s suicide and contested elevation of Karl Dönitz, pockets of German and Czech military refused to accept the surrender.

The US Navy is fully in control of the Hormuz. Those carriers hanging outside missile range are no longer threatened.

We’ve moved from Iran enforcing a blockade, to the US enforcing a blockade ON Iran. The terms to open the SoH from Iran? “Stop being so mean to us! It’s not fair you’re blocking the way!”

Feels pretty spot on with the outline from exactly a month ago:

This bifurcated dynamic is the foundation of the macro landscape. The Hormuz crude issue is an asymmetric warfare problem that U.S. air and naval superiority will resolve within weeks to months. Once escorts and minesweeping begin, signaling American control, it’s largely over. Marine deployments will likely limit incursion to control of coastal regions, leaving the Iranian people to resolve their remaining internal conflicts. Unlike Iraq, a shadow government embraced by the people is ready to go.

Now I know many readers will say, “You can’t know this!” And they’d be right. There is no “knowing” until it’s over. But it’s pretty much over. There was no 5-D chess. Just math.

The oil story collapsed under its own weight on Friday. Sure, Trump was the catalyst. But the reality that many are recognizing now has been well publicized on these pages — much of the oil was already making it out and demand destruction, particularly in emerging markets has been significant:

By my calculations, roughly 2MMbd in demand has already been destroyed. Had prices maintained at these levels, within six months we were looking at 10-20MMbd. Some of that lost demand will return as prices fall and we restock strategic reserves, but some will be permanently lost. We don’t run HVAC twice as much after skipping for a day, nor do we make two trips to the store to make up for the one we skipped last week. Combined with modestly increased production and (as predicted) removal of restrictions on Russian exports, oil will be increasingly well supplied. Meanwhile, the disruption is likely to prove unhelpful to a fuel likely already at peak demand.

Equity markets have recovered, albeit narrowly (poor breadth). Again unsurprising — “macro” products (SPX) have dominated single stock. It’s “RISK” on, not “specific risk” on. With that said, though positioning remains muted overall as the flow has been dominated by retail inflows and short-covering, the PACE of inflows is among the fastest in history:

I am reminded of the language of 1968:

“And all through the stormy course of 1967 and 1968, when things had been coming apart and it had seemed that the center really couldn’t hold- the rising national economic crisis culminating in a day when the dollar was unredeemable in Paris, the Martin Luther King and Robert Kennedy Assassinations, the shame of the Chicago Democratic convention, the rising tempo of student riots– the silly market had gone its merry way, heedlessly soaring upward as if everything were O.K. or would surely come out O.K. as mindlessly, maniacally euphoric as a Japanese beetle in July. Or as a doomed man enjoying his last meal. One could only ask: Did Wall Street, for all its gutter shrewdness, have the slightest idea what was really going on?” — The Go-Go Years, John Brooks

As history can tell us, 1968 was not “the end.” But it WAS the beginning of the end. With the late 1960s, the IPOs slowed and the torrid pace of retail participation began to disappear despite markets making new all-time highs. By the early 1970s, corporate distress was beginning to restructure the American economy as “old economy” behemoths could no longer cover their mounting pension bills.

My hunch is that this will be similar. Not because inflation will return and the Fed will be forced to hike rates to 13%, as “accommodative” Arthur Burns did in 1974, but because the economy is slowing and restructuring. High-tech buildouts and tariffs are slowly leading to a recovery of domestic manufacturing capacity which has expanded for 48 consecutive months — a new post-2000 record:

In contrast, Services PMI has been below the series average for the last three years. We are slowly healing from our 25 year manufacturing devastation, but that sector has shrunk to ~20% of the US economy and only 8% of employment. Meanwhile, as I hypothesized almost exactly three years ago, services is retreating (pre-ChatGPT btw):

The US economy has undergone a significant shift towards a services-driven economy over the years. However, there has been a recent downshift in services consumption per capita growth, even before the pandemic. This downshift is similar to the decline observed from 1907 to the end of World War II. — Yigaf, May 2023

The late Industrial Revolution was really a revolution in services. Washer women became washing machines. Single-viewing theater performances became “movies.” Singers and orchestras became records. Lamp lighters became light switches. Over this period, lifestyles changed radically. As I posited in 2023, we are on the edge of a similar shift where LLMs and “AI” will radically shift our experience of services from “work” to “products.” And with that shift, we’ll likely see services employment plummet as a fraction of work:

Where this stops, we don’t know. But with self-driving cars, autonomous delivery robots, humanoid robots, and “self-programming computers” either here or on the near horizon, I can rest confidently that while our war in Iran is winding down, our war with the machines is just beginning.

So let’s pivot to the conservative movement…

What’s Left to Conserve?

Why the “Invention of Conservatism” is Fracturing

I had the pleasure of attending the Spring 2026 meeting of The Philadelphia Society. For the uninitiated, this is the intellectual “town square” of the American Right, founded in 1964 following the Goldwater defeat. It was intended as a sanctuary for the movement’s brightest—academics, journalists, and high-conviction activists—to debate the future of freedom away from the immediate, distorting pressures of the next election cycle.

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War Update

In the summer of 1989, I returned from freshman year college to live and work in San Francisco. I held three jobs — mail clerk at a law firm, valet parking attendant, and designing an inventory control system for an apparel company. You can guess which one paid the bills (hint: it paid good tips). But I also picked up my lacrosse stick for the first time in six months and played adult club lacrosse with some of my high school buddies.

I was a mediocre crease defense. Good enough to play varsity at the high school level, but nowhere good enough for Penn. Fine for club. But one day that summer, I pulled an All-American NCAA lacrosse attackman as my coverage. It did not go well. Our goalie stopped a shot, and pitched it out for me to clear. Being clever and lazy, as most 19-year-old men are, I decided I’d pull that attackman off the midfield line, towards me, and increase the space available to my mids. I distinctly remember the look of exasperation on his face — “Are we really going to do this?” He began to jog towards me. I patiently waited. When he pulled far enough off the mids, I prepared to pass. His jog became a sprint. The ball left my stick headed to a midfielder…

Which was when this attackman jumped seventeen feet into the air, picked off the pass, and before he hit the ground had dumped an assist to wide open wing attack. And that was when I knew I had better work harder on that inventory control system. Because my future was not in sports.

The relevance? “Are we really going to do this?”

I know what the headlines say, “Talented upstart defenseman holds all-star attack at bay in early play!” I also know what really happened.

Oil is now transiting the Straits of Hormuz. The US Navy is in the Strait. The IRGC appears powerless to stop them. You’re welcome to disagree. But facts are facts.

Inflation

A “disappointing” inflation report reinforced a few key themes. First, remember that “residual seasonality” has corrupted the seasonally adjusted inflation data we receive. As a result, CPI is overstated in Q4 & Q1 and understated in Q2 & Q3. The February PCE and March CPI captured the two largest seasonal impact months; that is over now.

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We’ve been here before:

Let there be no mistake about the cost of war. We have arrayed an impressive international coalition against Iraq, but when the bullets start flying, 90 percent of the casualties will be Americans. It is hardly a surprise that so many other nations are willing to fight to the last American to achieve the goals of the United Nations. It is not their sons and daughters who will do the dying. Most military experts tell us that a war with Iraq would not be quick and decisive, as President Bush suggests; it’ll be brutal, and costly. It’ll take weeks, even months, and will quickly turn from an air war to a ground war, with thousands, perhaps even tens of thousands, of American casualties. — Senator George Mitchell, Jan 11, 1991

I fielded a call this week from a hedge fund manager who told me I was delusional. His exact assessment was that “Iran has already won.”

It was a perfect, real-time distillation of the consensus analytical trap. He sees the Strait of Hormuz functionally closed, U.S. interceptors being drained by cheap drones, and Brent crude elevated. To a standard model, that looks like an unmitigated U.S. defeat.

If this is an Iranian “victory,” it is the most suicidal victory in modern history. Winning a war of attrition by threatening your own country with a return to the pre-industrial age is only a victory if your goal is martyrdom. And some monolithically ascribe that goal to the Iranian people. I do not. But if Iran has “won” by breaking the global energy plumbing—specifically the structural 3-to-5-year hole in LNG and refining from the Ras Laffan strikes—who are the actual losers?

It is not the United States.

The consensus is screaming about a permanent, 1970s-style geopolitical rupture. But the commodity term structure is calling their bluff.

Look at the COZ6 (Dec 2026 Brent) contract. It is sitting at $79.02. That is up a mere 12.5% from June of last year—a period when the market was completely asleep. This is an absolute joke for a “World War III” energy crisis. The back of the curve is telling you the Strait of Hormuz will be cleared quickly. If you disagree, there are plenty of trades available. The on-the-ground reality is that over 50% of the blocked oil has already found alternate routes. Traffic is slowly opening in the Strait through the Oman coastline (~1.6 MMBpd starting this week), Saudi pipelines are maxed out (7 MMBpd), UAE pipelines are flowing (~1.5MMbpd), and Iran is shipping it’s own oil and tolling additional oil (~2MMbpd). While press headlines scream “$2MM toll!”, that is a $1 per barrel premium for a VLCC. And those deals become free if the IRGC falls. For those counting, that’s roughly 11MM of the 20MMbpd. The threshold for complete replacement, given gains in pipelines, increased production, and likely demand destruction, is 35%. We’re already well ahead of COVID…

Tanker rates are falling, but insurance remains expensive at 4x normal if you can get it. Both are likely to continue to retreat. But impressive as the numbers you may hear sound, that quadrupling of tanker insurance adds about $0.50 per barrel.

And remember that the “lost” 20MMbpd were from an oversupplied 105MMbpd total market. So we’re now delivering roughly 96MM of 105MMbpd pre-war demand. That excludes releases from strategic petroleum reserves (which must ultimately be made up in the future). The net result is that the alarming inventory drawdown of 10.2MMbpd will be lower this week. And likely even lower the week after that. And the 2025 floor of ~7700 mb is important, but we can go lower if needed. Rich countries can afford it. Poor countries cannot. Sucks to be poor, I’m sure. Never given it much thought (since it is 2026, I feel obliged to add the “/s”. At least it’s not March 2020).

Super backwardation in oil markets — prompt delivery at a 30% premium to spot, spot at a 30% premium to Dec 2026 futures — is incentivizing inventory release into markets; and the premium of prompt for both crude and products is destroying demand. Leisure travel is being reduced, work from home is being deployed, and emerging markets are introducing emergency rationing.

More importantly, the imminent arrival of U.S. ground troops fundamentally alters the kinetic math. The moment Marines land, the IRGC can no longer afford to waste their degraded missile inventory lobbing shots at passing tankers. They must pivot 100% of their surviving assets to a defensive, anti-invasion posture. By forcing Iran to fight a symmetric ground war, the U.S. functionally neutralizes Iran’s asymmetric anti-ship campaign. The crude blockage is temporary, even if the UAE LNG hole is structural. If traders actually believed in a permanent oil void, that Dec ‘26 contract would be in the triple digits. Maybe you believe differently. The markets are there for you to place your bets.

With this degree of positive carry, shorting is somewhat pointless. If I’m right, those Dec 2026 contracts fall to $60 (perhaps lower, depending on supply and demand). If I’m wrong, the carry from $79 to $110 (or higher) eats me alive. There is no trade on the short side. So you are hearing the motivated reasoning of crude oil longs in market commentary, and the cowardly voice of “no position” on the other side. I’ll remind you, that my insights took you for a 30% loss in Oil vs Gold last September… or a 44% gain, depending on how you want to look at it. Right now, there is no clear trade in either asset in my opinion.

Where I do think there is a trade, the US 2-year yield has violently reversed more quickly. We watched it spike to a 4.00% high in mid-March, prompting pundits to declare a new regime of structural inflation and endless Fed hikes. That was an illusion. It was a mechanical liquidity event—a VaR shock where levered yield-curve steepeners hit margin calls, and front-end Treasuries were indiscriminately liquidated to reduce gross exposure. Inflation is not the concern. I continue to believe Truflation is the “most” honest reporter of current prices:

But if you don’t believe them, perhaps you should check out Penn State, which, like Truflation, uses current real estate prices:

Today, that 2-year yield has fallen back under 3.80%. The mechanical liquidation is exhausted. The global panic is actually funding the U.S. Treasury market, as capital flees the structurally “doomed” industrial centers of Europe and Asia and floods into the only sovereign safe haven that is a net-energy exporter. But it didn’t reach 3.80% in a straight line. A “stellar” jobs report and rising PMI prices has raised doubts that the Fed will need to cut. First PMI Prices… whatever could it be? Oh… oil.

“Yeah, you’re delusional, Mike. Fine… so PMI is being driven by oil… I get it. But oil is a pass-through to everything else.”

Yes, by and large it is. A doubling of oil prices will raise prices… by about 1.5%. You know what else causes prices to rise? Tariffs. And we’re about to celebrate the anniversary of the largest tariff increase in nearly 100 years… with CPI down 0.4% YoY. Inflation swaps have this figured out… short-term inflation up. Forward inflation down. They did the same thing last year when tariffs were introduced:

“OK… but the strong job report…”

Yeah… about that:

And that’s before we get to the still-not-fixed Birth/Death adjustment, plugging away, adding roughly 100K to-be-revised-away jobs per month:

Which just might leave the BLS in the same position as private credit… “lying.”

And now… what you have all been waiting for…

The Toll Booth: Bitcoin’s Extraction Machine in Practice

Part 2 of “Bitcoin Is Not Sound Money”

Introduction to Part 2

Part 1 established the theoretical machine: Bitcoin’s design hardwires a temporal caste through perfectly inelastic supply, front-loaded issuance, and zero holder accountability. The extraction mechanism is not a bug—it is the system operating exactly as its parameters dictate.

More fundamentally, Part 1 demonstrated that Bitcoin does not fix the pathologies its proponents often correctly diagnose in the existing monetary system. The Cantillon effect is made permanent and immune to democratic correction. Wealth concentration is intensified and stripped of any productive obligation. Rent-seeking is perfected into a “constitutionally protected” (code) activity requiring zero effort.

That was the mechanism. This is what it looks like in the world—what it would become at scale—and why the maximalist endgame would make every problem they identify in fiat catastrophically worse.

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YIGAFers,

I apologize in advance. This note is asking you to read roughly 5,000 words across two long, dense letters — Radigan Carter’s extraordinary Twitter post and the one I publish below. Market conditions leave me no choice. We are in live conflict with real energy infrastructure offline, a violent bond repricing underway, and a Fed credibility trap colliding with mechanical market plumbing. Half-measures won’t cut it. The stakes require both lenses.

I wrote “The Fed’s Credibility Trap Meets the Flow-Inelastic Unwind” before reading Radigan’s letter. My thesis was already locked from the data: front-end yields at 3.9%, December 2027 Fed funds futures pricing almost no cuts, and the MOVE Index spiking 28% to 109. Only later did I see Radigan’s framework, and the contrast was immediate.

Radigan writes as the Operator — visceral, scarred by two decades of GWOT failure and his direct experience in nation-building in Iraq. From Oman, evacuating his wife while watching missiles fly, he walks you through the physical reality of a shattered Ras Laffan LNG train: custom vessels, Mammoet heavy-lift crews, sulfur cascades, fertilizer spikes, and the 6-week freight-contract trigger that locks in CPI pain no matter what any president tweets. His Shia theology lens explains the expected Iranian resolve. His “Suez moment” framing sees this as the definitive unravelling of the American empire. Phase 3 — summer earnings misses, AI-for-survival cost cuts, midterms panic — becomes his buying window. It is human, friction-filled, and impossible to dismiss from someone who actually commissioned those LNG facilities. And it mirrors many of the concerns you will read in the popular press.

My note is the Tactitian’s structural calculus with a laser focus on the front of the curve. I separate the reversible oil/Hormuz shock (solvable in weeks to months once Navy escorts and minesweeping begin) from the structural 3–5 year LNG hole at Ras Laffan. The Fed and market, still haunted by 2020–2023, are over-pricing permanence and erasing 2026 cuts — most visibly at the front end. That mispricing was triggered not by thoughtful repricing but by a flow-inelastic unwind: levered steepener books hit margin calls, the MOVE Index exploded, and Treasuries were liquidated first to raise cash. Europe and Asia eat the multi-year pain while the U.S., as net exporter, captures the windfall. The pivot will come from a violent K-shaped credit fracture — youth and non-college cohorts absorbing the entirety of net job destruction and credit stress — once oil normalizes faster than the market expects.

The two views clash in important ways. Radigan’s perspective is shaped by Iraq, where he saw, in person, the limits of U.S. power to reshape a tribal society held together only by Saddam’s brutality — a conflict turned worse by Iranian support for insurgency. That fuels his emphasis on theological resilience and inevitable quagmire. In my view, his Shia theology lens risks conflating the Iranian people with the IRGC regime that now cynically controls and weaponizes it — as evidenced by the new religious leader’s elevation in direct defiance of the former Ayatollah’s wishes and the new leader’s own compromised stature. This suggests the regime may prove more brittle under sustained pressure than the martyrdom narrative implies.

Yet the frameworks reinforce each other powerfully. Radigan’s ground-level friction — 6-week trigger, summer earnings pain, desalination risks, regional militias — keeps my models honest on repair lags and escalation. My front-of-the-curve mechanics and flow-inelastic unwind highlight the U.S. advantage that pure operator cynicism can underweight.

The practical synthesis is clear: use his physical timelines to time the exact moment delinquencies spike and the front end snaps. When that credit fracture arrives, the violent reversal in yields, the dollar, and the policy response will be profound.

I recommend keeping some cash and watching for the first clear Hormuz convoy catalyst. When the US fleet enters the Straits, the conflict is functionally “over.” But for now, the conflict continues to evolve (largely as I’ve expected). The opportunity remains.

The Fed’s Credibility Trap Meets the Flow-Inelastic Unwind

The bond market has undergone a violent repricing in recent weeks. Readers may remember that I turned structurally bearish bonds on a seasonal inflation framework last December 2027 Fed funds futures now imply a terminal rate around 3.75%–4.00%. Two-year Treasury yields closed near 3.88–3.91%, the 10-year Treasury yield settled at 4.39%, and equities weakened further—S&P 500 at 6,506.48, Nasdaq at 21,647.61. The US Dollar Index (DXY) ended around 99.50–99.65, elevated on safe-haven flows.

The mainstream narrative claims this stems from a geopolitical energy shock colliding with a Federal Reserve that may be forced to hike to contain oil-driven inflation.

This narrative is structurally false. It fundamentally misunderstands both the internal dynamics of the Fed and the mechanical plumbing of the bond market.

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For the last two years, a fierce debate has raged over why. Now that the dust is settling, the macroeconomic establishment is busy writing the official post-mortem. But a close look at the recent literature reveals that academia and the Federal Reserve are relying on contaminated statistics and accounting illusions to explain away what actually happened. And, of course, they are doing it to benefit the elite and corporate interests that increasingly dominate the discussion.

Let’s look at two of the most prominent recent attempts to explain the disaster—one pinning the blame on fiscal deficits, the other absolving corporate pricing power—and why the math underneath both of them completely falls apart when you look at the actual receipts.

Part I: The Fiscal Mirage and the Endogeneity Trap

A popular narrative among macroeconomists is the “fiscal mechanism”—the idea that unexpected government deficits were the primary driver of the unexpected surge in global inflation. A recent high-profile paper by Ricardo Reis attempts to prove this by plotting the unexpected deficit shocks of OECD countries against their unexpected inflation shocks, drawing a neat red trendline through the scatter plot.

It looks like a definitive macroeconomic law: countries that ran bigger deficits suffered worse inflation. My partner, Harley Bassman, would be thrilled (always a sign of errors in analysis). But to get that trendline, Reis errs in two massive, highly revealing ways.

Error 1: The Outlier Illusion vs. Statistical Rigor

In the paper, Reis explicitly notes that if you selectively discard two glaring outliers on the far left of the chart (Norway and Denmark), his regression line steepens and his R-sq improves. But subjectively cherry-picking which countries to exclude to make a theory look better is terrible statistics.

If you instead apply standard statistical rigor to the dataset—such as a 5% Windsorization, which objectively trims the extreme tails on both sides of the distribution rather than subjectively dropping two data points—the narrative collapses. The R-sq doesn’t improve; it drops by nearly 50%, falling to a meager 0.189. The trend is a fragile mirage entirely dependent on extreme outliers.

Error 2: Unnecessarily Complicating the Y-Axis

Worse, Reis unnecessarily complicates the inflation story. If you want to explain the consumer cost-of-living crisis, you should plot Consumer Price Inflation (CPI). But Reis didn’t do that. Because he is aiming to prove the Fiscal Theory of the Price Level (FTPL), his Y-axis uses a convoluted “debt impact” analysis, measuring how much the national debt was erased by unexpected inflation (the denominator effect).

It’s a niche academic debt metric, not a measure of household purchasing power. And it fundamentally distorts the data, hiding the mechanical effects of inflation on government balance sheets behind an accounting identity.

The Receipts: What Happens When We Clean the Data?

We can strip out these illusions. If we go to the IMF’s World Economic Outlook and Fiscal Monitor databases, we can rebuild this chart using the metrics that actually matter:

1. A Clean X-Axis: The Cyclically Adjusted Primary Balance, which explicitly strips out cyclical noise, inflation-tax windfalls, and interest payments to isolate the actual discretionary legislative choices made by politicians.

2. A Clean Y-Axis: The actual 5-year unexpected surge in pure consumer inflation, throwing out the convoluted “debt impact” math.

When you plot the clean structural data against actual consumer prices, the vaunted “fiscal mechanism” begins to breakdown even further. First, the full sample R-sq falls to only 0.08, weak sauce at best. Second, Windsorization now IMPROVES the outcomes, suggesting that there very well may be a mechanism with a similar coefficient (0.25) to the fabricated Reis’ result:

But the coefficient is far from statistically significant. You can always draw a regression line through a scatter plot—but if it collapses into statistical insignificance, you must look elsewhere.

Another method of testing this is to extend the regression into polynomial form. I’ve included a four-factor polynomial just for kicks, as it’s oddly shaped like my career trajectory and I always like to remind myself that this is the downslope, but the point remains — any higher order (2 factor, 3 factor, 4 factor, etc) regression suggests that there’s a “magic middle” fiscal deficit that drives unexpected inflation. Or maybe not. Because when we look at the countries, a different grouping falls out naturally:

This approach groups countries by WHY they experienced inflation. Estonia, Latvia, Lithuania, etc are all sitting on the front lines of the Russia embargo. Countries like the UK chose to subsidize domestic energy, keeping a lid on prices, but exploding deficits. Zero covid countries did zero covid things. And of course windfall exporters, e.g. Norway, experienced inflation largely as a result of economies booming due to oil exports. Asia? Safe havens? They remained structurally deflationary in a sea of elevated inflation. Can we rethink this chart even further and offend 90% of the world’s population in the process? Well, yes, this is YIGAF, and that’s our specialty:

The only trend I can actually identify that has any statistical validity is in the “increasingly European” path navigating between Scylla (unlucky) and Charybdis (stupidity). I’m sure my European readers are familiar with this trajectory. Relatively deflationary conditions persist in the “old.” And the United States? Really, the only country that aggressively engaged in fiscal stimulus? It’s sitting right in the center of the universe where Donald Trump thinks it belongs.

We can find statistical support for these groupings using the “coefficient of variation” — basically a test of “do groupings make sense?” If the coefficient of variance declines when data are grouped, it statistically suggests that the datapoints indeed share a common descriptive. If it increases versus the total sample, there is little evidence that the groupings are valid. This is exactly what we see — inflation CV falls when grouped. The same grouping results in an expansion of the deficit CV. This is yet another demonstration that Reis’s approach is completely wrong, and that deficits are not “the” driver of increased inflation. But then again, he’s in the UK, so fully in the grasp of the Charybdis whirlpool.

When you throw out the politics-contaminated math, the truth emerges. Inflation was a byproduct of who you relied on (Russia) and how stupid your politicians were. Both of these are solvable for almost any nation. Just not through deficit targeting.

Part II: The Fed’s “Flat Markup” Illusion

This kind of methodological blind spot isn’t isolated to academia’s fiscal theories. It’s exactly the same type of statistical gaslighting that the Federal Reserve Bank of San Francisco (FRBSF) used to confidently dismiss the “Greedflation” narrative.

During the inflation surge, critics argued that highly concentrated firms used the fog of global volatility to aggressively hike prices and pad their profit margins. In their May 2024 Economic Letter, the FRBSF attempted to put this debate to rest. They concluded that “aggregate markups... have stayed essentially flat” and that the post-pandemic path of markups “is not unusual compared with previous recoveries”. Therefore, they argue, corporate pricing power was not a main driver of the inflation surge.

To prove this, they plot the cumulative change in aggregate markups during the last four recoveries (1991, 2001, 2008, and 2020). To make the lines comparable, they index the start of the 2020 recovery to the exact moment the NBER declared the recession over (Q2 2020).

But treating the summer of 2020 like a normal business cycle trough is absurd. The economy wasn’t “recovering” in the traditional sense; it had been legally halted by government mandate and was waiting to be thawed by trillions in fiscal stimulus.

When you adjust for this and look at what happens when the economy actually reopens and the stimulus fully hits the system (starting in Q4 2020), the Fed’s “normal” narrative completely implodes.

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