Editor’s note: A version of this article originally appeared on 3-Circle Investments on Aug. 7, 2023. 

Warning: Investors seem to have a new appreciation for the current and expected fiscal situation.

Deficits are growing for as far as the eye can see. The Treasury has reminded the market how much borrowing needs to occur in the second half of the year. Fitch has reminded markets that the U.S. fiscal situation continues to deteriorate. Bill Ackman and Bill Gross reminded markets that there is money to be made shorting Treasuries. It seems like perhaps we have crossed the Rubicon here – and investors are starting to feel tremors in the bond market.

So where do we go next? Unfortunately, there really is only one way to fix the deficit situation in the current dysfunctional political environment in D.C.

There is no appetite for cuts to entitlements or defense spending, the only two line-items that can really make any difference on the spending side. There is no appetite for raising taxes on corporations or the wealthy despite ample room to do so. So that only leaves the interest expense item for the U.S. government, which is basically driven by the interest rate policy of the Federal Reserve.

Rate Cuts to Fix the Deficit?

The Fed is rapidly getting to a point where it may be forced to lower interest rates to save the U.S. government’s deficit situation. It may have to do so before slaying the inflation dragon. Cutting rates prematurely to save the government would lead to a significant devaluation of the U.S. dollar and reignite an inflationary reality again.

However, continuing to hike and hold interest rates at high levels will only make the government’s fiscal situation that much worse.

There is another potential way out of this, but no one is going to like to it. It involves allowing the market to do the job for the Fed to get it to a point where it can justify cutting rates. This involves a significant deterioration in risk asset prices to break this inflationary heat. The Fed is going to have to let this episode of bond market weakness exacerbate from here, destroying some more regional banks and over-levered overseas U.S. dollar borrowers along the way.

Inflation expectations are already creeping back higher again on the combination of the above Treasury supply situation and recent belief by the Fed of the “golden path” to an “immaculate disinflation.” The bond market is sniffing out a reality of the Fed going too soft on tightening now. Headline inflation expectations are rising again on back of gasoline’s rally. June CPI print was an interim low with July moving higher and August likely higher again.

This back-up in yields is going to continue and will hit equity multiples and credit spreads at a rapidly accelerating pace over the coming months. This portends a nasty risk-taking environment.

Brace for a Stock Market Crash

Given currently historic valuations, as risk premiums and term premiums rise, it’s not going to take a lot to topple this whole thing over. The Fed needs to let it happen; break the back of inflation while the real economy avoids a cataclysmic fall. Main Street gets a small victory as real wages rise, asset prices reset lower, and we move on to the next phase of the cycle.

In other words, a stock market crash could be coming. Retail investors need to get their house in order. Strong gains in stock markets so far this year need to be protected now. This would be a great time to reduce overall equity exposure or to add index puts or inverse stock ETFs in order to hedge gains. As volatility rises, the unwind of year-to-date gains could be swift and fierce. Investors also should feel comfortable shifting some of their capital into cash, money market funds or short-term Treasuries where 5%-plus yields are paying you handsomely to wait things out.

Protect and live to play another day.

On the date of publication, Craig Shapiro did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.