Structural Macroeconomics: Fiscal Dominance & Liquidity Dynamics

Ernesto Keaney CRPS®, RFC®Chairman & CEO | January 05, 2026

2026 Deep Dive Analysis: Evaluating Systemic Liquidity and Sovereign Debt

From the KFSC Strategy Desk for clients who are invested in the KFSC Risk Managed Strategies, or prospective clients who are interested in our risk-managed strategies.

Why Read This? Our Client Analogy: Imagine a household where the monthly bills exceed the income. To keep the lights on, the family must use a credit card just to pay the interest on their mortgage. This works temporarily to maintain a lifestyle, but eventually, the math forces a hard choice: cut spending drastically or find a way to devalue the debt.

The U.S. economy is currently facing a similar structural issue known as "Fiscal Dominance." This report looks "under the hood" to explain why standard economic rules are breaking down and how this mathematical reality limits the Federal Reserve's options. Most importantly, it explains why we are specifically positioning the KFSC Risk Managed Strategies defensively, moving away from assets that rely on the "credit card" economy (such as general stocks) and into assets that have historically preserved wealth and purchasing power (like Gold and Silver) when the bill comes due.

To understand why our KFSC Macro Regime Model is actively signaling a "Stagflationary Breakout," we must look at the specific data conflict the system is processing. The model presents us with the data to support this diagnosis, but it is our analysis of these metrics that identifies two opposing forces working simultaneously: Growth is decelerating, visible in cracking labor data (Nonfarm Payrolls dropping to +64k) and a contracting manufacturing sector (ISM at 48.2), while Inflation is re-accelerating (evident in sticky Core CPI at 3.3% and surging commodity input costs). When the model aggregates these divergent inputs, it identifies a regime in which the real economy is stagnating, yet the cost of living continues to rise. This specific mathematical combination defines what we consider the Late Cycle / Recession phase, signaling a turbulent environment that requires a departure from standard investment strategies.

Crucially, we do not arrive at this conclusion by looking in the rearview mirror at "lagging" data, such as last quarter's GDP. Instead, our model analyzes the speed and direction of change. We calculate the first derivative (velocity) and second derivative (acceleration) of over 98+ different economic indicators. This allows us to see not just whether data is good or bad, but whether it is improving or deteriorating at a faster rate, providing a forward-looking view of the structural "Plumbing" of the financial system.

Current market data indicates a divergence where equity valuations remain elevated despite slowing economic growth. Our analysis suggests this may be driven by a structural phenomenon known in economic literature as Fiscal Dominance, a scenario where fiscal policy (debt and deficits) exerts a dominant influence over monetary policy capabilities [1].

1. Interest Expense Dynamics vs. Tax Revenue

A critical metric in our structural analysis is the relationship between federal interest outlays and tax receipts, often referred to as the Sovereign Solvency Ratio.

The Metric: U.S. Federal Interest Expense as a percentage of Tax Receipts.
Current State: As of late 2025, data indicate that annualized interest payments on the national debt have risen significantly. Projections from the Congressional Budget Office (CBO) suggest that interest costs are on a trajectory to consume a historically high percentage of tax revenues [2].
The Implication (Fiscal Dominance): Economic theory suggests that when interest expense consumes a substantial portion of revenue, the central bank faces constraints. Maintaining high interest rates to fight inflation becomes increasingly difficult if it risks exacerbating the fiscal deficit to unsustainable levels [3].
Market Interpretation: The resilience in gold prices (approx. $4,420/oz) [9] likely reflects market anticipation of Yield Curve Control (YCC). In this scenario, the Federal Reserve would cap long-term interest rates (e.g., preventing the 10-Year yield from exceeding a set limit) by committing to purchase unlimited quantities of Treasury bonds. While this ensures the government can afford its interest payments, the mechanism requires the central bank to expand the money supply aggressively to absorb the debt the market refuses to buy. Historically, as seen in the post-World War II era (1942-1951), this policy effectively subordinates the currency to the bond market, often leading to sustained negative real interest rates and currency debasement, an environment where hard assets, such as gold, typically outperform.

Client Analogy: The Variable-Rate Mortgage Trap. Imagine a family with a massive variable-rate mortgage. As long as interest rates are 3%, they can afford the monthly payment. However, if rates rise to 7%, the interest payment consumes their entire paycheck, leaving them with nothing for food or electricity.

The U.S. government faces a similar mathematical reality. If interest rates remain high, the cost of servicing the national debt consumes too much of the tax revenue. To prevent a default, the Federal Reserve effectively steps in to "fix" the rate lower by buying the debt itself with newly printed money. This saves the government from a possible bankruptcy, but the flood of new money devalues the currency, which is why hard assets like gold tend to rise in this environment.

2. Net Liquidity: Analyzing Asset Price Drivers
While the Federal Reserve's headline policy often focuses on the Fed Funds Rate, we analyze Net Liquidity to gauge the actual capital available to financial markets. We utilize a variation of the formula often cited by liquidity analysts:
Net Liquidity = Fed Balance Sheet - Treasury General Account (TGA) - Reverse Repo (RRP)
The Mechanism: Changes in the Treasury General Account (TGA) and the Reverse Repo (RRP) facility can offset or amplify Federal Reserve balance sheet operations. For example, if the RRP facility drains (money flows out of the Fed and into the banking system), it injects liquidity into the markets, potentially offsetting Quantitative Tightening (QT) [4].
Current Status: Despite official tightening measures, RRP drainage has historically acted as a liquidity buffer. This dynamic may help explain why equity valuations (Shiller CAPE ~38.7x) have remained resilient in the face of recessionary economic data, assets may be pricing in liquidity conditions rather than earnings fundamentals [5].
Client Analogy:The "Bathtub Effect". To understand "Net Liquidity," think of the stock market as a bathtub and money as the water inside it. The Federal Reserve controls the main faucet (the Balance Sheet). When they announce they are tightening policy, it sounds like they are turning the faucet off to lower the water level.
However, there are also reserve tanks attached to this tub—specifically the "Reverse Repo" (RRP) facility, which acts like a holding tank where excess cash is parked. Even if the Fed turns off the main faucet, if money flows out of that holding tank and back into the main tub, the water level (asset prices) can actually rise or stay high. This explains the disconnect: the Fed says they are draining the tub, but the hidden reserve tanks are leaking water back in, keeping stock prices floating high despite the stormy economic weather outside.
Understanding the Valuation Impact:The result of this hidden liquidity is that stock prices remain elevated even as the economy slows. Specifically, the S&P 500 is trading at a Shiller CAPE (Cyclically Adjusted P/E) ratio of ~38.7x. For context, the historical average for this metric is closer to 17x. [10] This means investors are currently paying more than double the historical norm for every dollar of corporate profit. This extreme premium suggests that market prices are being supported by excess liquidity rather than fundamental earnings growth, increasing the risk of a correction if that liquidity dries up.
3. Evolving Asset Correlations
For decades, US Treasuries functioned as a hedge against equity volatility (negative correlation). However, recent data suggests a shift in this relationship.
The Correlation Shift: In high-inflation or stagflationary regimes, stocks and bonds have historically shown positive correlation, meaning they can decline simultaneously. This phenomenon was observed in 2022 and appears to be re-emerging in our late-2025 data [6].
Strategic Consequence: If bonds become less effective as a diversifier for equities, traditional "60/40" portfolios may face higher volatility. Our framework suggests that in such environments, capital tends to seek diversification in Real Assets (Gold, Silver, Commodities), which have historically low correlations with financial assets during inflationary periods.
Client Analogy:The "Broken Seesaw". A traditional "balanced" portfolio (like the 60/40) is supposed to work like a seesaw: when risky stocks decline, safe bonds usually rise, keeping your account relatively stable.
However, in an environment of high inflation, this mechanic breaks. Inflation is detrimental to both stocks (due to higher costs) and bonds (as it erodes fixed payments). Instead of a seesaw balancing you out, the market becomes an elevator where both stocks and bonds can go down together. Because the "seesaw" is broken, we must look for a different stabilizer, which is why we utilize Real Assets like gold and silver that historically rise when paper assets fall.
4. Commercial Real Estate & Banking Liquidity
Our models also monitor stress within the banking sector, specifically related to the commercial real estate (CRE) maturity wall.
Refinancing Risk: A significant volume of CRE debt is maturing in an environment of higher interest rates. Regional banks, which hold a large concentration of this debt, face potential credit headwinds [7].
Liquidity Support Mechanisms: Historically, during periods of banking stress (e.g., March 2023), the Federal Reserve has utilized emergency lending facilities to stabilize the system.
Conclusion: Potential future liquidity injections to support the banking system could act as a form of monetary easing. We view precious metals as a potential hedge against the currency debasement risks associated with such systemic support measures.
Client Analogy:The "Teaser Rate". Cliff Imagine a business owner who took out a massive loan when interest rates were near 0%. It was easy to make the payments then. Now, the loan is due, and they have to refinance at 7% or 8%. Suddenly, the monthly payment triples, but their income hasn't changed.
This is what is happening in the Commercial Real Estate Sector. Trillions of dollars of debt are hitting this "refinancing cliff." If borrowers can't pay, the banks that lent the money take the loss. To prevent banks from failing, the Federal Reserve often has to step in and provide cash (liquidity). This keeps the system afloat but dilutes the value of the dollar, furthering the case for holding hard assets to help mitigate the impact on purchasing power.
Summary: The Sovereign Debt Dilemma
The current macroeconomic landscape presents policymakers with a complex trade-off, often described in academic literature as the "Trilemma" or debt trap.
Option 1:The "Hard" Choice (Fight Inflation) If the Federal Reserve keeps interest rates high to sustainably return inflation to target, the cost of paying interest on the national debt skyrockets. This is like a family whose credit card interest payments become so high that they crowd out money for groceries. If the government pursues this path, it risks a severe recession or austere budget cuts, which is politically difficult and historically rare [1].
Option 2:The "Soft" Choice (Financial Repression) The alternative is what economists refer to as "Financial Repression." In simple terms, this means the government keeps interest rates artificially low (below the rate of inflation) to make the debt more manageable to repay. While this saves the system from default, it acts as a "stealth tax" on savers, your money in the bank earns less interest than it loses to inflation. This erodes the real value of the debt but also erodes your purchasing power [8].
Understanding Our Current Allocations in the KFSC Risk Managed Strategies: History suggests that governments with high debt loads often lean toward the second option, allowing some inflation, to avoid defaulting on their debt. This historical probability is the driving force behind our Overweight allocation to Silver and Gold in the KFSC Risk Managed Strategies. We believe these assets can serve as a potential hedge against the risk of currency devaluation.
Sources & Data Citations:
Cochrane, J. H. (2023). The Fiscal Theory of the Price Level. Princeton University Press.
Congressional Budget Office. (2025). The Budget and Economic Outlook: 2025 to 2035. CBO.gov.
Sargent, T. J., & Wallace, N. (1981). "Some Unpleasant Monetarist Arithmetic." Federal Reserve Bank of Minneapolis Quarterly Review.
Board of Governors of the Federal Reserve System. (2025). Factors Affecting Reserve Balances (H.4.1 Release).
Howell, M. J. (2020). Capital Wars: The Rise of Global Liquidity. Palgrave Macmillan.
Bloomberg Finance L.P. (2025). Correlation of S&P 500 vs. US 10Y Treasury Bond (12-Month Rolling).
Federal Reserve Board. (2025). Financial Stability Report, October 2025.
Reinhart, C. M., & Sbrancia, M. B. (2011). "The Liquidation of Government Debt." National Bureau of Economic Research (NBER) Working Paper No. 16893.
TradingView. (2026). Gold Spot Price (XAUUSD) Data as of Jan 05, 2026.
Shiller, R. J. (2026). U.S. Stock Markets 1871-Present and CAPE Ratio. Yale University Department of Economics.
Important Disclosures:
This commentary is for informational purposes only and should not be considered a recommendation to buy or sell any security or the provision of specific investment advice. The opinions and forecasts expressed are those of Keaney Financial Services Corp. as of the date of this commentary. They are subject to change at any time based on market and other conditions and may or may not come to pass. The KFSC Macro Regime Model is a proprietary tool. Its analysis is based on historical data; however, it in no way guarantees future results or provides a guarantee against loss. Past performance is not indicative of future results.
The KFSCIF Framework and KFSC Core Macro Regime Model are analytical tools used to support decision-making. They are not automated systems that predict the future or dictate trades. All portfolio decisions are made at the discretion of the advisor based on their human interpretation of the data.
Investing in commodities, especially precious metals, involves increased risks, such as political, economic, and currency instability, and rapid fluctuations, which can lead to significant volatility in an investor's holdings. Commodities may not be suitable for all investors. All investing involves risk, including the possible loss of principal. Although important, asset allocation and risk management strategies do not guarantee generating profits or shielding against losses.
Allocation & Positioning Disclosures:
This commentary is not intended as investment advice for the general public. It is specifically tailored for clients invested in the KFSC Risk Managed Strategies only and does not apply to any other investments managed by our advisors at Keaney Financial Services Corp. outside of these specific models. The portfolios are dynamic and adaptive, managed with discretion, and can change without notice. Furthermore, it is essential to understand that the KFSC Risk Managed Strategies are implemented across a spectrum of distinct models, ranging from Conservative to Aggressive. While the overarching macro themes described in this commentary inform our firm-wide outlook, the specific asset class allocations, weightings, and underlying holdings differ materially between these models, aligning with their respective risk mandates.

Research Disclosure:

Our research and data may include contributions from paid non-affiliated markets, macroeconomic analysts, and economists. We have also incorporated multiple artificial intelligence (AI) platforms to assist us in researching, diagnosing, absorbing, analyzing, and illustrating data with greater efficiency. Because our management and strategies are data-driven, our goal is to utilize information that we believe to be accurate and validated across multiple sources, where possible. It is critical for clients to understand, however, that all data is subject to error and no amount of research or analysis can eliminate the inherent risks of investing or guarantee a specific outcome.