--- title: "Stock market plummets 54%, stagflation strikes? Federal Reserve simulates extreme scenario of AI bubble burst" type: "News" locale: "en" url: "https://longbridge.com/en/news/276997470.md" description: "The Federal Reserve sets a \"severely adverse scenario\" each year for financial stress testing. The scenario for 2026 is set as a global economic recession, with the stock market dropping 54% and the VIX index soaring to 72%. The unemployment rate is expected to rise from 4.5% to 10%, with a collapse in real estate prices, nominal home prices falling by 29%, and commercial real estate dropping by 40%. The Federal Reserve suggests that a decline in risk appetite could lead to a severe recession, similar to the situations in 2000 and 2008" datetime: "2026-02-26T07:23:05.000Z" locales: - [zh-CN](https://longbridge.com/zh-CN/news/276997470.md) - [en](https://longbridge.com/en/news/276997470.md) - [zh-HK](https://longbridge.com/zh-HK/news/276997470.md) --- > Supported Languages: [简体中文](https://longbridge.com/zh-CN/news/276997470.md) | [繁體中文](https://longbridge.com/zh-HK/news/276997470.md) # Stock market plummets 54%, stagflation strikes? Federal Reserve simulates extreme scenario of AI bubble burst The Zhitong Finance APP noted that every year the Federal Reserve sets a "severe adverse scenario" to conduct stress tests on the financial system. The following is the severe adverse scenario for 2026: The Federal Reserve's severe adverse scenario for 2026 is set as: **A sudden decline in risk appetite triggers a global severe economic recession, leading to a significant drop in risk asset prices, a decrease in risk-free interest rates, and high volatility in financial markets.** In the first three quarters of this scenario, **the stock market falls by about 54%, while the U.S. market volatility index (VIX) soars, peaking at 72% in the second quarter.** These conditions also lead to an expansion of corporate bond spreads to a level of 5.7 percentage points. The ensuing chaos suppresses household demand for goods and services and prompts companies to significantly cut jobs and investments, with the economy and asset prices recovering slowly. The U.S. unemployment rate is expected to rise by 5.5 percentage points from a starting point of 4.5% in the fourth quarter of 2025, peaking at 10% in the third quarter of 2027. **The sharp contraction in economic activity leads to a collapse in real estate prices, including a 29% drop in nominal home prices and a 40% drop in commercial real estate prices.** Essentially, **the Federal Reserve suggests that a "sudden decline in risk appetite" could lead to a severe recession**—its transmission path seems to be through the negative wealth effect generated by a stock market bubble burst, with the unemployment rate soaring to 10% and subsequently triggering systemic credit events, leading to a housing bubble collapse. This is essentially also part of the pessimistic outlook of some analysts for 2026—a recessionary bear market accompanied by the bursting of the AI bubble. It is worth noting that the Federal Reserve formulates a severe adverse scenario and a baseline scenario every year. In almost all cases, the baseline scenario has proven to be correct—except, of course, in 2000 and 2008; in those two instances, the severe adverse scenario ultimately became a reality. Unfortunately, the macroeconomic situation in 2026 seems very similar to that of 1999-2000 and 2007-2008. ## Baseline Scenario First, the Federal Reserve's baseline scenario for 2026-2029 is essentially one of moderate economic growth, stable unemployment rates, and gradually declining inflation—in other words, the "Goldilocks" scenario. ![image.png](https://imageproxy.pbkrs.com/https://img.zhitongcaijing.com/image/20260226/1772089407752660.png?x-oss-process=image/auto-orient,1/interlace,1/resize,w_1440,h_1440/quality,q_95/format,jpg) According to this "Goldilocks" scenario, the Federal Reserve expects: 1) The 3-month Treasury yield will decline from 4.0% at the end of 2025 to 3.1% by the end of 2029; 2) The 10-year Treasury yield will gradually decrease, reaching 3.9% by the end of 2029; 3) The stock market will rise by 4.3% annually until 2029; 4) Nominal home prices will decline before the first quarter of 2027, then gradually rise until 2029; 5) Commercial real estate prices are expected to rise by 4.3% annually. Even in the Federal Reserve's "golden-haired girl" baseline scenario, there is not much comfort; the stock market is expected to perform poorly over the next three years, with an annual increase of only 4.3%. The Federal Reserve is likely aware of the bubble-like Shiller price-to-earnings ratio, and while the baseline scenario does not predict a bubble burst, it does forecast very modest performance, barely outpacing 3-month U.S. Treasury yields. ## Severe Adverse Scenario The Federal Reserve's severe adverse scenario predicts a significant recession, with the unemployment rate rising to 10% and the inflation rate dropping to 1.1%—which appears to be a typical deflationary recession. ![image.png](https://imageproxy.pbkrs.com/https://img.zhitongcaijing.com/image/20260226/1772089444830256.png?x-oss-process=image/auto-orient,1/interlace,1/resize,w_1440,h_1440/quality,q_95/format,jpg) Accordingly, in this scenario, the Federal Reserve would lower interest rates to near 0%, the 10-year yield would drop to 2.3%, the stock market would plummet by 54%, and real estate prices would also collapse. Credit spreads would widen sharply—this is a scenario similar to 2008. ## Global Stagflation and Dollar Appreciation However, the Federal Reserve's severe adverse scenario for 2026 is characterized by commodity price-driven stagflation. The global market shock in 2026 is marked by rising inflation expectations, while last year's global market shock was characterized by declining inflation expectations. In the current global market shock, yields on government bonds of all maturities are rising, whereas last year, yields were falling, with short-term yields declining more than long-term yields. In the global market shocks of 2025 and 2026, the dollar appreciates against most major currencies. In the current global market shock, due to inflationary pressures, prices of commodities such as gold, oil, and natural gas are rising, whereas last year's global market shock saw commodity prices decline. In the global market shocks of 2025 and 2026, credit spreads are widening, and stock prices are falling. ## How Likely is the Severe Adverse Scenario? The trigger for the adverse scenario in the U.S. is a "sudden decline in risk appetite." So, what could lead investors to seek safety in 2026? Additionally, the trigger for the global adverse scenario is commodity-driven inflation. What could lead to rising oil and gold prices in 2026? Firstly, the market is facing an unfolding AI bubble burst, temporarily masked by a rotation of funds into "value stocks." The unfolding AI bubble burst is dual: 1) mega-cap companies are depleting cash flows and borrowing to finance AI capital expenditures, while investors are questioning the return on this investment; 2) AI applications are disrupting many industries, including software. Ultimately, both will lead to credit events, with the current situation of Blue Owl unfolding. The Federal Reserve's adverse scenario predicts that the AI bubble burst could trigger a recession through negative wealth effects—and this is indeed very likely Secondly, investors are facing geopolitical situations, potentially an impending US-Iran war, which could trigger a surge in oil prices, a flight to safety into gold, and ultimately lead to a global recession. According to existing information, Iran is unwilling to completely abandon uranium enrichment, making this scenario quite likely. Therefore, the Federal Reserve's assessment of the high probability of severe adverse scenarios for the US and global economy is unsettling. ## Impact Although the S&P 500 index is close to historical highs, the VIX index is near 20, indicating that market participants are preparing for volatility. 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