The equity markets are currently priced at historical highs, and the short-term sentiment looks optimistic, stimulated by renewed optimism over a potential United States-China trade truce. Adding to this optimism is a softer-than-expected inflation print in the US and growing expectations of another Federal Reserve rate cut. But this apparent calm is based on fragile foundations; if shackled, they can bring enormous pain to the economy.

The US financial system is operating under conditions of extreme systemic imbalance, characterised by a dangerous feedback loop where structural weaknesses amplify short-term risks. The Economic Policy Uncertainty (EPU) is currently higher than it was at the time of the Great Financial Crisis (GFC) of 2007, market momentum is reliant on a small number of technology sector firms with extreme valuations, the heightened level of debt-to-GDP ratio has made the sovereign funding structure hyper-sensitive to an interest rate rise, political pressure on the Fed threatens to trigger fiscal dominance and hence distancing the Fed from its primary goal of price stability.

The current upward trend in the financial market is heavily concentrated, mainly driven by a few large tech giants, which are fewer in number, and reliance on such a narrow set of companies has resulted in significant concentration risks. This whole optimism can wash away with small disruptions in the performance of the organisation lying in the set of the magnificent 7. Any severe correction within them would transmit an outsized, systematic impact across major indices.

Furthermore, the US market exhibits extreme overvaluation based on the stock market capitalisation-to-GDP ratio, otherwise called the Buffett indicator, and the cyclically adjusted price-to-earnings ratio (CAPE), also known as the Shiller Ratio. The first metric compares the total market value of all publicly traded US companies to the nation’s annual economic output. Based on this standard, the US market exhibits extreme overvaluation in the US financial history, even higher than the dot-com era reading. The Buffet Indicator’s current reading is at an all-time high at 221.40% while generally reading above 120% suggests that the market is overvalued.

The Shiller Ratio, developed by economist Robert Shiller, is a crucial long-term valuation metric which averages corporate earnings over 10 years to smooth out business cycle fluctuations. The current reading of the Shiller Ratio is 39.99, which is near its highest level of 44.20 reached in 1999 around the dot-com bubble.

The US federal government has accumulated a massive debt of a massive amount, $36 trillion, which is 20% higher than the economy’s nominal GDP and exceeds the combined output for the next four big economies. The debt-to-GDP ratio stands at 119% by the second quarter of 2025, which is more than double the dot-com bubble numbers, and the Congressional Budget Office (CBO) expects it to increase to 135% by the year 2035.

The CBO has estimated a $1.8 trillion deficit for fiscal year 2025, and projects that the deficit will further increase to $2.7 trillion by the year 2035, while the average deficit between 1974 and 2025 stands at $3.8 billion.

The most immediate operational constraint is the soaring cost of debt service, as net interest payments have reached $841 billion, already exceeding Medicaid and second only to Social Security. The composition of lenders has also changed so much over time, as currently 80% of the debt is held by the market, thus making it highly sensitive to market fluctuations.

The sheer volume and composition of the debt make the government acutely vulnerable to a rise in interest rates, which would translate into higher bond yields, resulting in a greater share of public spending wasted in the form of interest payments. By the end of 2025, about a third of marketable debt, worth $9.2 trillion, would have matured, with a further $9 trillion maturing in 2026. The CBO expects annual payments to reach $1.8 trillion by 2035, totalling $13.8 trillion over the next decade.

This condition gives the federal government a greater incentive to pressure the Fed to tighten monetary policy, as elected politicians inherently favour low rates to boost the economy and secure short-term output gains – for example, the recent episodes of the US president publicly pressurising the Fed chairman to cut rates. This political compulsion is not merely driven by a desire for short-term economic stimulus, but also crucially by the overwhelming need to alleviate the soaring cost of servicing the $36 trillion national debt.

Lower rates dramatically reduce the government’s mandatory interest payments, offering a perceived short-term fix to the underlying fiscal insolvency. This phenomenon of fiscal dominance can result in major inflationary pressure, which will eventually force the central bank to raise interest rates, which will not only cause output loss but will also lead to increased payments for debt servicing. The political pressure to ease monetary policy during the Nixon administration increased the price level strongly and did not cause positive effects on the real economic activity (Drechsel, 2024).

The US News-based EPU has remained at high levels, after easing from its peak in April 2025 that followed the Liberation Day. The surge reflects rising institutional unease, from public broadsides against the Fed to the ousting of the Bureau of Labour Statistics chief, and a subtle drift towards a new era of protectionism. Conventional economic theory and empirical evidence suggest that a rise in policy uncertainty should unsettle investors, sending volatility higher. But for the past few months, that pattern appears to have broken as uncertainty is high, but the CBOE Volatility Index (VIX) is not showing massive deviations on average. The low VIX signals near-term market show complacency based on short-term optimism because of increased investments in artificial intelligence, contrasting sharply with the deep structural problems.

The explosion of a bubble in the US economy will most likely have direct spill-over effects on Pakistan’s economy. The United States is the biggest export partner of Pakistan, with almost 15% of total export production in FY25. Any recessionary pressure in the US would weaken consumer demand and directly reduce export earnings for Pakistan, like the sudden decline during the COVID-19 lockdowns, when exports to the US dropped by about $238 million during the first lockdown, and the recovery was sluggish post-COVID.

The deceleration of this kind would result in a current account deficit, pressurising the exchange rate, and may undermine recently gained macroeconomic stability for Pakistan. Besides, investor uncertainty that arises with a shrinking economy in the US will normally cause global portfolio rebalancing, which can spark outflow of foreign investment, further escalating the probability of rupee depreciation and can trigger an inflationary wave.

Ateeb Akhter is a visiting professor of economics at Grand Valley State University, Allendale, Michigan and Khanzaib Ahmad is a research assistant at the Economic Growth and Forecasting Lab at IBA