Why the 2026 Credit Cycle Won’t Look Like 2025 (Or the Last 15 Years)

One of the fundamental principles that I think about when I'm beginning to enter

into a new year is that the ideas that gave me an edge in the previous year can

very easily imprison me in the new year that's coming in the new period of time that we're entering. And so as we progress into the new year, one of the

things that I've talked about as you enter into the end of December is to take a moment and to reflect a little

bit about what exactly happened in 2025 so that you set the stage to make good decisions in 2026.

And what I want to cover today is why the 2026 credit cycle won't look like

2025 or the past 15 cycles. And so I'm going to walk you through the different divergences that you want to think about

so that you can have a very clear thought process as we enter 2026. The

main idea is that the 2026 credit cycle will be the year where copying last year is the worst possible strategy. And we

actually have a very unique setup to create the conditions for that type of thing. Let me summarize a little bit

thing. Let me summarize a little bit about what is exactly trained the way that we think and created certain

patterns in our heads about what will work in 2025. the market really got everyone

with the entire idea of inflation from tariffs. The entire inflation in the as

tariffs. The entire inflation in the as a response to tariffs, you can see in one year inflation swaps right here where you have them rise as we move into

the whole tariff dynamic. They're

elevated and then more recently they've begun to collapse. One of the ideas that has actually been misinterpreted by the market is that that was only driven by

tariffs and not the demand side of the economy. If you'll remember that

economy. If you'll remember that inflation swaps actually began to rise last or in 2024, not 2025. And they

began to rise as soon as the Fed started with a 50 basis point cut, which was too aggressive at the time. So we had

inflation really rise and then collapse and more recently collapse and the absence of uh government data has kind of mass that a little bit. So people are

not really taking that as seriously as they should. Everyone thought that the

they should. Everyone thought that the higher inflation was a massive issue or whatever their narrative what they came

up for it was. And when you look at the input of inflation into real interest rates, this is one of the things that drove the rally. You know, the expectation in the market was that as

real interest rates have been falling over the last even year and two years.

This has been one of the critical drivers of risk assets to the upside.

especially from April to May when we began to set a top in real interest rates and move down that actually drove

equities and pushed them to new highs which is one of the reasons why I've been talking about hey this shift in inflation that's taking place has begun

to push real interest rates higher and so the capital moving out the risk curve that took place between April and October of this past year when I was calling for

the credit cycle and explaining how capital is moving out the risk curve that has begun to shift a little bit.

And so this, you know, blindly buying the S&P 500 or whatever stock that you wanted and people just printing money, that period of time really set a bias in people that, hey, if you just buy these

stocks, you can begin to do incredibly well no matter what. and a lot more capital concentrated there as opposed to places like crypto. And as a result, you had capital moving out the risk curve.

And this is the Goldman Sachs mega cap versus nonprofitable tech index. You had

capital move out the risk curve. When

this line is moving down, it's an indication that people are buying nonprofitable tech over mega caps. And

so what we saw over the last year is a move down in this index which indicates capital moving out the risk curve. And

we've begun to consolidate at these lows. So during this time we really had

lows. So during this time we really had capital move out the risk curve over the last year right here. And this began to

create a bias and a mindset in people that hey as long as you know the Fed is being moderately accommodative or something like that cuts being priced in

the forward curve means risk assets rally. As I've said, there's going to be

rally. As I've said, there's going to be a moment in the future when the Fed cuts rates and equities keep going off a

cliff because the amount of disinflation in the system is actually greater than the amount of liquidity that the Fed is providing by rate cuts. That's why,

going back to the one-year inflation swap chart, that's why watching this is so important right now. And so the movement of capital at the risk curve

has overlapped with actually the movement down in labor market which is the labor market beginning to loosen more and now we're sitting at almost zero. You know all the people that were

zero. You know all the people that were talking about the labor market is collapsing for the last three years now.

Um, again, they're not really timing their models or trying to create an idea that actually has some type of falsifiability so that they can make

returns in markets. As we approach this zero bound in NFP and the three-month rate of change in NFP and we begin to see real interest rates rise, that's why

you can actually have some shifts in equities and a little bit of a pullback, which is actually one of the drivers we've seen over the last couple of months and I would say month or so with some of the pullbacks in equities. Those

have been driven by a very specific reason. And if you don't know that

reason. And if you don't know that reason, then you don't know why they could actually fall potentially. And so

that is one of the important drivers to understand right now. And so, you know, the labor market was resilient enough in 2025 for rate cuts to be bullish. That

has shifted. And you will begin to notice that if people just try to buy a dip just because the Fed is going to cut, it might not work in the same way

that it did in 2025. The other thing is that 2025 really implanted this idea in people's minds about the dollar and we

had the initial move down right here in the dollar and you had equity sell off on the tariff announcement but we had the dollar continue to fall and that began to push up equities just because

of how crossber flows function. You can

have the dollar fall and equities fall or the dollar fall in equities rally depending on the source of flows. And

you have begun to see a lot more complacency where people think that oh the dollar is just going to continue to support risk assets which in my view if you have the dollar make

another leg lower that could actually begin to create headwinds for risk assets. And then the other thing in 2025

assets. And then the other thing in 2025 is that everyone believes that the high valuations in the S&P 500 beget higher

valuations. One of the key things that

valuations. One of the key things that we have seen is valuation expansion, not earnings, but valuations expand in the S&P 500. On the lefth hand side, you

S&P 500. On the lefth hand side, you have the price to sales ratio bands for the S&P 500. We're at an all-time high in terms of price to sales ratios. And

then just the outright price to sales ratio going back over the last 30 years, we are at an all-time high in terms of valuations for the S&P. And so this has

created a mindset for people that okay, valuations don't really matter. And all of the guys who are value investors that keep screaming for a top because of valuations, they've basically been

discredited. And what's important to

discredited. And what's important to understand about valuations is that you don't want to misunderstand the signal from just the language that

we're using or the quantification we're using to price ideas. Valuations are a reflection of liquidity. They expand and contract based on liquidity. There's

this old school idea that they expand or contract based on market irrationality.

There is really on a broad market basis no evidence for that at all. And so when you actually begin to test that thesis and say, "Oh, does valuations just rise?

Is just Mr. Market mispricing everything that's taking place?" We don't really see evidence for that, especially when you look back over a long enough period of time. The key thing for valuations

of time. The key thing for valuations here is that as you have liquidity begin to balance out, which we have seen, you've seen real rates rise, changes in

liquidity have a larger impact on risk assets when the level of valuations is higher. And so 2025 has brought together

higher. And so 2025 has brought together a lot of unique factors that create people to think that these certain guard

rails that exist for where risk assets are going to move are kind of firm in place and they're beginning to build complacency around that. And the danger

isn't that 2026 is going to be a hard year. It's that 2025 taught you the

year. It's that 2025 taught you the wrong lessons for the next regime.

That's the risk that can take place right here. And so there are three

right here. And so there are three reasons that I want to cover how 2026 is not like the 2010s to 2024 and especially not like 2025. And I'm going

to lay that out for you. The first point is we have a different starting point.

We're entering 2026 with a a totally different combo of policy rate, term premium, and sovereign balance sheet than we had coming into 2025. You will

notice that moving into 2025, we had inflation swaps rising as the Fed was pausing. When you have that happen, real

pausing. When you have that happen, real rates fall. And what does that do? That

rates fall. And what does that do? That

puts more liquidity into the system.

We're actually seeing the opposite now where inflation swaps are falling faster than the Fed is cutting, which is pushing real rates higher. And on top of

that, we have much steeper yield curves, which means that long-end interest rates, you have had the Fed cut rates marginally, but long interest rates are

still at these levels. And now we have real rates at these higher levels, which I'm going to cover this in a moment, but understanding that mechanism is the

critical factor for January in 2026.

And so the yield curve is significantly steeper than it was. We move back and forth between bear steepening, bull steepening, some steepener twists and things along those lines as the S&P 500

has made new highs this year. And then

as we move into the end of this year, several critical things began to set the stage for bigger moves. The key thing was rate rate cut pricing for 2026

functionally blowing out across every major country even in the US a little bit. These are the M6 to M7 contracts

bit. These are the M6 to M7 contracts which is just pricing rate cuts or hikes between March of 2026 and March of 2027.

So in the lines up here you can see the Euro zone, Australia, the UK, Canada, you have all these major countries and

what we have is these curves blowing out. The US is down here in blue. You

out. The US is down here in blue. You

had that move up and price less cuts as we moved into the end of this year which is you know in my view an unwinded positioning where everyone thought oh 2026 is going to have a bunch of rate cuts because we're replacing Powell.

that can still happen, but we just un unwound a lot of the positioning from that. And so you had rate, you know, the

that. And so you had rate, you know, the expectations for cuts blow out and you actually are having hikes get priced in these other countries while you still have cuts get priced on a marginal basis

in the US. So that is setting the stage for a much bigger move especially in January in my view. There's also a different transmission mechanism. That's

the second point. The way rate of changes and liquidity uh pulses hit banks, private credit, and funny markets next year is not going to rhyme with

2025. One of the main drivers for that

2025. One of the main drivers for that is that we are seeing higher real interest rates not only on two-year real interest rates, but also 10-year real interest rates right here, which are

both rising right now. This means that inflation expectations are falling faster than nominal rates. And so the net result is that's putting more

downward pressure on growth. Now, that

wouldn't be a big deal if growth was really strong right now. The problem is when we look at any of the real-time consumption data, we're actually just

next to the lower bound for contraction.

That is a big issue because when growth is really strong, the economy can handle higher rates. But when growth is at the

higher rates. But when growth is at the lower bound and almost negative, any type of rise in real interest rates will begin to push equities off a cliff. And

that's the risk that you really need to manage in 2026. Very different than 2025. Very different. And then the third

2025. Very different. And then the third point is that the 2025 uh you know riskreward or you know 2025 really rewarded a neutral to short bond

behavior. Right? Right when we came out

behavior. Right? Right when we came out of that entire positioning in the tariff drawd down getting short bonds was just one of the clearest kind of signals and

plays by January 2026 this is likely to reverse so 2025 was all about being short or neutral bonds now that's beginning to reverse as we move into

2026 the key thing is not just saying oh let me blindly buy bonds there's actually some really specific signals to time that and to understand the drivers behind it because you'll notice that as

We are moving into this new section of the end of the year and then into January. We actually have complacency in

January. We actually have complacency in a lot of positioning. Credit cycles are back, excuse me, credit spreads are back down. You have in blue here the implied

down. You have in blue here the implied ball for the HYG ETF. And then the move index just made a new low in terms of bond volatility. Those are all setting

bond volatility. Those are all setting up for a lot more complacency, especially in the interest rate complex as we're moving into January when you

have the compression of, you know, the riskreward beginning to form. On top of all of this, we have the forward curve

pricing a 17% chance of a cut in January, which is pretty hawkish in my view. You know, that should be much

view. You know, that should be much closer to a coin flip. And so you have that as we move into this year as well.

And so when you begin to pull these ideas together, there are new rules for 2026 that you want to begin to think about. You want to anchor decisions to

about. You want to anchor decisions to the path of policy and liquidity, not just the levels because we are at an incredibly elevated level of valuations

right now. And we also have inflation

right now. And we also have inflation expectations falling. So the rate of

expectations falling. So the rate of change and the policy path is going to be critical. You want to begin to think

be critical. You want to begin to think about 2026 as a multi-regime year, not a smooth extension of 2025.

And then finally, you want to size exposure by credit and liquidity regime first before you begin to pick assets second because you could have shifts in

interest rates that help risk assets for a short period of time and then hurt risk assets for another period of time.

So, those are several of the key factors that you want to begin to think about as you're beginning to wrap your mind around these changes that are taking

place in 2026 and the divergences from 2025. Like I said at the beginning, you

2025. Like I said at the beginning, you know, the ideas that really gave you an edge in one year can imprison you in the next year simply because you have this

bias in your mind that, oh, if I just, you know, do these specific things, I keep getting paid for them, so let me just keep doing that and keep sizing up.

That begins to face issues when you have a shift in the macro regime. And so what I want to do is I'm going to pull together all of these different moving

parts, rules, and ideas, tangibly connect them to a full regime map, scenario tree, and positioning map. And

I'm going to connect them to all the in-house trading view models for the Capital Flows community member in a live stream on Monday at market close. So

I'll be laying out the 2026 macro regime playbook. It's a closed dooror live

playbook. It's a closed dooror live stream event for everyone who's a paid subscriber on the Substack. It'll be

Monday at market close wherever you're watching this video. The link for it for the live stream will be linked below and you can join that and be able to go

through and walk through all of the different types of ways that we are beginning to see divergences from 2025 and how that sets up for things in 2026.

And if you were in person in the live stream and there after market close, you can ask any question that you want and I will walk through that in real time. And

then on top of that, wherever you're watching this below uh where the live stream event is, it will be recorded.

You can also send me a message if you want me to talk about something specifically in the live stream. So all

of that will be re reserved exclusively for paid subscribers on the Substack.

I'm gonna continue to put out research so that you have a big picture view about what is taking place, especially as it relates to interest rates because here's the thing I'll say. 2026 will be

all about understanding interest rates as they relate to growth. That will be the lynch pin that determines if we move into a bare market in equities or if we continue to melt up further in the

credit cycle. So, if you are new to the

credit cycle. So, if you are new to the Substack, there is an entire list of educational primers on the main page of the Substack. There's a playbook on the

the Substack. There's a playbook on the credit cycle, path dependency framework, the S&P, Bitcoin, interest rates, uh an entire macro development thesis playbook, an entire list of book

recommendations, and then on the main page right here, they're all in a single spot for you to easily access on the main page. If you just go to the capital

main page. If you just go to the capital flows research.com page, click on this main article right here. If you go through all of those, that will begin to set a framework to for you to be able to

think about how the macro regime is developing from a fundamental basis. And

then as you want to pull together all those moving parts, you can become a paid subscriber on the substack if you want to. So those are the main ideas

want to. So those are the main ideas that I wanted to lay out in this session. And as a reminder, you know,

session. And as a reminder, you know, you really want to begin to think about how did the ideas that help me in 2025

potentially set the stage to hurt me if I don't begin to examine their underlying drivers and the potential biases that I have moving into the new

year. Simply analyzing that and reducing

year. Simply analyzing that and reducing your rate of air can significantly put you in a better spot for taking big bets in 2026.

And with that, I will catch you guys on the live stream and I will see you soon.