The Market’s Liquidity Cushion May Be Getting Tested

Highlights

• Abundant liquidity may be one explanation for the stock market’s resilience despite rich valuations, persistent inflation, slowing economic conditions, widening fiscal deficits, and geopolitical volatility — though that resilience may become increasingly fragile if Treasury yields continue climbing.
• There appears to still be a significant amount of cash supporting risk assets. US M2 money supply, a broad measure of the total amount of money circulating in the US economy, remains above roughly $22 trillion today, versus approximately $15 trillion before COVID in 2019 — an increase of roughly $7 trillion in system liquidity. Put differently, average household liquidity in the US — effectively cash available across the system — increased by roughly $50,000 since COVID.
• Importantly, it appears that much of that excess liquidity ended up with wealthier households that already own most financial assets. Because this group is generally more active in financial markets, a disproportionate share of the post-COVID cash surge may have flowed back into equities and gold rather than into consumption.
• One concern is that much higher long-term Treasury yields could start changing that behavior. At some point, higher yields and borrowing costs could make paying down debt and locking in yield appear more attractive than allocating additional capital to equities and gold.
• The move in Treasury yields may become increasingly meaningful. The 10-year Treasury is now trading at almost 4.6%, up from roughly 4.1% at the start of the year. Outside of the brief post-COVID inflation shock, these are the highest sustained levels seen since before the Global Financial Crisis. A continued move toward a sustained 5% yield could become a much more serious test for liquidity-driven asset prices.
• Strong cash flow, solid balance sheets, pricing power, durable economic moats, and selective exposure to long-term AI growth themes are likely to contribute to favorable outcomes.

Expensive Market, Weak Macro — Still Strongly Supported by Cash

On a pure macro basis, the current equity market could arguably be trading at disproportionate levels.

Valuations remain elevated by historical standards. Inflation appears to have shown signs of reaccelerating during 2Q26, with the latest CPI and PPI releases both pointing toward renewed upward pressure in the inflation pipeline. At the same time, economic growth is slowing, fiscal deficits continue widening, and the geopolitical backdrop remains unstable. More importantly, there is still little evidence that inflation pressures are meaningfully reversing.

Yet equities continue finding support.

One possible explanation is that there remains substantial liquidity in the system.

The post-COVID liquidity surge created an enormous amount of excess capital that continues circulating through financial markets. Even after several years of rate hikes and quantitative tightening, M2 money supply remains roughly $7 trillion above pre-pandemic levels — the equivalent of roughly $50,000 per US household in additional liquidity since COVID.

Importantly, much of that liquidity appears to have accumulated among higher-income households and investors with significant financial asset ownership. Because this cohort is also the most active in markets, the marginal dollar may have continued flowing disproportionately toward equities and gold rather than toward consumption.

Adding to this effect, a growing portion of market inflows is now effectively automatic — from retirement contributions to passive ETFs and systematic strategies. Because most of that money is deployed through market-cap-weighted vehicles, the largest stocks keep attracting a disproportionate share of the flows, helping support index levels even as the broader macro backdrop may be deteriorating.

That liquidity dynamic may help explain why:

• market pullbacks continue finding buyers,
• volatility spikes remain relatively short-lived, and
• richly-valued sectors continue trading at elevated multiples despite weakening macro conditions.

Equities may continue trading broadly sideways around current levels over the near term.

But “sideways” does not necessarily mean calm.

The range can still become increasingly violent as markets swing between:

• abundant liquidity acting as support, and
• macro deterioration acting as resistance.

So far, liquidity appears to have remained a dominant factor.

When Higher Treasury Yields Start Changing Behavior

The market’s excess liquidity has continued flowing outward into equities, gold, and other financial assets because, for some investors, the alternatives have simply not been attractive enough.

But that equation can change if Treasury yields continue moving materially higher.

The key point here is not that “higher rates are bad for stocks.”

An important issue is that higher long-term yields can begin changing how investors think about debt itself.

Today’s financial system is carrying both:

• enormous liquidity, and
• enormous debt loads.

Inflation may have helped soften the burden of carrying that debt. As long as inflation stays relatively high and borrowing costs remain manageable, carrying debt is not particularly painful in real terms. In that environment, investors may remain more inclined to continue allocating capital toward equities, gold, and other appreciating assets.

The leverage component inside equities also matters here.

Investor margin debt currently sits around $1.2 trillion according to the latest FINRA data, near historical highs and up from roughly $850 billion–$900 billion two years ago. As long as financing costs remain manageable and asset prices remain elevated, the system has thus far been able to support a significant amount of leverage.

In fact, current leverage ratios still appear relatively healthy largely because equity collateral values themselves remain extremely high.

However, that dynamic could reverse.

If Treasury yields continue rising, markets face pressure from both directions at the same time:

• financing costs move higher,
• while asset prices themselves become more vulnerable to multiple compression.

That combination matters because falling collateral values and rising borrowing costs tend to reinforce each other.

At some point, investors stop asking:

“Where can I chase returns?”

and start asking:

“Why don’t I just pay down debt that is getting this expensive?”

That behavioral shift could become significant.

Because at that point, liquidity no longer keeps recycling back into financial assets.

Instead, the marginal dollar increasingly goes toward:

• reducing leverage,
• paying down debt,
• locking in yield, and
• strengthening balance sheets.

That is one mechanism through which higher Treasury yields could reduce liquidity within the system.

And unlike geopolitical headlines or temporary inflation spikes, Treasury yields directly compete with equities and gold for capital allocation.

That is why the recent move in the long end may be important for markets.

The 10-year Treasury is now trading at almost 4.6%, up from roughly 4.1% at the start of the year, while the 30-year Treasury has climbed above 5%. Outside of the brief post-COVID inflation shock, these are the highest sustained levels seen since before the 2008 Global Financial Crisis.

If the 10-year Treasury sustainably pushes through 5% — and especially if the 30-year Treasury continues moving deeper into a 5-handle toward 6% —the risk of a broader liquidity-driven repricing across equities and gold could increase materially.

A 5% 10-Year Treasury Is No Longer a Fringe Scenario

At the start of the year, a move toward 5% still looked like a relatively low-probability tail scenario. Today, the combination of persistent inflation, rising long-end yields, and growing fiscal pressure may make that outcome appear more plausible.

The key issue is that inflation appears to be reaccelerating while long-term yields are rising more slowly than inflation expectations themselves.

In other words, real rates may not actually be tightening as much as nominal yields suggest.

That matters because if inflation continues drifting toward the mid-3% range — and especially if markets begin fearing a return toward 4% inflation — then a sustained 4.5%–5% 10-year Treasury yield stops looking particularly restrictive.

In fact, it can become increasingly accommodative in real terms.

That creates a difficult problem for the Federal Reserve.

The market still largely expects the Fed to avoid aggressive tightening as growth slows. But if inflation continues firming while liquidity remains abundant, simply keeping the front end unchanged may not be enough to meaningfully tighten financial conditions.

At that point, the pressure could shift toward:

• maintaining restrictive policy for longer,
• continuing quantitative tightening, and
• allowing long-term rates to rise further if necessary.

In other words, the policy debate may gradually shift from:

“When does the Fed cut?”

toward:

“How much tightening is actually required to absorb excess liquidity?”

That distinction could become increasingly important for asset prices.

Because if the market begins realizing that structurally higher long-term rates are needed to restrain inflation and cool liquidity-driven asset appreciation, the adjustment process across equities and gold could become much more volatile than investors currently expect.

Stocks Still Have Support. The Risk Is What Happens If It Breaks.

Liquidity appears to remain abundant, while passive flows continue to provide support, and there is still a meaningful amount of cash capable of cushioning pullbacks.

But at current valuations, the downside risks may outweigh upside potential if liquidity conditions begin tightening more aggressively.

The market is already pricing in a very supportive environment:

• elevated valuations,
• resilient liquidity,
• manageable inflation, and
• no major disruption to financing conditions.

At the same time:

• inflation appears to be firming again,
• growth looks to be slowing,
• fiscal deficits remain large, and
• geopolitical conditions remain generally unstable.

Yet despite all of that, markets continue trading near elevated levels largely because liquidity continues outweighing macro concerns in market pricing. That may leave relatively limited room for additional upside from multiple expansions alone, even if liquidity conditions remain as supportive as they have been over the past couple of years.

The downside scenario, however, could be more significant.

If inflation continues firming and the Fed is ultimately forced to absorb more liquidity through prolonged quantitative tightening and restrictive policy, financial conditions could tighten materially faster than markets currently expect. And the bigger risk may be even more uncomfortable: that long-term Treasury yields continue rising regardless of the Fed’s preferred stance.

Because once the long end begins repricing independently:

• borrowing costs rise,
• refinancing pressure increases,
• leverage becomes harder to carry, and
• liquidity-driven asset appreciation becomes harder to sustain.

That could be a scenario in which the market stops behaving like a liquidity-driven trading range and starts repricing more violently around fundamentals and financing conditions.

Importantly, this does not require a recession. It simply requires long-term yields rising far enough to begin changing investor behavior around leverage, debt, and risk-taking.

That is why the current setup may present an unfavorable risk asymmetry:

• limited upside if liquidity merely remains abundant,
• but potentially significant downside if higher Treasury yields begin draining that liquidity out of the system.

Positioning: Favor Cash Flow, Avoid Pure Duration

Over the past several years, gold has increasingly behaved less like a classic “risk-off” asset and more like a liquidity barometer supported by abundant capital, negative real rates, and momentum-driven flows. If liquidity conditions tighten meaningfully, gold may not provide the diversification many investors expect in the short term.

Pure long-duration growth equities, particularly where valuations depend heavily on distant future cash flows and continued multiple expansion may remain especially vulnerable.

Companies and sectors with the following characteristics are likely to perform favorably:

• strong current cash generation,
• durable balance sheets,
• pricing power,
• hard-asset exposure, and
• near-term earnings visibility.
  

These include cash-producing technology businesses — particularly companies with dominant platforms, real profitability, and AI-driven demand support — rather than speculative growth stories dependent on cheap capital.

In an environment where liquidity becomes scarcer and financing costs rise, markets may increasingly favor current cash flow and balance-sheet strength over distant promises of future growth.

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