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Even With Cuts, The Fed Is Braking into a Slowdown: R-Star, Output Gaps, and a Return of QE

• Real interest rates are sitting above the economy’s natural pace just as growth slips below potential, a late-cycle setup that historically forces the Fed into easing whether it wants to or not.
  
  
• At the same time, the Fed’s (un)surprising $40B-a-month liquidity injection may help lift asset prices even as the real economy continues softening underneath.

What you need to know: Real interest rates are still sitting far above the economy’s “natural” level - basically its organic speed limit - at the same time the output gap is turning negative, a combo that signals the Fed may be running tighter than the slowing economy can¹. 

Why it matters: This is the point in the cycle where the economy is sending signals the Fed can’t ignore. Real rates - adjusted for inflation - remain above the economy’s natural pace just as growth slips below trend, meaning the slowdown is already happening through softer hiring, weaker demand, and fading pricing power. The longer policy stays tighter than the economy can absorb, the higher the risk that overtightening turns a normal slowdown into something harsher. Put simply, the Fed still has its foot on the brake even though the engine is already losing power.

Now the Deep Dive: These are the kinds of economic phrases that sound like they belong in a PhD dissertation, not with your morning coffee. Most people tune them out - and honestly, who can blame them?

But buried inside that jargon are signals that actually tell us where the economy may be heading.

And right now, those signals are flashing.

So, let’s break it down without the academic nonsense.

I’ve written before about the natural rate of interest, but the gist is that every economy has a natural real interest rate - basically the rate it would settle at on its own without Fed interference. Not too stimulative, not too tight - just right.

Economists call it r-star. Nobody can see it or even agree where it actually sits, but it’s there – and the Fed still uses it because it matters.

Here’s a way I like to think of it. Imagine the economy like a house with a natural temperature level it will settle at without any tampering with the thermostat.

• If the Fed sets the thermostat too high, the house overheats.
• If it sets it too low, the house freezes.

And that’s the key - the Fed can only influence the economy by moving rates above or below that natural temperature.

A simple example: if the economy is anemic because birth rates are low, households aren’t spending, and companies aren’t hiring - the Fed may cut rates below where they think r-star is to heat things back up via cheaper loans to boost demand. And if the economy runs too hot, the Fed hikes above r-star to cool things back down.

Now layer that onto the sinking output gap, which measures whether the economy is running above or below its potential growth rate.

• Positive gap = engine running hot
• Negative gap = engine losing power

So, when real rates remain well above r-star at the same time the output gap turns negative, you get a worrying mix. The Fed still has its foot on the brake even though the engine is already slowing.

And you can see it everywhere - hiring is cooling, wage growth is softening, pricing power is fading.

Which makes the Fed’s latest move even more interesting.

Yes, they cut rates again on Wednesday (by 0.25%), and it was a contentious cut as many Fed governors dissented (more trouble in paradise?). But the real story here is that they announced $40 billion a month in T-bill purchases starting December 12^th - effectively expanding their balance sheet (aka “money printing”)².

They insist it isn’t Quantitative Easing (QE), but liquidity is liquidity, and pumping reserves back into the banking system eases financial conditions whether they admit it or not (and likely a tailwind for markets).

• I’ve recently argued that shrinking bank reserves would leave the Fed little choice but to restart QE sooner than most anticipated. This week’s $40B-per-month T-bill buying shows that moment has arrived.

So now we’re in a strange moment where:

• The economy is weakening (negative output gap)
• Real rates are still too tight (theoretically above r-star)
• And now, liquidity is rising (QE)

This is where markets and the economy start telling two different tales - the economy says, “we’re slowing,” but liquidity says, “asset prices can still push higher.”

Thus, while r-star and output gaps sound like dry textbook terms, they’re actually showing real-world warnings about where we are in the cycle. And right now, they’re telling us the Fed’s easing hasn’t been enough.

You don’t need to be a theory expert to understand r-star. You just need to know it exists.

And that’s the edge, right? Paying attention to the things everyone else assumes don’t matter. 

Figure 1: New York Federal Reserve Bank, December 2025

China’s Record $1 Trillion Trade Surplus Signals Weak Demand at Home — and Trouble for Everyone Else

• China’s record-shattering trade surplus isn’t a sign of strength as the mainstream preaches - it’s evidence of collapsing domestic demand as Chinese consumers fail to absorb the goods China keeps producing.
  
  
• With the U.S. importing less, China’s export firehose is now pointed at Europe — and Brussels may respond with tariffs of its own to avoid being flooded by underpriced Chinese goods.

What you need to know: China just posted a record year-to-date trade surplus above $1 trillion, driven not by booming strength at home, but by weak domestic demand and a flood of exports now spilling into the rest of the world as U.S. demand dries up³. 

Why it matters: A growing surplus isn't just a sign of an export-driven economy - it’s the mark of one that cannot generate enough internal demand to absorb what it produces. The U.S. used to be the giant bucket that caught China’s export firehose, but with American imports from China down nearly 30% year-over-year, that water now spills into Europe, Africa, Southeast Asia, and Latin America – pushing up their national deficits. And Europe, already struggling with industrial decline and political pressure, is not willing to become China’s new bucket.

Now the Deep Dive: China’s record-breaking $1 trillion year-to-date trade surplus looks impressive at first glance (and it is) – but when you realize why it exists, it’s troubling.

See, a chronic surplus is really a sign of domestic weakness, showing that Chinese households and businesses aren’t buying enough to absorb what they produce.

• Put simply, China isn’t exporting because it can - it’s exporting because it must. Otherwise, its growth would sink, firms would close, and layoffs would surge.

Thus, this makes China’s surplus a global issue.

Why? Because a $1 trillion surplus somewhere means a $1 trillion deficit somewhere else. And with the U.S. importing far less - down nearly 30% year-over-year - the glut is spilling onto everyone else.

• Think of America as a giant bucket and China as the hose. For decades, the U.S. bucket was big enough to catch China’s export water flow without flooding the yard (the rest of the world). But today the bucket is catching less, and the hose hasn’t slowed (it’s actually gotten worse). Now the extra water is drowning the garden - flooding into Europe, Southeast Asia, Africa, and Latin America.

And that’s where the problems start.

Europe is increasingly becoming the “new bucket” as it has the wealth and scale.

And it’s not happy about it.

• European automakers, green-tech firms, and industrial manufacturers have been warning for years that China’s export machine - fueled by state subsidies and excess capacity - is wiping out pricing power across entire sectors.
  
  
• Brussels has already launched multiple anti-subsidy investigations into Chinese EVs, solar equipment, and batteries.
  
  
• EU leaders like Ursula von der Leyen and Emmanuel Macron are now openly discussing tariffs and “strong measures,” calling the situation a “life-or-death” threat to European industry⁴.

This may all sound familiar - because I wrote a few months ago about the E.U. gearing up for its own trade war with China - effectively forcing Beijing into a two-front battle (against the U.S. and the E.U.).

This is an offensive strategy designed to keep China from exporting its economic weakness to everyone else - because fundamentally, a gigantic trade surplus like that shows us that China can produce far more than its own citizens can afford to consume.

This imbalance forces Beijing to “push the excess abroad.” And when every major economy is trying to protect its own industries, that creates friction - and friction creates policy.

So yes, while China is hitting its 5% growth target. But it’s doing so through exports, not domestic strength - and that distinction matters.

This weakness doesn’t stay inside China. It spills outward, at a discount, container after container, until other countries push back.

Such a massive surplus makes one thing clear - further confrontations aren’t just “possible.” They’re becoming inevitable.

Because when one country wields the firehose and everyone else has small buckets, the garden always floods

Figure 2: FT, December 2025

Governments Are Drowning in Short-Term Debt – And That’s a Problem

• Bond investors are refusing to buy long-term government debt, cornering countries into short-term borrowing that must be rolled over constantly — leaving trillions exposed to whatever interest rates the future brings.
  
  
• By relying on short-term debt, governments have essentially turned their finances into a global adjustable-rate mortgage, where even a small flare-up in inflation could send borrowing costs soaring overnight

What you need to know: Bond markets are now forcing governments into short-term borrowing, pushing trillions of debt onto the shortest maturities⁵ - a setup that might be cheap today but becomes explosive when all that debt must be rolled over at whatever interest rates the future holds⁵.

Why it matters: Borrowing short-term might look cheaper right now, but it makes governments dangerously exposed to rate spikes. If inflation rises or central banks hike again, countries will be forced to refinance enormous sums at higher rates - think trillions suddenly costing much more. It’s like swapping a fixed 30-year mortgage for an adjustable one right before the lender resets the rate. This situation doesn’t just raise borrowing costs - it makes fiscal crises more likely, more sudden, and harder to contain. 

Now the Deep Dive: Governments around the world are shortening the maturity of their debt because investors don’t want to take the long-term risk anymore.

Why not?

Because inflation is sticky, and there’s a ton of debt being added (increasing the supply = pushing rates higher). Meanwhile, the usual big “whales” (central banks, pension funds, insurers) aren’t buying like they used to.

Put simply, long-term investors don’t want to risk inflation spiking or a tidal wave of debt pushing the long end up - making their bond face values collapse (leading to their own issues).

The U.S., U.K., and Japan - three of the world’s biggest debtors - are leading the way here.

• The U.K. slashed long-dated bond sales down to near a record low⁶.
  
  
• Japan is issuing more short-term bills after investors dumped its super-long bonds⁷.
  
  
• The U.S. Treasury is leaning more heavily on T-bills as deficits swell (interestingly, as I noted in topic 2, the Fed announced that it will begin buying $40B worth of T-bills each month – helping fund the government).

In fact, the average maturity of global government bonds has fallen to just 8.8 years - the lowest since 2014, and it’s been dropping steadily since 2021.

Thus, governments are choosing the only door left open - the short end of the curve.

But that door comes with a catch – a dangerous one.

Short-term debt must be rolled over constantly.

And rolling over trillions every few months is like refinancing your mortgage every quarter and hoping rates don’t blow up in your face.

If inflation flares, if central banks get hawkish, or if bond markets demand a premium from the glut of bonds being issued - governments will feel the hit immediately. Not decades from now.

That’s the risk long-term investors worry about - today’s “cheaper” borrowing turns into tomorrow’s fiscal stress crisis.

• Although for investors who can hold to maturity, the long end still offers juicy yields

The point is, such growing dependence on short-dated borrowing can turn government finances into something far more fragile and far more sensitive to rate swings.

• Aka the more debt that sits at the front end of the curve, the more governments are at the mercy of whatever rates bond markets decide to throw their way.

Something to keep in mind.

Figure 3: Bloomberg, December 2025

Anyway, who knows how this will all play out?

This is just some food for thought as we watch how these trends develop.

We’ll be keeping a close eye on things. Enjoy the rest of your weekend.

Sources:

1. https://www.newyorkfed.org/research/policy/rstar
2. https://www.bloomberg.com/news/articles/2025-12-10/fed-says-it-will-begin-treasury-bill-purchases-on-dec-12
3. https://apnews.com/article/china-trade-tariffs-trump-exports-953ab5e9056cf7b21c00c54bec1d79dd
4. https://www.bloomberg.com/news/articles/2025-12-07/macron-warns-eu-may-hit-china-with-tariffs-over-trade-surplus
5. https://www.bloomberg.com/news/articles/2025-12-03/uk-and-japan-lead-global-government-exodus-from-long-bond-sales
6. https://www.lse.co.uk/news/uk-cuts-costly-long-dated-gilt-issuance-again-raises-t-bill-sales-bisv5rgk7ux18ct.html?utm_source=chatgpt.com
7. https://www.japantimes.co.jp/business/2025/11/28/economy/extra-budget-bond-issues/

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