How this bull market could unravel and what to watch for, according to Larry McDonald

The recent stock market rally and the surprisingly resilient U.S. economy are reliant on an uneasy balancing act between the U.S. Treasury market, the oil market and struggling regional banks, according to one bestselling author and market risk expert.

Larry McDonald, author of “A Colossal Failure of Common Sense” about the downfall of Lehman Brothers, told CNBC that another spike in inflation could have major repercussions through the U.S. economy.

The price of oil is a likely candidate for that rebound in inflation, McDonald said, which could then push long-term bond yields higher in a way that puts even more pressure on regional banks.

“If oil rips here, like 20 bucks from here, it’s going to wipe out one of these big regional banks because the long end will go up,” he said. Many regional banks have a high amount of long-term bonds and loans on their books that will go down in value if yields rise.

McDonald’s warning, and his new book, “How to Listen When Markets Speak,” come with the stock market hovering just under record highs and the Dow Jones Industrial Average flirting with the 40,000 level.

The rally in equities has continued in the first quarter of 2024 despite signs that inflation could be sticky, another flare-up in the regional bank sector, and continued conflict in the Middle East that could threaten oil production.

Part of the reason for the rather calm rally could be the actions of U.S. policymakers, according to McDonald. He said the U.S. Treasury under Secretary Janet Yellen is “very dangerously, but brilliantly” issuing a lot of short-term debt to fund the U.S. government, which is helping to keep long-term rates stable.

“Yellen is piling in, for like the last year and a half, into short-term Treasurys, and she’s sucking the volatility out of the market,” he said.

But a spike in oil prices would push up inflation expectations and, therefore, the long end of the Treasury curve, according to McDonald, potentially pushing the U.S. economy into recession.

“There’s massive financial condition tightness on the consumer level, whereas financial conditions on the corporate level are relatively easy. … If inflation really picks up again, it’s going to start to go up to the middle class consumer and trigger recession,” he said.

McDonald has built a career on identifying and discussing big risks in the market, including with his investing newsletter, The Bear Traps Report. He previously worked at Lehman Brothers and ran an investing newsletter around convertible bonds.