Wall Street has been on guard about rumblings in the US financial system. Moody's Analytics Chief Economist Mark Zandi joins Yahoo Finance Live to weigh in on the state of the financial sectors and areas for concern following regional bank failures in early 2023.

Zandi states the system is “this engine that’s shaking under stress” of higher interest rates and does not predict stabilization until the yield curve evens out. Furthermore, Zandi expresses concern about liquidity risks in the US Treasury market, from ballooning debt and warnings of a potential “freezing up" on bonds. When asked about the reality of the public debt crisis, Zandi plainly states: "We're here."

For more expert insight and the latest market action, click here to watch this full episode of Yahoo Finance Live.

Video Transcript

JARED BLIKRE: There's been lots of concern in Wall Street notwithstanding all the talk about a soft landing or even no landing, about rumblings in the financial system. And that the Fed's tightening so far, which has been considerable over the last year plus, might break something. And in your notes, you're warning about the potential for an earthquake-- another earthquake in the financial system.

We had the mini banking panic earlier this year. What does that look like? And as-- far as you can tell, we can't predict black swans, but where might that come from?

MARK ZANDI: Yeah, that's the thing that really concerns me, you know, high rates, higher for longer putting a lot of pressure on the banking system and the financial system more broadly. I have this image in my mind of the financial system as kind of like this engine that's shaking under the stress of the higher interest rates. They, kind of, blew a gasket back last March.

And the Fed and Treasury, kind of, put the gasket back in and taped it up, but it's still shaking. And it's going to stay that way until we start to see rates come back in, the yield curve becomes more normally shaped. And so there's a lot of stress.

What actually breaks? Very difficult to know. I mentioned just one thing that I'm watching that makes me nervous. Is the liquidity-- so-called liquidity in the US Treasury market.

The Treasury market is very large. It's getting larger very quickly because of our large budget deficits and debt. But, kind of, the plumbing that's involved in making sure that trading is done in an orderly way so that there's buyers and sellers, and they can match up, and you know transact has not been able to keep up for lots of different reasons.

And I worry that at some point, we might see a freezing up of the Treasury market. And of course, that's really important for the entire financial system because everything is priced up, all the securities out there, all these stocks, and bonds, and everything else are priced off of US Treasuries. And if trading is disrupted there, that's a problem for all markets.

BRIAN SOZZI: Mark, is the public debt crisis here? Is this it?

MARK ZANDI: We're here. It's one thing when you have very low interest rates. The pressure to do things on the fiscal side are much less intense. You don't have to worry about it as much because you're just not adding to your interest expense. But now that rates are up, it's a big problem because debt plus higher rates means higher interest payments.

Here's a factoid for you, we're going to be paying soon more in interest expense on our debt than we do to fund our defense budget. I mean, that doesn't make any sense whatsoever. And so we've got to make some changes.

And if you look at current law, if we make no changes in tax policy or spending policy, it's just unsustainable. Our debt load is going to rise to a place where the interest rates are going to rise. The economy is going to cave under the weight of all of that, so we've got to make some changes. So I think we're here.

Now, obviously, we're not going to make any changes until the other side of the next election. But hopefully, soon after the next election, we get a little bit of clarity around what voters want and we can make some hard choices at that point. But we're going to need to do that.