The S&P 500 has risen by 82% over the past 3 years, and the Federal Reserve has reduced its assets by 27%.
The market expects a 25bp interest rate cut possibility of 86% this week. However, economic stress and discussions about changes in the Fed leadership may make the policy direction unclear.
Market performance exceeds traditional liquidity theory
The stock rally during the quantitative tightening period has challenged long-standing market beliefs.
According to data shared by Charlie Bilello, the S&P 500 has risen by 82%, and Fed assets have decreased by nearly 1/4.
This divide suggests that factors outside central bank policy are now influencing investor confidence. Analysts highlight other sources of liquidity that triggered the rally.
Fiscal deficit,
Strong corporate stock buybacks,
Foreign capital inflows,
Stable bank reserves offset quantitative tightening.
Endgame macro explains that markets react to expectations about future policy, asserting that the current balance sheet level is not everything.
However, profits are concentrated among a few mega-cap tech companies. Thus, major market performance masks weaknesses in sectors related to core economic fundamentals.
Psychological liquidity is also important. The market reacts to anticipated policy changes rather than the current situation. This forward-looking mindset can also drive stocks up when the Fed adopts a tightening stance.
Stock market rise... economic tension
Strong stock performance masks serious economic stress. With borrowing costs rising, corporate bankruptcies are nearing a 15-year high. Meanwhile, consumer delinquencies on credit cards, auto loans, and student loans are also increasing.
Commercial real estate is affected by declining property values and challenging refinancing conditions. These pressures are not reflected in major stock indexes because small businesses and vulnerable sectors are underrepresented. The connection between index performance and overall economic health has now weakened significantly.
This divide shows that the stock market primarily reflects the strengths of large corporations. Companies with solid balance sheets and limited consumer exposure perform well, while those reliant on credit or discretionary spending face headwinds.
These economic gaps complicate the Federal Reserve's challenges. While major stock indexes suggest easy conditions in financial markets, the underlying data reveals tightening pressures affecting many areas of the economy.
Fed credibility under pressure... imminent interest rate cuts
Many investors and analysts are now questioning the Fed's direction and effectiveness. James Son describes this as an overstated and lagging curve, urging the Fed to rely less on market signals in their commentary.
Treasury Secretary Scott Bessent recently shared sharp criticisms in a discussion.
"The Fed is becoming a universal basic income for PhD economists. I donโt know what they are doing. They are never right... If an air traffic controller acted like this, no one would get on a plane." A user reported, quoting Bessent.
This perspective indicates growing skepticism about the Fed's ability to anticipate economic transitions and act swiftly. Critics argue that policymakers tend to lag behind the market, exacerbating uncertainty.
Still, the market expects a 25bp rate cut on Wednesday.
Leadership uncertainty and inflation risks
The leadership change at the Federal Reserve adds volatility to policy outlooks. Kevin Hassett is likely to replace Jerome Powell. Known for his moderate stance, Hassett could bring loose policies that raise inflation expectations.
This outlook has impacted the bond market. The yield on 10-year Treasury bonds is rising. Investors are assessing whether the eased monetary policy under new leadership will increase inflation. Beyond short-term cuts, the market reflects a broader atmosphere of adjustment.
Investors expect two additional 25 basis point rate cuts in March and June 2026. If Hassett becomes Fed Chair in February, Powell's remaining term may limit his actions.
This transition makes the Fed's policy guidance less predictable, and the market is paying attention to the changing leadership.
This uncertainty arises as the Fed tries to manage mild inflation and a robust economy under stricter financial conditions. Mistakes in policy or timing could easily lead to economic deterioration that inflation can pull or avoid.
Historical trends provide some context. Charlie Bilello notes that bull markets typically last about five times longer than bear markets, emphasizing the value of compound returns.
The current rally may sustain, but concentrated profits, economic stress, and questions about the Fed's approach make it unclear whether the market can maintain such resilience as financial policies evolve.