The S&P 500 index has increased by 82% over three years even as the Federal Reserve (Fed) has reduced its balance sheet by 27%.
The market anticipates an 86% chance of a 25 basis point rate cut this week. However, economic pressures and discussions about a change in Fed leadership may create uncertainty in policy direction.
Market performance outpaces traditional liquidity theory.
The rise in stocks during the tightening phase challenges long-held beliefs in the market.
Data shared by Charlie Bilello indicates an 82% increase in the S&P 500 while the Fed's assets have decreased by nearly a quarter.
This segmentation suggests that factors beyond central bank policy are currently influencing investor confidence. Analysts point to alternative liquidity sources supporting stock rises:
The fiscal deficit.
The strong share buybacks of companies.
Capital inflows from abroad, and
Stable bank reserves compensate for tightened monetary policy
EndGame Macro explains that markets respond to expectations about future policies, not just current balance sheet levels.
However, the increases will be concentrated among very large technology companies, masking the weakness of the sectors tied to core economic fundamentals.
Psychological liquidity is also important. Markets respond to anticipated policy changes, not just current conditions. This forward-looking mindset can drive stocks higher even if the Fed is in a tightening stance.
Economic tension is overshadowed by stock profits.
The strength of stocks obscures deep economic stress, with corporate bankruptcies nearing a 15-year high as borrowing costs rise, while credit card, auto loan, and student debt burdens increase.
Commercial real estate is impacted by declining asset values and stringent refinancing conditions. This pressure is not reflected in leading stock indices, as smaller companies and riskier sectors are less mentioned, weakening the relationship between index performance and overall economic health.
This divergence indicates that the stock market reflects the strength of large companies primarily. Firms with strong balance sheets and less consumer risk tend to perform well, while those relying on credit or unnecessary spending face obstacles.
This economic gap complicates the U.S. central bank's mission, while leading stock indices suggest easy financial conditions. Fundamental data reveal tight pressures affecting various parts of the economy.
The Fed's reputation is under pressure close to a rate cut.
Many investors and analysts are questioning the direction and effectiveness of the Fed. James Thorne explains that the Fed has become too large and lagging, suggesting not to rely on Fed statements for market signals.
Treasury Secretary Scott Bessent shared intense criticism in a recent discussion.
The Fed is becoming a baseline income for PhD economists. I don’t know what they are doing wrong all the time... If air traffic controllers did this, no one would board a plane, one user reported, citing Bessent's remarks.
These views reflect growing skepticism about the Fed's ability to predict economic conditions and respond promptly. Critics say policymakers often lag behind the market, leading to uncertainty.
Nevertheless, the market anticipates a 25 basis point rate cut this Wednesday.
Uncertainty in leadership and inflation risks.
Changes in leadership at the Federal Reserve increase volatility in predicting policy direction. Kevin Hassett is seen as a potential replacement for Jerome Powell, known as a moderate. Hassett may bring looser policies that could raise inflation expectations.
This trend has shifted the bond market, with U.S. 10-year Treasury yields rising as investors gauge whether a new leadership could lead to higher inflation under a relaxed monetary policy. In addition to short-term cuts, the market is also pricing in a more accommodative stance.
Investors expect another 25 basis point rate cut twice in 2026, likely in March and June. If Hassett becomes Fed Chair soon, it could sideline Powell's responsibilities.
This transition makes the Fed's guiding policy difficult to predict as the market focuses on the upcoming leadership change.
This uncertainty arises as the Fed tries to manage slightly above-target inflation while the economy remains strong amidst tight financial conditions. Policy missteps or mis-timing could easily lead to a resurgence of inflation or an unnecessary economic downturn.
Historical trends provide some context. Charlie Bilello points out that bull markets tend to last five times longer than bear markets, highlighting the value of compounding returns over market timing.
The recent increase may continue, but profit-taking focused on a single point, economic stress, and uncertainty about the Fed’s approach makes it unclear if the market can maintain such strength when monetary policy changes.