The S&P 500 has risen by 82% over three years even as the Federal Reserve (Fed) has reduced its balance sheet by 27%.
Markets expect an 86% chance of a 25 basis point cut this week. However, economic stress and discussions about changes in Fed leadership may make policy paths less clear.
Market Performance Exceeds Traditional Liquidity Theories
The stock rally during a period of quantitative tightening has challenged long-standing market beliefs.
Data from Charlie Bilello shows that the S&P 500 has risen by 82% while Fed assets fell by nearly a quarter.
This divergence shows that factors outside of central bank policy are now affecting investor confidence. Analysts highlight alternative liquidity sources driving the rally:
Budget deficit,
Strong corporate buybacks,
Foreign capital inflows and
Stable bank reserves countering quantitative tightening.
EndGame Macro explains that markets react to expectations of future policy, not just current balance levels.
But gains are concentrated in a few mega-cap tech companies. Therefore, headline market results mask weaknesses in sectors tied to core economic fundamentals.
Psychological liquidity is also significant. Markets react to expected policy changes, not just current conditions. This forward-looking mindset allows stocks to rise even when the Fed maintains a tightening line.
Economic strains hidden by stock gains
Strong stock performances mask deeper economic stress. Corporate bankruptcies are approaching 15-year highs as borrowing costs rise. At the same time, consumer delinquencies on credit cards, auto loans, and student loans are increasing.
Commercial real estate is affected by declining property values and tougher refinancing conditions. These pressures are not visible in top stock indices, as smaller firms and vulnerable sectors are underrepresented. The relationship between index performance and broader economic health is now much weaker.
This gap suggests that stock markets primarily reflect the strength of large corporations. Firms with strong balance sheets and limited consumer dependence tend to perform well, while others dependent on credit or discretionary spending face headwinds.
This economic gap complicates the Federal Reserve's task. While major stock indices suggest easy financial conditions, underlying data reveals tightening affecting many areas of the economy.
The Fed's reputation is under pressure as rate cuts approach
Many investors and analysts are now questioning the Fed's direction and effectiveness. James Thorne described it as bloated and slow and emphasizes that one should rely less on Fed comments for market signals.
Finance Minister Scott Bessent expressed sharp criticism in a recent discussion.
"The Fed is becoming a universal basic income for PhD economists. I don’t know what they are doing. They are never right… If air traffic controllers did this, no one would board a plane," a reported user stated, quoting Bessent.
These perspectives show increasing doubts about the Fed's ability to foresee economic swings and act swiftly. Critics argue that policymakers tend to lag behind the markets, creating uncertainty.
Still, the market expects a 25 basis point cut this week on Wednesday.
Leadership uncertainty and inflation risks
Changes in leadership at the Federal Reserve increase volatility in policy forecasts. Kevin Hassett is the likely successor to Jerome Powell. Known for his dovish stance, Hassett may implement a more relaxed policy that could raise inflation expectations.
This possibility has impacted the bond markets. The 10-year yield on government bonds has risen as investors consider whether a more accommodative monetary policy under new leadership will increase inflation. In addition to short-term cuts, markets are also pricing in an overall tone of easing.
Investors expect two additional rate cuts of 25 basis points in 2026, likely in March and June. If Hassett becomes Fed Chair as early as February, Powell's remaining time could lead to him being sidelined.
This transition makes the Fed's policy guidance less predictable as markets focus on the upcoming change in leadership.
This uncertainty arises as the Fed attempts to manage modest inflation above target and a resilient economy under tighter financial conditions. Missteps in policy or timing could easily revive inflation or cause unnecessary economic deterioration.
Historical trends provide some context. Charlie Bilello notes that bull markets typically last five times longer than bear markets, emphasizing the value of compound interest over market timing.
The ongoing rise may continue, but concentrated gains, economic pressures, and doubts about the Fed's strategy make it uncertain whether the markets can remain this resilient as monetary policy evolves.