The S&P 500 has risen 82% in three years, even as the Federal Reserve (Fed) reduced its balance sheet by 27%.
Markets are anticipating an 86% chance of a 25 basis point rate cut this week. However, economic tensions and rumors about changes in Fed leadership could make policy directions less clear.
Market Performance Outperforms Traditional Liquidity Theories
The rally in stocks during a period of quantitative tightening has challenged long-held market beliefs.
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Data shared by Charlie Bilello shows that the S&P 500 rose 82%, while Fed assets fell by almost a quarter.
This separation suggests that factors outside central bank policies are now influencing investor confidence. Analysts highlight alternative liquidity sources driving the rally:
- fiscal deficits,
- Strong corporate buybacks,
- Foreign capital inflows, and
- Stable bank reserves offset the quantitative adjustment.
EndGame Macro explains that markets react to expectations of future policies, not just current balance sheet levels.
However, the gains are concentrated in a handful of mega-cap technology companies. As a result, overall market performance masks sector weaknesses tied to core economic fundamentals.
Psychological liquidity is also significant. Markets respond to anticipated policy changes, not just current conditions. This forward-looking mindset allows stocks to rise even as the Federal Reserve maintains a restrictive stance.
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Economic tensions obscured by stock market gains
Strong stock performance masks deeper economic stress. Corporate bankruptcies are approaching their highest level in 15 years as borrowing costs rise. At the same time, consumer delinquencies on credit cards, auto loans and student debt are increasing.
Commercial real estate is being hit by falling property values and tighter refinancing conditions. These pressures are not reflected in the main stock indices, as smaller companies and vulnerable sectors are underrepresented. The link between index performance and overall economic health is now much weaker.
This split suggests that stock markets primarily reflect the strength of large companies. Companies with strong balance sheets and limited consumer exposure tend to perform well, while others that rely on credit or discretionary spending face headwinds.
This economic division complicates the Federal Reserve’s task. While major stock indices suggest relaxed financial conditions, underlying data reveals tightening pressures affecting many areas of the economy.
Fed’s reputation comes under pressure as rate cut nears
Many investors and analysts now question the direction and effectiveness of the Federal Reserve. James Thorne described it as bloated and backward, urging to rely less on the Fed’s comments for market signals.
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Treasury Secretary Scott Bessent shared harsh criticism in a recent discussion.
“The Fed is becoming a universal basic income for economists with PhDs. I don’t know what they do. They are never right… If air traffic controllers did this, no one would get on a plane,” one user reported, quoting Bessent.
These outlooks show growing doubts about the Federal Reserve’s ability to forecast economic turns and act quickly. Critics argue that authorities tend to lag behind markets, fueling uncertainty.
Still, the market expects a 25 basis point cut this week on Wednesday.
Leadership uncertainty and inflation risks
The change in leadership at the Federal Reserve adds volatility to policy forecasts. Kevin Hassett leads as Jerome Powell’s likely replacement. Known for his dovish stance, Hassett could adopt looser policy that could raise inflation expectations.
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This prospect has sent shockwaves through bond markets. The 10-year Treasury yield has risen as investors weigh whether looser monetary policy under new leadership will push inflation higher. Beyond short-term cuts, markets are also pricing in a broader tone of accommodation.
Investors expect two additional 25 basis point rate cuts in 2026, likely in March and June. If Hassett takes over as Fed chair in February, the remainder of Powell’s term could put him on the sidelines.
This transition makes the Fed’s policy direction less predictable as markets focus on the upcoming leadership change.
This uncertainty arises as the Federal Reserve attempts to manage modest above-target inflation and a resilient economy under tighter financial conditions. Policy or timing errors could easily reignite inflation or cause avoidable 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 compounding returns over market timing.
The current rally could persist, but concentrated gains, economic stress and questions about the Federal Reserve’s approach leave it unclear whether markets can remain as resilient as monetary policy evolves.
