Macro Analysis: The Fed's Quiet Pivot: Contradictions, Valuations, and the Anatomy of a Fragile Rally

Thoughts on the Market by Andy Krieger

May 11, 2025

The Federal Reserve has ended quantitative tightening, resumed balance sheet expansion, and held rates steady, all while inflation remains above target for the sixth consecutive year. Equity valuations sit at levels exceeded only once in modern history. Inflation expectations are deteriorating on every time horizon: University of Michigan 1-year expectations reached 4.7–4.8% in April before easing slightly to 4.5% in preliminary May data, while 5-year expectations have climbed to 3.4–3.5% — well above pre-pandemic norms of roughly 2.3–2.8%. The Fed's last remaining claim to credibility — that long-run expectations were anchored — is increasingly difficult to sustain with a straight face. Meanwhile, every major peer central bank is either hiking or preparing to hike in response to the same inflationary shock. One could be forgiven for concluding that the Fed's commitment to price stability has been reduced to consistent lip service.

What follows is a data-grounded examination of that contradiction, and its implications for markets, consumers, and FX… but never fear, fellow traders: a variety of trade ideas can be found at the end of this report.

The Balance Sheet: What the Data Actually Shows

The Federal Reserve's balance sheet peaked at $8.94 trillion in April 2022, swollen by pandemic-era asset purchases. From June 2022, the Fed began quantitative tightening (QT), allowing securities to roll off the balance sheet at a capped monthly pace. That process ran for 42 months and removed approximately $2.4 trillion — roughly 27% of peak assets — before ending on December 1, 2025, with the balance sheet standing near $6.5–6.6 trillion.

Critically, the balance sheet did not contract to its pre-pandemic level of roughly $4.2 trillion. In addition, the current balance sheet is nearly $6 trillion more than it was before the Great Financial Crisis. With only half of the pandemic expansion reversed, the Fed clearly didn’t finish its job. From the trough to today, the balance sheet has expanded by roughly $140 billion — modest in dollar terms, but significant as a directional inflection: the Fed has moved from active tightening to active maintenance and marginal expansion. Clearly, the Fed has been following a very different agenda than the one it publicly professes.

What the Fed Is Actually Buying

The nature of the purchases matters. Beginning December 10, 2025, the Fed initiated "reserve management purchases" — buying short-duration Treasury bills (maturities of one year or less) to maintain ample banking system reserves and to keep short-term rates near the target range. This is not QE in the 2020 sense: the Fed is not buying long-duration bonds or mortgage-backed securities to suppress long-term yields. It is, however, a net addition of liquidity to the financial system.

Simultaneously, maturing MBS holdings continue to roll off and are reinvested into Treasury bills rather than replaced with new MBS. Over time, this reshapes the composition of the balance sheet toward shorter-duration assets, thus reducing the duration footprint while maintaining overall size.

Inflation: Six Consecutive Years Above Target

U.S. inflation has remained above the Fed's 2% target continuously since March 2021, and is now in its sixth consecutive year of overshoot. Core PCE, the Fed's preferred measure, stood at 3.2% in March 2026, re-accelerating from 3.0% in February and remaining sharply above target. The April 2026 FOMC statement acknowledged that "inflation is elevated, in part reflecting the recent increase in global energy prices." Driven by the Iran conflict's disruption of the Strait of Hormuz, oil prices rose roughly 70% from late February to early April, which has reignited concern about a second inflation wave before the first has fully subsided. One obvious question for the Fed is how many times it can attribute inflationary pressure to "one-time" effects before the excuse loses credibility entirely. What is inflation, after all, if not a sustained higher level of prices, regardless of whether the rise came from one trigger or many?

Inflation Expectations: The Anchoring Narrative Is Fraying

The Fed's traditional defense against accusations of policy failure has been that long-run inflation expectations remained anchored, implying that consumers and markets still trusted the Fed to eventually deliver 2% inflation. That defense is looking less and less believable. University of Michigan 1-year inflation expectations surged to 4.7–4.8% in April 2026, a post-2022 high, before easing only marginally to 4.5% in preliminary May data. More troubling for the Fed, 5-year expectations have risen to 3.4–3.5% — the highest in months and materially above the pre-pandemic range of approximately 2.3–2.8%. Market-based measures confirm the trend: 1-year inflation swaps are up approximately 75 basis points since the Iran war began, and the 10-year breakeven inflation rate recently hit its highest level since early 2023.

The New York Fed's April survey showed more stability at the 3- and 5-year horizons, producing a divergence between the two surveys. But that divergence is, itself, a warning rather than a comfort. When Michigan and New York Fed data begin to split, it typically signals that expectations are in transition rather than settled. When consumers' long-run expectations start moving persistently, the Fed historically has very little time before the psychology becomes self-reinforcing — precisely the dynamic that turned the 1970s supply shock into a decade of structural inflation, and ultimately, crushing stagflation.

The Food Inflation Pipeline

A less-discussed but consequential transmission channel is underway. Fertilizer prices, shipping insurance, and freight costs have risen sharply alongside energy. Historically, agricultural input cost increases lead food CPI by 6–12 months. If the current disruption persists, consumer food prices are likely to accelerate in the second half of 2026, adding a consumption-eroding dimension to the inflation picture at the precise moment household finances are showing stress.

Government tax measures have temporarily cushioned the blow for consumers. That cushion is finite. Credit card delinquency rates, real wage stagnation, and declining personal savings rates suggest the consumer buffer is narrowing — a dynamic that could accelerate sharply if food and energy costs continue rising.  This can lead to sharply reduced consumption coupled with higher inflation, which would essentially mark the beginning of a nasty stagflationary cycle.

The Fed vs. the World: A Growing Policy Divergence

While the Federal Reserve has held rates steady and quietly expanded its balance sheet, other major central banks are moving — or preparing to move — in the opposite direction. The contrast is striking and raises a pointed question: if peers with comparable inflation mandates are tightening in response to the same energy shock, what does the Fed know, or fear, that they do not move in tandem?

The Reserve Bank of Australia Has Already Acted

The RBA moved first among major developed-market central banks, raising its policy rate by 25 basis points to 4.35% after headline inflation in Australia jumped to 4.6% in March 2026, up from 3.7% the prior month; this was a direct consequence of higher fuel prices flowing through the economy. Australia's willingness to hike into an energy shock reflects both its inflation mandate and its relative insulation from the growth downside that constrains European and U.S. policymakers.

The ECB Is Primed to Hike

The European Central Bank held at 2% at its April meeting, but the tone has shifted materially. Eurozone inflation hit 3% in April, driven by energy. ECB President Lagarde stated the bank would not be "paralyzed by hesitation" — a direct allusion to its costly delay in 2022. A Bloomberg survey of economists conducted May 4–7 now shows consensus expectations for two 25-basis-point ECB hikes in 2026 — one in June and one in September — which would bring the deposit facility rate to 2.5%. Euro OIS curves are pricing as many as three hikes. The Bundesbank president has stated a hike "will be needed if there is no significant improvement." Other central bank governors called it "all but inevitable."

The Bank of England Is Watching Closely

The BOE also held at its most recent meeting, but Governor Andrew Bailey told CNBC that a protracted energy price shock could "force the bank's hand" on borrowing costs. UK inflation is expected to breach 5% in 2026 — the worst outcome among major G10 economies — and markets are pricing in rate action before year-end.

The Bank of Japan: Hawkish Dissents Mount

Even the BOJ, the last bastion of ultra-loose policy, left rates unchanged at 0.75%, but registered three hawkish dissents at its most recent meeting. The BOJ raised its core inflation forecast (ex-fresh food and energy) to 2.6% for fiscal 2026 and 2027, with a return to target not expected until fiscal 2028. Governor Ueda signaled the bank "intends to make appropriate policy decisions to avoid falling behind the curve." The direction of travel is unmistakable. The Japanese central bank is moving cautiously, but after 35 years of crushing deflation, their caution is warranted.

What the Divergence Means

The Fed's inaction is not irrational in isolation — it faces a uniquely complicated dual mandate, heavy Treasury issuance requirements, a leadership transition, and a domestic consumer already under stress. But the divergence from peers creates its own risks. A tightening ECB and BOE, combined with a Fed on hold and gently expanding its balance sheet, exerts downward pressure on the dollar relative to the euro and sterling. It also raises the uncomfortable question of whether the Fed is effectively prioritizing fiscal accommodation — keeping rates from rising further to manage the government's $39 trillion debt burden — over its inflation mandate. That suspicion, if it takes hold, is precisely how central bank credibility erodes. If global investors start to genuinely lose faith in the integrity and effectiveness of the Fed, the dollar will begin a major decline that will be historic in proportion.

Equity Valuations: Expensive by Every Measure That Has Ever Mattered

U.S. equity markets are not merely elevated. By the two most historically durable valuation metrics — the Shiller CAPE ratio and the Buffett Indicator — they sit at levels that, in the full sweep of market history, have only been exceeded or matched immediately before catastrophic repricing events.

The Shiller CAPE ratio currently reads approximately 40.9 - 48.6% above its 20-year average of 27.5. The historical median across the full 20th century is 16.1. At this level, the implied expected annualized future return over the next decade is approximately 1.3%.

The Dot-Com Comparison: Similar, But Not Identical

The Nuance the Bears Miss

The dot-com comparison has important limits. In 2000, the dominant companies were largely speculative; many had no earnings, burned cash, and were valued purely on narrative. Today's largest companies — Microsoft, Apple, Nvidia, Alphabet, Meta — are among the most profitable enterprises in history, generating extraordinary free cash flow and holding fortress-like balance sheets. Some valuation premium is arguably justified.

But "some premium" and "the current premium" are two very different things. The market is not just pricing in great businesses, it is pricing those businesses at multiples that compress future returns almost to zero. And the concentration problem is real: the top 10 S&P 500 names control 41% of the index while generating only 32% of its profits. The index is no longer a diversified proxy for the U.S. economy. It is a highly leveraged bet on a handful of technology companies maintaining both their dominance and their current valuations.

The Vertical Integration Risk

An underappreciated and growing risk is the pattern of the largest technology companies investing capital directly into their own supply chains and customer ecosystems. When a dominant platform simultaneously owns the infrastructure, supplies the components, funds the customers, and operates the marketplace, the apparent diversification of risk is illusory. A significant shock to any one node propagates through a tightly coupled system. This is not a speculative concern, it is a structural feature of how the Magnificent Seven have deployed capital over the past 24 months, and it materially increases the left-tail risk of a synchronized repricing.

Geopolitical Amplifier: The Strait of Hormuz

Approximately 20% of global oil and liquefied natural gas transited the Strait of Hormuz until very recently. On March 2, 2026, the IRGC officially confirmed the strait was closed to "unfriendly nations." Tanker traffic dropped to near zero, protection and indemnity insurance was cancelled from March 5, and all major carriers — Maersk, CMA CGM, MSC, and Hapag-Lloyd — suspended transits. Qatar Energy declared force majeure on all LNG shipments on March 4 after Iranian attacks on its Ras Laffan facilities, removing 20% of global LNG supply overnight. Fertilizer shipments also rely on this corridor. The conflict has already driven oil prices up more than 60% from late February 2026 levels even with the recent sell-off to slightly lower levels — contributing directly to the Fed's current inflation bind. As of this writing, approximately 1,550 vessels remain stranded with 22,500 mariners trapped. DHL forecasts 4–6 months to normalization.

One scenario worth stress-testing — not a certainty, but a plausible strategic logic — is that Iran's calculus extends beyond near-term military objectives toward a sustained pressure campaign on Western economies, and on the U.S. in particular. If Iranian leadership judges that it can absorb current pain for an extended period (with Russian supplies via the Caspian corridor partially offsetting sanctions pressure and the restocking the Iranian drone supplies), the economic cost to the West — elevated energy, freight, insurance, and food prices — may be viewed as a strategic asset rather than a side effect.

This scenario does not require deliberate orchestration to play out. Prolonged instability in the region produces the same economic transmission regardless of intent. The relevant question for investors is not Iran's precise motivation but the duration of disruption — and how that interacts with the Fed's already constrained policy space.

How This Tightens the Fed's Trap

The Fed currently faces a complex array of challenges:  inflation above target; growth softening; ever-widening fiscal deficits requiring heavy Treasury issuance; a leadership transition (Jerome Powell being replaced by Kevin Warsh); and collapsing consumer confidence. A prolonged Hormuz disruption adds persistent energy and food inflation to this list, eliminating the Fed's ability to cut rates into a weakening economy without risking an inflation resurgence. The probable outcome is extended stasis: rates on hold, balance sheet maintained or gently expanded (the Fed will likely try to quietly keep expanding the balance sheet while talking tough on inflation), and inflation sticky above 3% for longer than markets currently price.

The Carry Trade Time Bomb: BOJ Normalization and the Yen

The yen carry trade — borrowing in Japanese yen at near-zero rates to invest in higher-yielding assets globally — is among the largest and most crowded positions in international finance. It has been profitable for years precisely because the Bank of Japan maintained ultra-loose monetary policy while the rest of the developed world tightened.

That calculus is changing. Japan has experienced sustained inflation above its 2% target — a structural shift after decades of deflation. The BOJ has begun a cautious normalization path. Ten-year JGB yields are now above 2.5%, their highest level in 29 years, and these levels will likely begin attracting the repatriation of overseas Japanese assets seeking higher domestic yields. The critical question is not whether further rate hikes come, but when they accelerate. The August 2024 episode is instructive: a single modest BOJ rate move triggered a sudden, violent unwind that briefly crashed global equity markets and drove Dollar/Yen lower by more than 20 yen, a move so powerful that central bank reassurances were required to stabilize conditions. That was a warning shot.

When the BOJ moves into a genuine, sustained hiking cycle, the unwinding of the yen carry trade will not be orderly. The scale of the position — built over years at near-zero borrowing costs — is large enough to generate forced selling across multiple asset classes simultaneously. For U.S. equities already trading at historically extreme valuations, this represents an exogenous shock risk that is independent of, and additive to, the domestic valuation concerns outlined above.

The connection to the Hormuz scenario is direct: prolonged energy disruption will accelerate Japanese inflation, forcing faster BOJ normalization, which in turn accelerates the carry unwind. These are not three separate risks. Instead, they are potentially sequential triggers in a single shock chain.

FX Implications

The U.S. dollar's safe-haven status rests on a variety of pillars: the depth and liquidity of U.S. Treasury markets, the Fed's credibility, U.S. economic strength, the dollar's undisputed hegemonic status, and global risk aversion that drives flows toward dollar-denominated assets. The first two are under pressure. Fed credibility is eroding through six consecutive years of inflation overshoot and the perception of undisciplined fiscal borrowing and spending. Treasury market liquidity has been periodically strained — and the long-term ramifications could be staggering.

In a global risk-off environment driven by geopolitical shock, the dollar still benefits from safe-haven flows. But in a scenario where the shock is specifically a U.S. domestic consumption squeeze — food and energy inflation breaking the consumer while growth slows — coupled with a crisis of confidence regarding U.S. fiscal and monetary policy, the dollar doesn't merely lose its tailwind. It begins to face overwhelming headwinds. Capital does not flee to the U.S. in a U.S.-centric downturn. It flees from the U.S. Tens of trillions of overseas funds are currently invested in U.S. assets, and the mere hedging of a modest fraction of these positions will overwhelm any central bank attempt to stop the flood.

Summary: The Anatomy of a Fragile Regime

The current macro environment is defined by compounding contradictions, each of which is tolerable in isolation but dangerous in combination.

The Fed has ended tightening and is gently expanding its balance sheet, directing liquidity into a system while verbally maintaining a restrictive posture. Equities have responded with a rally that is, by every durable valuation metric, historically extreme. The businesses underlying that rally are, to their credit, genuinely excellent, but they are priced for perfection in a world that is increasingly imperfect.

Inflation is sticky above 3%. Energy prices have re-accelerated. Food inflation is in the pipeline. The consumer is running out of cushion. And the Fed — facing a leadership transition, a fiscal deficit requiring continuous heavy Treasury issuance, and a geopolitical shock it cannot control — has no clean exit. It cannot cut rates meaningfully without risking a third inflation wave. It cannot raise rates meaningfully without breaking credit markets already reliant on liquidity support and further damaging consumer confidence and domestic consumption.

This is not a prediction of an imminent crash. Markets have a frustrating ability to remain expensive for longer than logic suggests. But the configuration of risks — extreme valuations, concentrated holdings, carry trade overhang, consumer stress, and geopolitical uncertainty — means that when the repricing comes, its severity will likely be amplified by the structural fragilities built up during the liquidity-dependent regime of the past several years.

Whether or not one chooses to label the current equity market conditions as a bubble, the reality is the same. The market has grown over eleven-fold since the GFC, and it is in desperate need of a major, multi-month, multi-year correction. The AI boom disrupted what was shaping up to be the requisite repricing a few years ago, but the current valuations are too extreme to continue without a major move lower. This doesn't mean markets can't trade somewhat higher first — but when the move down comes, it will be significant.

On February 9, 2026, I wrote that there were far too many risks in the system for a sustained risk-on environment to persist without a sharp correction at some point in the relatively near future, while not ruling out a rally to 7,350 in the S&P 500. The sharp correction followed just weeks later — and what appears to be a terminal rally in the S&P 500 is now underway. The downside opportunity, when the top is confirmed, will be substantial.

In the meanwhile, I want to wish you all the best of luck with your trading.  Strap on your seatbelts.  When this market turns, it will be wild.

Andy Krieger

From Imre Gams:

My Framework

I treat markets as auctions, not prediction machines.

Most sessions on a day-to-day basis are balanced.

Edges form at the extremes of value.

I trade acceptance and rejection at those edges.

If value migrates, I align with it.

If it fails, I trade the rotation.

I am not in the business of forecasting.

I am in the business of validating participation.

_________________________________________________________ 

S&P 500 E-Mini Futures (ES):

The week opened with the market dipping to within two points of the first downside target at 7198. The weekly low was 7199.50.

Buyers didn't hesitate. From there, the market was lifted through the cited upside target zone of 7301 to 7327 and kept going — closing the week above 7420.

Another historic close.

This market has been relentlessly resilient. At some point that changes. Every uptrend ends. But trying to pick the top is a fool's errand. The job is to have clear parameters that tell you when the picture has changed — and to act on them, not anticipate them.

For sellers to take control, I'll need to see a decisive break below the 7336 to 7361 support zone. Until that happens, the focus stays on the upside.

The next upside target zones span 7457 to 7478, followed by 7533 to 7542.

Above 7336, buyers remain in control. That's the line. 

Gold Futures (GC):

Gold tried to make a run at the second downside target of 4411 early in the week. Sellers couldn't sustain it. The weekly low held above the prior week's lows of 4522 and buyers stepped back in, reclaiming the 4611 to 4661 zone. The week closed at 4730.

The picture is becoming clearer.

Gold has been carving out a range between the upper control zone of 4820 to 4883 and the lower zone of 4611 to 4661. The market keeps coming back to test both sides. That's not noise — that's structure.

So the approach shifts. Rather than looking for a directional breakout, the focus moves to playing the range. Fading strength into 4820 to 4883. Buying weakness into 4611 to 4661.

A sustained breakdown below 4611 keeps 4411 in focus. A clear breakout above 4883 opens the door to the 5085 to 5207 zone.

Until one of those happens, the range is the trade.

Crude Oil Futures (CL):

Last week's control level of $102.52 proved decisive. Sellers held it as a ceiling and the market sold off sharply — hitting the first downside target zone of $94 to $97 in quick succession. The second zone of $86 to $88 was missed by just over $2.

That first downside target zone of $94 to $97 is now the control zone. How the auction resolves within it is the key question heading into this week.

Above it, $102.52 becomes the first upside target — the level that acted as a ceiling last week now becomes the objective for buyers. Beyond there, the upside target zones come in at $110 to $112 and then $114 to $115.

Below the control zone, $86 to $88 comes back into play. And below that, $80 stands as the next significant downside level.

Watch how price behaves inside $94 to $97. That's where this week's story gets written.