The Regime Letter: Looking Through, Not Looking Away
The market is giving liquidity the benefit of the doubt, but credit still gets the final vote.
Now that’s how you finish a week!
So the market has been on a roll lately, but let’s take a gander at what is happening under the hood and where the pressure points are starting to show.
The market is telling us two different stories right now, and that is probably the most important thing about this setup.
The first story is the one everyone can see. The U.S.-Iran war is still sitting in the middle of the market, the Strait of Hormuz remains part of the risk channel, and oil is no longer just a commodity price sitting quietly on a screen. It has become a transmission mechanism, meaning if it stays elevated long enough, it can work its way into inflation expectations, transportation costs, consumer behavior, margins, and eventually the Fed’s reaction function. That is why this is not just a geopolitical story. It is a regime story.
The second story is the one the index is telling us, and that story is not panic.
The S&P 500 is not acting like it is hiding under the desk. It has been pushing to record highs, the Nasdaq has been leading again, and the market has spent the past month looking through war, oil, and geopolitical uncertainty because earnings, AI infrastructure, liquidity, and labor-market resilience have been strong enough to keep buyers engaged. That does not mean the risks are gone, and it certainly does not mean the market is right to ignore them, but it does mean we should be precise. The market is not nervous at the index level. It is looking through the war, but it is doing it selectively. Reuters reported that the S&P 500 and Nasdaq hit record highs on May 8, while AP reported the S&P 500 closed at an all-time high of 7,398.93, up 2.3% for the week and 8.1% year-to-date.
That is the distinction that matters.
Our uncertainty of regime reading, or UoR, which is our internal measure of how unstable or unclear the market regime is, has been moving around sharply, and that tells us the market is still processing shocks underneath the surface even if the index itself looks calm. In a cleaner regime, that movement would be smoother. This is not a clean regime. It is a market trying to decide whether the war and oil shock are enough to change the path, or whether they are sitting on top of a still-supportive liquidity backdrop.
For now, the plumbing is not confirming a full tightening event.
The Treasury General Account, or TGA, which is basically the Treasury’s checking account at the Fed, has been drawing down, and when that account falls, money can move back into the banking system. Bank reserves have been moving higher too, which tells us there is more cash sitting inside the banking system than there was before. The reverse repo facility, or RRP, which is where money market funds can park cash overnight at the Fed, is basically drained. This matters because the easy liquidity reservoir from the last few years is no longer sitting there in the same way.
This is not the same thing as the Fed announcing quantitative easing, or QE, which is the formal expansion of the Fed’s balance sheet through asset purchases. We do not need to dress it up as something it is not. The Fed is not openly easing, but the effect of the plumbing still matters because the system is easier than the Fed’s public posture sounds.
Now that is the part I care about the most.
The Fed can sound cautious for another week, but the market knows a leadership transition is coming, and that makes the reaction function harder to handicap. Powell’s term as Fed Chair ends May 15, Kevin Warsh is expected to take over, and the inflation backdrop is not exactly handing him a clean runway. March CPI was still running at 3.3% year over year, energy was up 12.5% over the prior year, and Reuters reported that strong April job growth complicates any Warsh push for lower rates.
That matters because the bond market may not treat a rate-cut bias into sticky inflation as a free lunch. It may treat it as a credibility trade.
So the Fed risk is not generic anymore. It is not simply “will they cut or won’t they.” It is whether a new Fed Chair tries to lean easier before inflation has actually given him permission, and whether the bond market decides that deserves a higher term premium.
That is a different kind of risk altogether.
The credit market is still the referee here. High yield option-adjusted spreads, or OAS, which measure how much extra yield investors demand to own junk bonds over safer Treasuries, are still sitting in a zone that suggests strain, not panic. If that widening stays slow and contained, then the market can keep looking through the war and oil volatility. If spreads start moving quickly toward 350 basis points or higher, that is when the conversation changes because the market is no longer just processing volatility, it is pricing damage.
So for now, I would frame the regime this way:
War risk is high.
Oil risk is real.
Liquidity is still supportive.
Fed credibility is entering the conversation.
Credit is the line between volatility and real damage.
That is not a clean regime, but it is the regime we have.
Our framework still suggests liquidity matters more over the next 60 days, but with a shorter leash than we had a month ago. The market can look through geopolitical noise and it can even look through oil for a while, but it cannot look through a sustained Hormuz-driven energy shock, a fast credit deterioration, a term premium breakout, or a Fed leadership transition that makes the bond market question whether policy is getting easier for the right reasons.
That is the line.
What Still Works
From a framework standpoint, we still prefer themes that do not need a perfect economic story to work.
Power infrastructure, energy reliability, defense capacity, public safety technology, AI infrastructure, industrial automation, and financial infrastructure normalization still make sense because they are not dependent on the consumer suddenly feeling wonderful again. They are tied to bottlenecks, national priorities, productivity, security, and balance sheet plumbing, and those are the areas where our framework continues to spend more time.
This is a thematic framework, not a blanket recommendation across these sectors, and valuation, balance sheet quality, execution risk, concentration risk, and client-specific suitability still matter.
In our internal framework, AI infrastructure remains one of the stronger thematic areas, though that does not remove valuation, crowding, or execution risk. The cleaner point is simpler: the theme has not broken. It is volatile, crowded in places, and sensitive to earnings, but the inference demand story is still intact. The market needs confirmation that AI spending is not just training-cluster enthusiasm, but a broader infrastructure cycle tied to inference, software integration, energy efficiency, and productivity. Reuters tied the latest record highs partly to gains in AI-related stocks and robust AI data center demand, which is exactly why this theme remains central even as the macro backdrop gets messier.
Power infrastructure and energy reliability remain structurally important because the world keeps asking for more electricity at the same time the grid keeps reminding everyone it has real limits. Data centers, industrial reshoring, electrification, energy security, and reliability all point in the same direction. The exact winners matter, and execution risk is real, but the theme itself is not going away because oil moved around for a week or the Middle East got uglier.
Defense capacity and security infrastructure also remain intact, although the buckets matter. Traditional defense platforms, public safety technology, cybersecurity, intelligence systems, drones, counter-drone capabilities, and domestic security infrastructure all live inside the broader security theme, but they are not the same thing. Some are tied to national defense budgets, some are tied to state and local public safety budgets, and some are tied to corporate security and critical infrastructure protection. The common thread is that security spending is becoming less discretionary as the world becomes less orderly.
Industrial automation remains one of the cleaner structural themes because labor scarcity, reshoring, supply chain redundancy, productivity pressure, and higher real-world execution costs all point in the same direction. Companies are not investing in automation because it sounds futuristic. They are doing it because finding workers is hard, building things is expensive, and margin pressure does not politely leave the room just because management asked nicely.
Financial infrastructure is interesting, but the framing needs to stay precise. Banks, capital markets, payments, exchanges, clearing, custody, and private-market infrastructure all benefit from different pieces of normalization. Banks care about deposits, reserves, credit quality, and net interest margins. Capital markets care about deal flow, underwriting, advisory, issuance, and CEO confidence. Exchanges and clearing platforms care about volumes, volatility, and market structure. Payment rails and custody platforms care about transaction growth and asset movement.
So the better framing is not simply “financials.” The better framing is financial infrastructure normalization.
If the market starts to believe the plumbing is supportive and the war shock is something it can process rather than something it needs to fully reprice, then capital markets activity can thaw. Advisory, underwriting, issuance, M&A, credit formation, payment volume, and market plumbing all become more interesting, not because every financial company suddenly deserves a premium, but because the system becomes more valuable when liquidity moves back through private-sector channels instead of emergency-era Fed facilities.
That is the theme.
What Is More Fragile
Consumer reacceleration is the weaker piece, and as the conflict has lasted longer than I thought it would, the idea of a near-term U.S. consumer reacceleration is looking more premature.
That does not mean the consumer is dead. It means the theme needs more help than the structural parts of the market do. It needs rates to settle down, credit to stop tightening at the margin, employment to hold together, and households to feel less squeezed by the combination of inflation, borrowing costs, energy prices, and headline fatigue.
Until then, our framework gives more weight to the things the world needs to build than the things the consumer needs to feel better about buying.
Housing-linked cyclicals, lower-end discretionary, traditional retail, rate-sensitive consumption, and parts of home improvement may eventually become interesting again, but I do not think we need to force it. The timing still depends on credit and rates. If mortgage rates settle, employment holds, and inflation cools enough for the Fed to get more comfortable, then that conversation gets better, but right now it is still a more fragile part of the market.
Cheap is not enough.
A sector can look cheap and still stay cheap if the theme behind it is not improving, and that is the difference between value and a waiting room with worse lighting.
The Quieter Liquidity Angle
The quieter angle here is that the market may be getting more liquidity support than the Fed’s public posture suggests.
Not because the Fed is trying to goose risk assets. That is not the claim. The better point is that the interaction between TGA drawdown, reserve balances, exhausted RRP, and global capital movement may be leaving the system easier than the headlines imply.
That kind of support does not arrive with a press conference, but it still matters because markets do not just trade on the headline itself; they trade on whether the system can absorb the headline. Right now, the system is absorbing more than you would expect if you were only reading the front page.
There is also a global angle worth watching, but I would not overstate it. If yen strength and carry unwind concerns push capital back toward dollar assets at the same time domestic reserves are rising, then the result can feel easier than the Fed’s policy language sounds. That does not mean every move in the yen is suddenly bullish for U.S. risk assets. It means the plumbing and cross-border capital flow picture is more complicated than the simple version of “war equals risk-off.”
The same thing applies to quantitative tightening, or QT, which is the Fed shrinking its balance sheet instead of expanding it. If QT keeps fading as a market concern and reserves remain healthy, then banks and private markets can absorb more of the liquidity function that had been sitting inside Fed facilities. That is why financial infrastructure still matters here, not because every financial company is magically attractive, but because capital markets, bank balance sheets, payment rails, clearing, lending, custody, credit formation, and liquidity transmission all become more important when the market is moving away from emergency-era plumbing and back toward private-sector absorption.
What Breaks the Thesis
The main risk is credit.
High yield spreads in the high 200s are manageable because they tell us there is strain, but not systemic stress. If those spreads start moving quickly toward 350 basis points or higher, the tone changes, and at that point the market is no longer just processing volatility, it is pricing damage.
That would force a different posture.
The second risk is oil. The market can look through some energy volatility, but it cannot look through a sustained Hormuz-driven oil shock that bleeds into inflation expectations, consumer behavior, margins, and Fed policy all at once. Brent above $100 already matters, but the bigger issue is whether the war creates a persistent refined-products shock, not just a scary crude chart. Reuters reported that the Fed’s latest Financial Stability Report identified geopolitical risks and an oil shock as top worries, with 75% of survey respondents citing geopolitical instability and 70% pointing to the oil shock.
The third risk is term premium. If term premium starts breaking higher, then the bond market is telling us inflation, supply, fiscal risk, or Fed credibility is becoming harder to ignore. That matters because the entire liquidity-supportive argument depends on rates not becoming a new source of pressure.
The fourth risk is the Fed leadership transition. Powell’s term as Fed Chair ends May 15, and Warsh is expected to inherit the chair at a very awkward moment: CPI is still running around 3.3%, energy is moving the wrong way, the labor market is still sturdy enough to complicate the case for cuts, and the market is already trying to figure out whether a Warsh Fed means a more explicit easing bias. That is a credibility trade, and I am not convinced the bond market has fully priced it yet. If Warsh leans too hard into rate cuts before inflation has given him permission, the bond market may not treat that as support for risk assets; it may treat it as a Fed independence and inflation credibility problem. That is where term premium can move higher even if the front end wants cuts, and that is exactly the kind of thing that could challenge the liquidity-supportive thesis.
The fifth risk is the consumer. If jobless claims rise meaningfully, retail sales weaken harder than expected, and credit delinquencies keep building, then consumer reacceleration gets pushed out again. That does not necessarily break the whole market, but it would reinforce the bifurcation between structural winners and cyclical casualties.
So the watch list is pretty simple:
Credit.
Oil.
Term premium.
Fed leadership.
Employment.
Not exactly a beach read, but here we are.
The Bottom Line
So that is where we are.
The market is not panicking. It is looking through the war, but doing it selectively. The S&P 500 and Nasdaq are at record highs, earnings are still doing enough work, AI infrastructure is still leading, and liquidity is still supportive enough that the index has not treated the war and oil shock as a full regime break.
That does not mean the market is safe. It means the market is giving credit and liquidity the benefit of the doubt.
The war matters. Hormuz matters. Oil matters. The Fed leadership transition matters. Credit matters most.
That leaves us with a simple playbook. Our framework still favors structural scarcity, respects credit, avoids forcing weak cyclicals simply because they look optically cheap, and does not treat every war headline as a new regime unless the bond and credit markets begin confirming real damage.
The system is still being tested, but for now the pipes are still running, and as long as the pipes are still running, I am not ready to treat this like a full defensive regime.
Luke Perry
Whalen Financial, Portfolio Manager
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