THE REGIME LETTER: The Market Is Looking for the Wrong Backstop
The Fed still matters, but it may no longer be the whole story.
“The market tells you everything. You just have to listen.”
Howdy everyone, ok so I’m back from a brief hiatus, energized and ready to go, and there’s no shortage of loud things to point at this week. SpaceX is pricing what looks like the largest IPO in history, the tape is still being pulled around by the Iran energy shock and headlines that a deal could get signed in Europe this weekend, and markets are still within shouting distance of the highs even while inflation is making itself a little harder to ignore.
You can turn on CNBC or Bloomberg and get plenty of that.
What I want to talk about is quieter, and I think more durable, because underneath all the noise there’s a bigger question the market may not be asking clearly enough: who actually backstops this market now?
For most of the post-crisis period, liquidity was a Fed question. When something broke, the Fed cut, when markets seized up, the Fed expanded the balance sheet, and when financial conditions tightened too fast, the Fed talked the market back from the ledge, and while nobody ever really put that deal in writing, everyone understood the arrangement.
I’m not sure that’s the arrangement anymore.
And before anyone accuses me of building a whole regime out of one week of plumbing data, let me be clear about what I’m saying and what I’m not saying. I’m not saying one week of reserves rising and the Treasury General Account falling proves that liquidity is suddenly back, because it doesn’t. I’m not saying the all-clear has sounded, because it hasn’t. And I’m certainly not saying banks are about to lend money to anything with a pulse and a logo.
What I am saying is that the old backstop may not work the same way, and if that’s true, then the market needs to stop asking only when the Fed comes back and start asking who actually carries liquidity through the system next.
That’s the piece.
A Different Kind of Fed
Kevin Warsh was sworn in as Fed Chair on May 22, and his first FOMC as Chair is June 16-17. That matters more than any single reserve print, because what we’re really talking about here is the reaction function the market has been trained to expect.
Warsh has spent years arguing for tighter inflation discipline, a smaller balance sheet, and less of the forward-guidance hand-holding that turned the Fed into something close to a standing put under risk assets. That doesn’t mean he’s reckless, and it doesn’t mean the Fed won’t respond if something truly breaks, but it does suggest the threshold for comfort may be higher than investors are used to.
The marginal source of liquidity is less likely to be the Fed than it was in the last cycle, and I’m not sure the market has fully repriced what that means.
The Fed still matters enormously, of course. It still sets the price of money, controls the policy rate, manages the balance sheet, and decides how much oxygen the system is allowed to breathe, but if inflation is running too hot, if energy is feeding into the inflation picture, and if Warsh is less interested in using forward guidance as a market sedative, then the Fed may be less willing and less able to play the reflexive backstop role investors got used to under Powell.
That doesn’t mean the backstop disappears, it means the backstop changes.
And if the Fed is less likely to carry the next liquidity cycle by itself, then liquidity has to travel through other channels: bank balance sheets, deposit flows, credit creation, capital markets activity, private credit, exchanges, payments rails, and the large financial institutions capable of absorbing and redeploying capital.
That’s where this gets interesting.
What the Plumbing Says, and What It Doesn’t
The plumbing data this week is interesting, but it needs to be kept in its proper place.
Bank reserves expanded by roughly $67 billion for the week ended June 10, while the Treasury General Account fell by roughly $48 billion, and that’s a real move, because when the Treasury spends down cash, that money doesn’t disappear into the ether. A meaningful portion can flow back into the banking system, show up as reserves, and ease some pressure on bank balance sheets.
That’s plumbing, and it’s not magic.
It’s also not a regime by itself, because one weekly move can reverse just as quickly when the Treasury rebuilds its account around tax dates, refunding, or debt-ceiling dynamics. So I don’t want to wave one H.4.1 print around like it’s the Dead Sea Scrolls of liquidity. The thing to watch is the trend over the next several weeks, not one data point that happens to fit the story we’d like to tell.
But there is something important underneath it. The old domestic reverse repo buffer is basically gone. Total reverse repos still look large because of foreign official accounts, but the “Others” line, which is the part that used to function as the big domestic money-market sponge, is now sitting below $1 billion. That changes the transmission. When that buffer was huge, flows could get absorbed there before they really mattered to bank reserves. With that buffer drained, movements in the TGA and other balance-sheet plumbing have a cleaner path into the banking system.
And that’s the part worth flagging.
Credit isn’t acting like the world is ending. High-yield spreads are tight, investment grade is calm, the 2s10s curve is positive but not especially steep, and financial conditions are easier than the fear narrative would suggest. Whatever else is true, this isn’t what a credit accident looks like.
But the bulls have to sit with something too: inflation isn’t cooperating, and the problem is more specific than just saying prices are hot. Headline inflation is being pulled higher by energy, while core inflation is still more contained, which means the Fed constraint is real, but it’s also tied directly to the Iran and oil path. If oil cools on a deal, some of that pressure can ease. If oil rips again, the Fed has even less room to comfort the market.
That’s the tension. Credit and financial conditions are calmer than the mood, the plumbing is less hostile than the defensive model would suggest, but inflation and geopolitics are still real constraints. So the right conclusion isn’t that liquidity is back and everyone should run around like the band just got back together.
The right conclusion is narrower and more useful: the old Fed-centered liquidity map may be outdated, and this week’s plumbing data is one more clue that we need to look harder at the balance sheets that can absorb, transmit, and redeploy liquidity if the Fed is no longer doing all the heavy lifting.
The Transmission Lens
If the Fed is a less reliable marginal backstop, the next question is who carries liquidity through the system instead?
The honest answer is that liquidity has to move through balance sheets, and the banking system is the obvious place to start. That doesn’t mean “buy banks” is the conclusion, because that’s too blunt and too easy. The point is that banks may matter more in this regime because liquidity may have to travel through them rather than around them.
Large banks with strong deposit franchises benefit if funding costs stabilize while asset yields stay elevated. They don’t need a 2021-style boom. They need stabilization. They need funding pressure to stop getting worse, deposit trends to improve, credit losses to remain manageable, and loan demand to stop deteriorating, because in an earnings-driven market, stabilization can be enough to change the story.
Regional banks are a little different. The upside could be larger, but so is the risk. Commercial real estate exposure still matters, local economic conditions still matter, credit quality still matters, and you can’t just throw a dart at a regional bank screen and call it macro work. That’s not detective work, that’s happy hour with a Bloomberg terminal.
The timing is the hard part.
With headline inflation being pulled higher by energy and an Iran shock still sitting in the tape, this is a structural watch first, not some full-throated victory lap. The catalyst that turns the bank-transmission thesis from interesting to actionable is not my opinion, and it’s not one weekly reserve move. It’s banks actually reporting stabilizing deposits, better funding conditions, manageable credit costs, and loan growth that doesn’t look like it’s rolling over.
Until the data confirms it, the thesis stays on the board.
The Factor Question
The other thing I care about is whether the market is being driven by geopolitics or by earnings, because those are very different games.
In a geopolitics-driven market, correlations rise, positioning goes defensive, and everything trades on the last headline. In an earnings-driven market, the tape gets more selective, and the market starts separating companies that can actually deliver from the ones that just sound good in a deck.
A few weeks ago, I would’ve said the handoff toward earnings was beginning. This week I have to be more honest than that. With an Iran energy shock still in the tape and a potential deal hanging over oil, geopolitics still has the wheel. Earnings revisions may be trying to matter more at the margin, but the handoff hasn’t been confirmed yet.
The test is concrete and close.
Over the next two to three weeks, do companies that beat estimates get sustained follow-through, or do those beats turn into one-day pops that fade? If beats stick, then the earnings handoff is real and the defensive posture can start to unwind. If beats fade, if misses get shrugged off, or if everything trades around oil and the Fed, then we’re still in the headline regime and anyone calling the all-clear is early.
I’d rather be honestly early and waiting than confidently wrong.
The Themes, Judged on Their Merits
Power infrastructure still looks like one of the cleaner themes, and it’s the one least dependent on the regime question. This isn’t only an AI story anymore, it’s capacity, reliability, grid stress, generation, and transmission against a physical economy that needs more power than the old system was built to deliver. Real backlogs, real pricing power, real demand that shows up in quarterly numbers. In almost any regime, that travels.
AI infrastructure stays important, but it’s becoming more selective. The easy part was believing in the buildout. The hard part is figuring out who converts that buildout into revenue, margins, and durable earnings power. The market may still love the AI story, but it’s going to become less forgiving of companies that only have a theme and not the numbers to support it.
Defense and strategic autonomy remain structurally important, but if geopolitics stops being the dominant factor, they may not lead every week. That doesn’t weaken the long-term thesis, but it does mean the next leg needs orders, backlog, and execution to carry the stocks, not just the geopolitical tape. Right now, with an active shock still in play, this is the theme most exposed to headlines, for better and worse.
Financial infrastructure may be the sleeper, because if balance sheets become more important than the Fed’s, then payment systems, exchanges, asset managers, private credit platforms, and large financial institutions deserve more attention. Same caveat as the banks, though: structural watch first, position on confirmation.
Biotech and healthcare become more interesting in an idiosyncratic, catalyst-driven market, where late-stage readouts and approvals can re-rate names quickly. It’s also high-variance, and nothing in biotech should ever be treated like a free lunch unless you enjoy expensive indigestion. If you express it, you diversify across timelines, because the failures are as binary as the wins.
The common thread is simple enough. In the old regime, you wanted to know what the Fed would do, while in this regime, you may need to know who can absorb liquidity, who can transmit it, and who can turn it into earnings.
What Would Actually Change My Mind
This is the section that matters most, because a view you can’t falsify isn’t a view, it’s a horoscope.
The first test is the June 16-17 FOMC, because it’s the first under Warsh and the first real read on the new reaction function. A hawkish tone, a visible discomfort with easy financial conditions, or any signal that the Fed is willing to tolerate market volatility in order to protect inflation credibility would make the benign liquidity read harder.
The second test is inflation. PCE, durable goods, retail sales, and jobless claims all matter because they tell us whether the consumer and inflation backdrop support any of this. If claims start grinding into the mid-250,000s and staying there, that’s an early labor crack worth respecting. If headline inflation cools because oil cools, the Fed constraint loosens a notch. If headline inflation keeps rising because energy keeps pulling it higher, the Fed’s room to provide comfort narrows even further.
The third test is the weekly H.4.1 trend. One print doesn’t make a regime, but several weeks of reserve growth, falling funding pressure, and improving deposit conditions would matter. If the Treasury rebuilds the TGA and reserves fall back, then the plumbing clue was a head-fake, not a signal.
The fourth test is earnings reaction. If companies that beat numbers get sustained follow-through, then the market is starting to care about fundamentals again. If beats fade and misses get ignored because everything is still trading around oil, inflation, and the Fed, then we’re still in the headline regime.
The fifth test is bank commentary. Deposits, NIM, loan growth, credit costs, capital markets activity, and management tone will tell us whether the transmission thesis is actually showing up in the real economy or just living comfortably on a whiteboard.
The biggest single risk to everything above is that the Iran situation escalates instead of resolves, oil rips higher, and the whole market collapses back into one macro risk-on/risk-off trade. In that world, the defensive model isn’t stale, it’s correct, and the transmission thesis gets overwhelmed by flight-to-quality.
That’s not a failure of the framework, that’s the framework telling us what would kill the idea.
The Bottom Line
The market still treats liquidity as a Fed question, and I think that may be the wrong question.
The better question is who backstops this market now that the institution everyone relied on may be both less willing and, with headline inflation still being pushed around by energy, less able to play the old role.
I don’t have a tidy answer, and I’m suspicious of anyone who claims one this week. What I have is a spine I’m confident in, which is that a Warsh Fed is probably not the reflexive backstop the last cycle conditioned everyone to expect, and a set of consequences I’m watching rather than betting the book on.
Credit is calm, conditions are easier than the mood, and the plumbing hints that liquidity may rebuild through balance sheets rather than through a press conference. But headline inflation is being pulled higher by energy, the Iran path still matters, and the earnings handoff hasn’t been confirmed by the tape.
So for now, I’m doing the boring, honest thing. I’m respecting the defensive model while it’s still earning its keep, keeping the transmission shift on the board, and refusing to upgrade a watch item into a full thesis until the data signs off.
That may sound less exciting than declaring a new regime on the spot, but markets don’t owe us clean labels just because we’d like to write prettier headlines.
Regime shifts don’t usually arrive with a podium and a flag. They start as small contradictions, a defensive model that no longer quite lines up with the plumbing, a backstop that quietly stops showing up the way investors expect, and a market that slowly learns it has been listening to the wrong signal.
I think we may be early in one of those moments, early enough that the right move isn’t to shout, but to listen harder.
Luke Perry
Whalen Financial, Portfolio Manager