Late-Cycle Without Signals: Why Market Stress Needs Quant Evidence

There’s a growing anxiety among market participants about where we stand in the economic cycle. The question keeps surfacing—what stage are we in, and what comes next? Yet any clear-cut answer is increasingly elusive. The conventional business cycle framework—relying on output, inflation, and employment—is proving inadequate. Since 2008, and especially after the COVID shock, policy distortions and geopolitical dislocations have severed the link between traditional macro indicators and market outcomes.

Take equity markets as a case in point. If we rebase the S&P 500 to each administration’s Inauguration Day, the underperformance of Trump’s second term stands out clearly—worse than not only his own first term but also both Obama terms and Biden’s.

Instead of asking where we are in the business cycle, it’s more useful to consider the longer arc of the financial cycle—the rise and fall of risk appetite as expressed through credit and asset prices. These cycles, which can stretch across decades, often peak with a toxic mix of leverage, complacency, and mispricing of risk. The aftermaths are severe: banking crises, deep drawdowns, and long, slow recoveries.

At present, the signs are mixed. There is no evident credit bubble. Big Tech’s AI push, for example, is mostly being financed by retained earnings. Nor is housing overheating. Yet early warning signs are accumulating. Leverage is rising in pockets of the market. Credit spreads, notably Option-Adjusted Spreads (OAS), have compressed to historical lows—signalling that risk might no longer being priced with discipline.

More worrying is the financing structure behind some of the most visible AI firms. Many are loss-making. Their valuations are sustained not by fundamentals but by vendor-financed capital loops that echo the incestuous mechanics of pre-2008 structured credit.

In the short term, liquidity stress is starting to flash amber. The combination of quantitative tightening, heavy T-bill issuance, and an expanding Treasury General Account is draining reserves from the banking system. As reserve balances decline, we are seeing spreads rise in key funding markets. Both SOFR and TGCR have pushed above the Fed’s Interest on Reserve Balances, reflecting increased competition for cash. Money market funds are moving out of the Fed’s reverse repo facility into higher-yielding assets, further tightening available liquidity.

These dynamics could become more acute into year-end, especially if balance sheet constraints intensify. Funding market volatility is not yet systemic—but persistent stress in this area has historically been a precursor to broader market dislocations. Our concern is that if the Fed misjudges the reserve floor or ignores these signals, credit conditions could tighten abruptly.

Our Turbulence Index, fine tuned within 20Quant and Simplify Partners, tracks multivariate correlation shifts across asset classes using Mahalanobis distance. While overall market conditions remain stable, we’ve observed a pattern of spikes—particularly in April and August of this year—that suggest latent fragility. These are the kind of statistical surprises that often precede regime shifts.

Stepping back, the deeper structural issue remains what the BIS once termed “excess financial elasticity.” Central banks, reluctant to lean against booms, are then forced into aggressive support during busts—effectively socialising risk while encouraging further speculation. The result is a prolonged, distorted financial cycle. The US, which leads the global cycle, may still have room to run. But this expansion is being sustained not by productivity or discipline, but by policy inertia and speculative capital.

And this comes at a cost. Public debt across major advanced economies is already at wartime levels. The appetite for fiscal consolidation is minimal. If productivity growth disappoints—and there’s reason to be cautious about assuming AI will be a deus ex machina—then inflationary monetary financing becomes increasingly likely. So does financial repression, with institutions compelled to hold government debt at real negative rates.

In that environment, all but the shortest-duration nominal fixed income becomes potentially dangerous. Real assets, active risk management, and dynamic hedging will be essential. And so will tools capable of capturing early warning signals—not through forecasts, but by mapping the statistical footprint of market stress, as we do with our Turbulence Index.

We remain attentive to these shifts and will continue to update our analysis as conditions evolve.

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Federico Polese

This newsletter is the intellectual property of 20Quant Srl.

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