iCapital Market Pulse: Peak Liquidity?

Key takeaways:

• Global liquidity conditions appear exceptionally supportive, with fiscal transfers, easier real monetary policy, expanding bank credit, and abundant private-market dry powder reinforcing one another.
• With liquidity abundant even as Treasury yields approach two-decade highs, markets may be more vulnerable to a rate shock than the headline conditions imply.
• The liquidity story could reverse if tariffs and oil revive inflation, fiscal policy turns restrictive, or slowing profit growth weakens investor demand for stocks and corporate bonds.

Baggy jeans aren’t the only thing back from the ‘90s

Liquidity is widely discussed but rarely defined. We think of it simply as the availability of capital across monetary policy, fiscal policy, banking activity, and capital markets. Based on the Bloomberg Financial Conditions Index, financial conditions haven’t been this supportive since the 1990s, and it’s not just coming from one source (Exhibit 1). Easier real policy, bank lending, fiscal transfers, and capital-market confidence are all pushing in the same direction.

Where the cash is coming from

1. The Federal Reserve

Back to real ZIRP: With headline Consumer Price Index (CPI) having risen by ~100 basis points (bp, or one hundredth of one percent) while the Fed has cut its policy rate by 175bp, the real federal funds rate has plummeted to near zero. Although nominal zero interest-rate policy (ZIRP) ended more than four years ago, real policy rates are again near zero (Exhibit 2).

Closet quantitative easing (QE): While the Fed does not classify its purchases of Treasury bills as official QE, those purchases are still expanding the balance sheet and adding liquidity into the economy to the tune of nearly $300 billion so far this year (Exhibit 3).

The yield curve is encouraging banks to increase lending: Not every yield-curve spread tells the same story. For banks, the 3-month vs. 5-year Treasury yield spread may be the best proxy for the rates they earn on loans relative to the rates they pay on deposits. That spread is near its highest level since 2022, providing a strong incentive for banks to make new loans (Exhibit 4).

2. The banking system

Over the past several years, banks have increased both loan issuance and lending profitability (Exhibit 5).

The bank tightening cycle is over: Despite better loan profitability, US banks have been tightening lending standards since 2022 (Exhibit 6). However, with the exception of commercial and industrial loans, which are still seeing modest tightening, the tightening cycle has ended for consumer and real estate loans (Exhibit 6). Additionally, while the 3-month vs. 5-year Treasury yield spread is at a four-year high, at 50bp, it remains well below its 30-year average, suggesting even more potential for better loan profitability and easier lending standards (Exhibit 6).

3. Fiscal policy

Record tax refunds have supported household bank accounts: Consumer balance sheets have benefited from a surge in tax refunds this year as the result of last year’s tax cuts (Exhibit 7).

Corporate refunds are also booming: So far, roughly $100 billion of the $160+ billion total refunds have been distributed after the Supreme Court nullified the earlier section 122 tariffs on imported goods, resulting in a large short-term boost to corporate cash (Exhibit 8).

Where the cash is showing up

1. Private capital markets

Private-capital liquidity is less abundant than it was at the fundraising peak in 2023, but trillions of dollars of uncalled commitments still represent substantial purchasing power waiting for a clearer path to deployment (Exhibit 9).

2. Public capital markets

Growth and liquidity are hard to disentangle because the willingness to invest tends to rise as fundamentals improve, which drives better investment performance, which in turn results in more willingness to invest. This is what John Maynard Keynes described as animal spirits. Healthy economic growth and booming corporate profits have increased investor demand for stocks and corporate bonds, resulting in higher valuations over the past decade.

Stocks are far from cheap: S&P 500 valuation multiples based on forward earnings have fallen back to 20x from their recent high of almost 23x, the 76th percentile of their post-Global Financial Crisis (GFC) range (Exhibit 10). But based on our 5-year trend-adjusted P/E (TAPE) or price-to-free-cash-flow, both measures remain at the 97th percentile of their respective post-GFC ranges (Exhibit 10).

Investor appetite for risk is also evident in bond markets: The extra compensation fixed income investors are demanding to lend to corporations rather than the US government remains very low by historical standards. Currently, investment grade corporate bond spreads over Treasuries are in the 12th percentile of history since 1995, while high yield corporate bond spreads are at the 3rd percentile (Exhibit 11).

What could interrupt the cycle?

Abundant liquidity is clearly visible in asset prices. The investable question is: What could drain liquidity and pressure valuations? Here are five risks to liquidity worth monitoring:

1. Surging interest rates: Elevated deficits, inflation and policy uncertainty have pushed the 10-year Treasury yield to the high end of our 4.0%–4.8% expected range for 2026. If we were to breach the upper end of that range and approach 5%, near the highest level in two decades, we would expect liquidity to tighten meaningfully across markets and the economy (Exhibit 12).

2. Tariffs back on the upswing: We noted earlier that the disbursement of tariff refunds has been a temporary boost to liquidity, but the latest round of Section 301 tariffs should cause effective tariff rates to rebound to the prior 10% levels, creating another inflationary headwind for the economy (Exhibit 13).

3. Oil could force the Fed’s hand: While our base case is for the Fed to remain on hold for the rest of the year, we forecast that if crude oil prices remain above $80 per barrel through the month of August, this would force the Fed into a hiking cycle (Exhibit 14).

4. Fiscal drag: The Hutchins Center on Fiscal and Monetary Policy attempts to quantify the impact of local, state, and federal tax and spending policy on economic growth. According to their estimates, fiscal impact is set to swing from a 0.8 percentage point boost to GDP growth in the first quarter to a 0.5 percentage point drag on growth in the fourth quarter with a growing drag in 2027 (Exhibit 15).

5. Slowing earnings growth: Investor enthusiasm has been supported in part by exceptional profit growth. Aided by several one-time items, including gains on AI-related investments, the S&P 500 is on track for 49% EPS growth in the second quarter (Exhibit 16). Based on consensus estimates, growth is expected to remain healthy but decelerate through year-end (Exhibit 16). If earnings momentum slows, valuations and risk appetite may become more difficult to sustain.

For now, liquidity remains a tailwind, but expensive equities and historically tight credit spreads suggest that markets already reflect much of the benefit. With liquidity near a 30-year high-water mark, the greater risk is that the tide begins to recede.