The Beacon | It's Getting Spooky
The Hidden Transition
TL;DR
Surface calm, shrinking cushion: funding looks orderly today, but the Federal Reserve’s Overnight Reverse Repurchase Facility (ON RRP) and bank reserves — our system’s shock absorbers — are materially thinner. Leading labor flows (quits, hires/ quits, hours worked) are rolling over even with unemployment ~4%, signaling decelerating labor momentum. Credit spreads are tight while high-yield volatility rises and default risk hasn’t fallen correspondingly — poor compensation for the risks that matter. Playbook: prioritize quality and liquidity, fade credit beta on strength, and size hedges like you actually want to keep your job through the cycle.
Playbook: Keep quality and liquidity front and center. Fade credit beta on strength—when the music’s still playing, that’s when you find your seat near the exits. Respect the curve risk and term premium. Size hedges like you actually want to keep your job through a cycle. Still a “deceleration” regime, not a crash, but the margin for error is about as thin as airline coffee.
Executive Summary
2025 is the year of market contrasts. Headlines look just peachy—unemployment only a hair above 4%, payrolls growing, stocks making new highs. But peel back the curtain, and late-cycle supports like labor momentum, liquidity buffers, and honest credit pricing are all looking a little wobbly. The machine still runs, but it’s making a new noise every week. Flexibility? Not what it used to be.
The most significant change concerns liquidity buffers. In 2022, the Federal Reserve’s Overnight Reverse Repurchase Agreement (ON RRP) facility served as a primary source of Liquidity. When Treasury bill yields were below the ON RRP rate, money market funds deposited substantial amounts at the Federal Reserve, thereby insulating private repurchase markets and banks. This excess Liquidity has since returned to Treasury bills and broader markets. Concurrently, bank reserves are now near the minimum level deemed sufficient by the Federal Reserve. While neither development alone constitutes an immediate risk, together they reduce the system’s capacity to absorb future shocks.
The second notable change involves labor market dynamics. While headline unemployment remains stable, leading indicators such as quits, the hires-to-quits ratio, and the quits-to-layoffs ratio have declined, and long-duration unemployment is increasing. Employers are reducing employee hours, which typically precedes headcount reductions. This trend does not indicate a collapse but rather a deceleration that reduces the likelihood of a smooth economic adjustment.
The third significant change pertains to credit markets. Despite late-cycle signals from labor and Liquidity, credit spreads have not widened accordingly. High-yield option-adjusted spreads (OAS) remain below 3 percent above Treasuries, and BBB spreads are near their tightest levels of the cycle. Although this does not indicate an immediate crisis, the combination of narrow spreads and increasing high-yield volatility suggests inadequate compensation for risk. This pattern is indicative of late-cycle complacency.
These developments do not necessitate a recession forecast. However, they require an accurate characterization of the current regime as one of deceleration with diminished buffers. Late-cycle transitions often appear stable until limited shock absorption capacity amplifies the impact of modest disruptions. The primary objective is to assess the system’s reduced ability to absorb shocks rather than to predict specific events.
Structural changes in liquidity, labor, credit, and macroeconomic conditions are monitored using three analytical methodologies: a threshold band model, a Markov regime-switching model, and a proprietary rotation framework. The following summarizes the evolution of these conditions from May through October 2025.
I. Liquidity — Vanishing Shock Absorbers
The financial system’s still processing transactions like a champ, but those liquidity reserves—ON RRP and bank reserves—are seriously depleted in 2025. The real story isn’t today’s stress; it’s how little shock absorption we have left. This isn’t a fire drill, but I’d keep my shoes by the door.
Figure 1 — Liquidity Cushion Index (LCI, z‑score)
What it is: Z‑score average of ON RRP/GDP and Reserves/GDP.
Why it matters: It measures cushion, not daily stress. The line is flat pre‑2008 because there were effectively no excess reserves in the pre‑QE regime—there wasn’t a cushion to vary.
Although funding conditions may currently appear stable, the reduced liquidity buffer increases systemic fragility. This vulnerability may become apparent during periods of heightened issuance, quarter-end activity, or when dealer capacity is constrained.
Figure 2 — Yield–Funding Stress vs Funding Stress
What it is: Our YFS composite (curve inversion + plumbing) overlaid with BGCR–EFFR.
Why it matters: Both improved from 2023 peaks, but remain sensitive in a low‑cushion world. With RRP essentially drained, small frictions re‑emerge quickly, especially around month/quarter ends.
Rate dispersion is a key indicator of underlying liquidity stress. When Liquidity is unevenly distributed, market participants with varying access to funding price assets differently.
Figure 3 — Repo Rate Dispersion vs Volume
What it is: 99th–1st percentile BGCR spread vs tri‑party repo volume.
Why it matters: Rising dispersion alongside elevated volume says access is uneven—a classic pre‑stress configuration that rarely makes headlines until it breaks something visible.
Bottom line for Liquidity. The system cleared a lot of flow in 2023–25 because the “overflow tank” was in place. Today, that second‑tier buffer is gone. Issuance can still clear—until a minor speed bump forces balance‑sheet intermediation that no longer scales. That is why we care about the cushion. It doesn’t forecast tomorrow’s stress. It calibrates how big it will be when it arrives.
II. Labor — Momentum Fades, Resilience Thins
While aggregate labor market indicators appear robust, more granular data reveal weakening trends. Leading indicators are declining, and the re-employment process is becoming less effective.
Figure 4 — Labor Fragility Index (LFI, z‑score)
What it is: Composite of long‑duration unemployment share (+), quits (–), hires/ quits (–).
Why it matters: Higher = more fragile, the climb since early 2024 says job‑finding is harder, and the underlying fabric is wearing thinner even before layoffs rise.
Labor Fragility Index (z) — Higher = more fragile. Rising duration share + weaker flows = tougher re‑employment channel.
Figure 5 — Labor Dynamism Index (LDI, z‑score)
What it is: Composite of quits (+), hires/ quits (+), quits/ layoffs (+).
Why it matters: Lower = less churn/optionality—workers step back from job‑switching when they sense fewer outside options. LDI tends to lead payroll growth by a few quarters.
The underlying causes are evident when comparing quits to payrolls and hours worked to overall employment.
Figure 6 — Payroll Growth vs Quits Rate
What it is: Headline payroll YoY vs quits (z) on a matched window.
Why it matters: Payrolls can stay positive while quits slide—that’s a late‑cycle tell that momentum is fading under the surface, with the headline lagging the flow.
Figure 7 — Hours Worked vs Employment
What it is: Hours YoY (utilization) vs employment YoY (headcount).
Why it matters: Hours are the first lever firms pull; cuts here often precede flat/negative payrolls and softer income.
Bottom line for Labor: Nobody’s calling for a jobs crash here, but let’s not sugarcoat it—momentum’s bleeding out, and the odds of a fairytale disinflation are getting slimmer. When workers stop quitting and firms quietly trim hours, you’re late in the cycle. Credit should care, even if equities are still busy scrolling TikTok.
III. Credit — Priced for Perfection
If credit markets had a motto right now, it’d be: “What, me worry?” Spreads are tighter than my jeans after Thanksgiving, and everyone’s acting like default risk is a bedtime story for bears. Investors are still pricing high-yield and investment-grade credit like the storm’s done and dusted, even as the real economic weather radar blinks red. This isn’t just quirky sentiment—it’s classic late-cycle psychology, and the footprints are everywhere.
What’s less obvious, but even more consequential, is the steady migration in credit quality beneath the surface. Over the past decade, the share of BBB-rated bonds—the lowest investment-grade rung—has quietly surged, reaching nearly 50% of the entire IG universe. This is not just a technical detail; it’s a slow-moving build-up of risk that gets obscured when attention is focused solely on headline spreads and aggregate yields.
Nearly half of all IG bonds are now teetering on the edge—one downgrade away from joining the junkyard. That’s a lot of “safe” assets just waiting for a nudge. Tight spreads and market calm are the magician’s misdirection—what you don’t see is the trapdoor under your feet—classic late-cycle complacency at work.
Historical analysis demonstrates that during periods of heightened uncertainty, such as early 2020, credit spreads widened significantly, reflecting increased risk aversion and higher capital costs for lower-quality borrowers. In contrast, by 2025, spreads have narrowed to levels that imply expectations of a nearly flawless economic outcome, with high-yield option-adjusted spreads below 3 percent and BBB spreads at cycle lows. This pattern suggests that markets are not currently pricing in the possibility of renewed volatility.
However, a significant divergence persists: compensation for credit risk is declining, while the actual risk persists. Despite sub-3 percent high-yield spreads, the 12-month default probability for high-yield issuers has not decreased accordingly. In several market segments, default risk remains elevated or is increasing.
The chart above? It’s the punchline. HY spreads have collapsed, but default risk hasn’t RSVP’d to the party. Usually, these lines would dance together—risk up, spreads up. This cycle, spreads are screaming “no worries!” while the fundamentals are quietly updating their wills. If you’re paying up for high yield now, you’re basically betting on a fairy godmother. Spoiler: She rarely shows up this late in the cycle.
This isn’t just a trivia question for credit nerds—it’s a live wire for portfolios. When spreads stop reflecting real risk, your traditional signals go haywire. The margin for error is paper-thin. If something bad happens, spreads won’t widen—they’ll teleport.
Portfolio managers and asset allocators should prioritize analyzing default data over relying on surface-level indicators. Allocating capital based on the assumption that current spreads provide sufficient protection is increasingly risky. Adhering to fundamental analysis is essential, even when market signals suggest otherwise.
Despite current market optimism, both labor and liquidity indicators are signaling late-cycle risks, making the current pricing of credit risk anomalous. Historically, when such divergences occur, credit markets tend to adjust after other indicators. Compensation for credit risk is now minimal, and the margin for error is minimal. In this context, complacency becomes a substantive risk factor.
The forward-looking Sharpe for credit beta is poor at current spreads. Investors are being paid less and less to shoulder more and more risk, especially as volatility creeps higher beneath the surface. It’s the classic late-cycle mismatch: tight spreads, rising HY vol, and a market that seems to be ignoring the growing fragility in labor and Liquidity. This is not a call for panic or a forecast of imminent collapse. It is, instead, a recognition that the market’s risk/reward profile is deeply asymmetric. When the next shock arrives, the buffer is too thin to provide meaningful protection, and the repricing can be both rapid and severe.
This is the context in which we must frame our allocation and risk management decisions. It is not enough to note that credit appears well-behaved; we must ask why, and for how long. The lessons of previous cycles are clear: credit can ignore macro stress for a time, but when it moves, it tends to move first—and fast. This is the moment to be vigilant, to avoid over-leveraged exposures, and to favor balance-sheet strength over yield-chasing. The reward for patience and discipline will be greatest when the first cracks emerge, not when the market is still dancing on the edge.
Figure 8 — Credit–Labor Gap vs High‑Yield Spreads
What it is: HY OAS (bps) vs our Credit–Labor Gap = z(HY OAS) − z(LFI).
Why it matters: Negative gap = spreads too tight relative to labor stress; historically, a pre‑widening configuration as credit “catches up” to macro.
Figure 9 — HY Spread Difference vs HY Volatility
What it is: HY spread tightness against realized HY spread vol (Spread–Vol Imbalance).
Why it matters: Tight spreads with rising vol = poor compensation for risk; this is a late‑cycle mismatch that rarely persists.
The credit‑equity handoff matters here. Equities can ignore a lot while momentum is strong. That’s precisely why we track EMD.
Figure 10 — Equity Momentum Divergence (EMD, z‑score)
What it is: Distance of SPX from medium/long‑term trend, scaled by realized vol.
Why it matters: > +1σ signals stretched momentum with thin shock‑absorption—prone to air‑pockets when credit finally moves.
Bottom line for Credit: Not calling a meltdown on a calendar date—but let’s be honest, the Sharpe for credit beta right now is the stuff of stand-up comedy. When the flow turns, credit’s the first to trip on the rug. And the carpet is definitely starting to wrinkle.
IV. Quality vs. Risk: A Chart of the Cycle
A striking illustration of this late-cycle dynamic is the relationship between the iShares MSCI USA Quality Factor ETF (QUAL) and the S&P 500 ETF (SPY). As the chart above shows, QUAL has recently traded at or near all-time lows versus SPY, even as macro risks have mounted. This is not merely a technical quirk—it is a symptom of a deeper behavioral pattern among investors.
Despite mounting evidence of late-cycle fragility, there remains a robust appetite for risk in public markets. Investors, intent on chasing returns, continue to pay a premium for lower-quality, higher-volatility names—often at the expense of better-capitalized, higher-quality companies. In effect, the market is rewarding risk-taking while discounting the virtues of balance-sheet strength and operational resilience. This is not the first time we’ve seen such a pattern at this point in the cycle. Late-stage bull markets are notorious for their willingness to pay up for growth and narrative over quality and substance. But the current divergence is particularly acute, raising important questions for anyone allocating capital in this environment.
Why pay a premium for risk at the expense of quality? Part of the answer lies in the momentum-driven nature of today’s markets. When the prevailing trade is to “buy the dip” and chase performance, quality factors can lag—even as the fundamental backdrop deteriorates. The temptation to reach for yield, embrace leverage, and ignore mounting macro headwinds is understandable but also dangerous. The QUAL/SPY ratio is a real-time barometer of investor psychology, and its current lows should be viewed as a warning sign, not a green light.
For disciplined allocators, this presents both a challenge and an opportunity. The challenge is to resist the siren song of risk premia that are no longer compensating for underlying volatility. The opportunity is to build positions in quality assets—those with strong balance sheets, sustainable cash flows, and proven management—at a moment when the market is indifferent to their virtues. History suggests that these moments are fleeting and that the rewards for patience and selectivity can be substantial when the cycle turns.
V. Macro — The Hidden Transition
Put the pieces together, and the macro shape is unmistakable: the buffer is thin, labor energy is fading, and credit is priced like neither is true. In essence, the market appears to be whistling past the graveyard, confident that the good times can continue indefinitely. But this is precisely the kind of late-cycle transition that has, time and again, caught investors off guard. It is a state that feels calm and orderly—until, quite suddenly, it isn’t.
What makes this moment so perilous is not simply the convergence of warning signals, but the market’s apparent indifference to them. Whether it’s the erosion of liquidity buffers, the visible loss of labor dynamism, or the persistent underpricing of credit risk, each factor alone would warrant caution. Taken together, they describe an environment where the margin for error is vanishingly small. Investors may not be able to predict the catalyst for the next episode of volatility, but they can control their exposure to the consequences. In this regime, the prudent course is to prioritize resiliency over return, and to build portfolios that can weather a broader range of outcomes than the market currently imagines.
The hidden transition is only hidden to those who are not looking. For those willing to read the signals, the message is clear: this is a time for humility, discipline, and a renewed respect for risk. The next chapter will not be written by those who chase the last basis point of yield or the next narrative-driven rally, but by those who recognize that the cycle is changing—and who are prepared to change with it.
Figure 11 — Macro Risk Index vs S&P 500
What it is: MRI (z) = +Fragility −Dynamism +YFS +CSE +EMD −LCI, overlaid with S&P 500 (index=100).
Why it matters: When MRI rises while equities climb, markets are under‑pricing macro risk. Divergences don’t pick dates; they define asymmetry.
Macro Risk Index vs S&P 500 — Macro risk rising while prices rise = under‑priced risk; the divergence defines the asymmetry.
This is also where the LCI concept pays dividends. If you think of ON RRP + reserves as the system’s crumple zone, the economy can handle bumps with minor visible damage while the crumple zone is intact. With that zone mostly gone, small bumps do bigger things.
Cross-Asset Implications
Sequence and sensitivity. In the late cycle, credit usually moves first, equities second, and rates are the referee. With curves still distorted by policy expectations, the term premium becomes the silent swing factor: if funding frictions regain traction. At the same time, the cushion is thin, term premia can rise even as growth slows — bad optics for both multiples and spreads.
Correlations and hedging. The stock‑bond hedge has been less reliable during periods of positive correlation. That does not kill duration as a hedge; it qualifies it. In an asymmetric repricing led by credit, a measured amount of belly duration still provides convexity — don’t assume a 2010s‑style negative correlation saves you mechanically. Credit options (CDX/ETF puts) or equity vol can be sized precisely to the stress you fear.
Dollar dynamics. If funding tightens and term premia rise, the USD tends to bid, which is a headwind for global beta and for commodity spill‑overs. It’s not a one‑way trade; it’s a symptom of the same plumbing that concerns us.
Earnings path. The earnings channel reacts later than flows, but it reacts. Lower hours and softer churn bleed into wages and revenue growth; pair that with rising funding costs, and you get a margin + mix that is less favorable, just as multiples are rich. That is the equity asymmetry.
Tactical Playbook
Credit.
Fade beta on strength. Tight HY/BBB + rising HY vol is a poor forward Sharpe.
Favor balance‑sheet quality. Up‑in‑quality IG and “rising stars” over BBBs hovering near the cliff.
Keep dry powder. Do not sell crises you don’t own — buy them. The best credit entries come after the first gap widens.
Equities.
Quality, cash, and duration sensitivity. Prefer cash‑flow compounders with self‑funding models; pare high operating leverage and “narrative carry.”
Be tactical with momentum. EMD > +1σ doesn’t time a turn; it tells you the payoff profile has skewed. Use it to size hedges, not to call tops.
Rates.
Belly over the long end. Add convexity without fully embracing the 30-year volatility.
Curve normalization trades. If cuts are front‑loaded in pricing, hedge that optimism; harvest roll‑down where the curve still pays you.
Macro Hedges.
Gold + quality duration. Complementary convexity if policy or plumbing wobble.
USD vs cyclicals. A clean way to reflect funding‑led stress without over‑concentrating equity or credit risk.
Optionality over leverage. Spreads are tight; vol is not exorbitant. Pay for convexity now, not after the gap.
Risk Management
Trigger discipline. Treat LFI > 0σ, LDI < 0σ, and LCI drifting toward 0σ as a regime set. If HY OAS ticks up while SVI stays elevated, tighten sails.
Exit discipline. If LDI re‑accelerates and hours firm, or if funding frictions stay muted despite a thinner cushion, dial hedges back—update views, not priors.
What To Watch (Simple Checklist)
Cushion: LCI direction (z) and CL/GDP level view.
Flows: LDI (quits/hires/layoffs) and LFI (duration/flows) confirm the same story.
Credit tells: CLG negative (credit too tight vs labor), SVI elevated (spreads too tight vs vol).
Plumbing: BGCR–EFFR and repo dispersion — first hints live here.
Divergences: MRI up while SPX up is the definition of asymmetry.
That’s our view from the Watch. As always, we’ll be sure to leave the light on…