The markets have gained despite war, disease, rate hikes and recession fears thrown at them. This piece seeks to analyse what's going right for the markets and what may challenge them, going forward. First the positives: Indian indices have gained for the second straight week. Foreign investors, after being massive sellers through March, bought a handy $370 million of shares on Friday. Their return to India is in step with the bounceback of risk assets world over. Last week, both the US and European markets saw their best weekly returns since 2020. Helping the sentiment was the fall in crude oil prices for the second straight week even as commodities from copper to coal saw a good 10-20 percent cool off in prices. The Nasdaq is now nearly 10 percent above its early March lows, while the Nifty is nearly 9 percent off its post-Ukraine lows.The prime reason for the bounceback is the correction from oversold levels. No matter what the fundamentals, when the CBOE VIX ( the volatility index or the fear gauge) hits 35, the markets are in heavily oversold terrain and a bounceback is usually likely. Speaking of fundamentals, the market has had three big worries: 1. the war, 2. the resurgence of Covid and resultant lockdowns in China and East Asia and 3. the Fed's tightening schedule.Also Read: Brokerages laud new MFI norms for banks; details hereCurrently, the big positive for the market is that the negatives are known. The market has somewhat gauged the worst that can happen to prices, inflation and growth due to the war. The assumption it is making is that crude prices won't get past $130/barrel again. Secondly, it is believing what the WHO is saying about the latest Covid wave: that it is milder and hitting countries with more ageing populace and those that haven't gone through widespread infection like India went through last May with delta and in January with Omicron. Finally, the market appears to have fully discounted the seven rate hikes that the Fed indicated this year plus the three next year.Also Read: View | The influence of CBDC and crypto tax on millennial investorsTwo questions arise now: 1. Can markets rise to their all-time highs anytime soon and 2. Can they set new highs in 2022.Right now, even if the Nasdaq is 10 percent off its lows, it is 13 percent off its last October highs. Likewise the Nifty is 9 percent off its recent lows, but it is 7.3 percent off its all-time highs hit last October. What's different now is global inflation is sure to be much higher than that envisaged last October, and growth will definitely be slower than earlier estimated. Can markets pole vault those October highs, as they roll forward the Earnings per share(EPS) calculations to 2023? Possibly yes. Firstly, inflation is good for the EPS of many companies. It is certainly good for commodity companies and for consumer companies that can pass on costs. Many companies may earn in realisations what they lose in volume. 2023 EPS may still have to be downgraded if they haven't already been. But if the 2004-2008 rate hiking cycle is anything to go by, markets should climb in the early part of the rate hiking cycle. The descent starts only when it becomes clear that rate hikes are biting off growth, which isn't the case now. As Fed chairman Jerome Powell said, “the economy is robust enough to withstand several rate increases”.Also Read: US Fed hikes interest rates after over 3 years; how it will impact IndiaSo, what can scare the bulls? The future course of the war looks unlikely to scare the bulls right now, as the negatives are known. The future course of Covid remains uncertain, but the WHO.’s analysis appears to be comforting for now.The bigger scare for the bulls can come from the Fed's balance-sheet reduction timetable. The Fed's balance-sheet is around $9 trillion strong, up from only $4.5 trillion before March 2020. Of this $9 trillion, $5.7 trillion are US government treasuries and $2.7 trillion are mortgage-backed securities. The Fed has revealed precious little about the balance-sheet reduction timetable except that: 1. It will be reduced faster than in 2017 and 2. that it will eventually like to hold only treasuries, not MBS.The maturity profile of the Fed's balance-sheet shows that $405 billion will mature in 90 days, and $1.2 trillion of treasuries will mature in a year. In 2017, the Fed allowed a maximum of $50 billion of bonds per month to mature and run off its balance sheet. A similar amount this time will be too little. It will crunch the balance sheet by $600 billion in a year, which amounts to just 6.5 percent of its $9 trillion balance-sheet.Even if the Fed were to double the amount, i.e. all the $1.2 trillion of treasuries that mature in the next 12 months are allowed to run-off, the reduction would be just 13 percent. The Fed's balance-sheet would still be nearly double its pre-Covid size. It is possible, that's why the markets are not deterred by the Fed tightening just yet.The Fed could face some problems even allowing this first tranche of $1.2 trillion to run off. Last time, the run-off had created serious short-term illiquidity in the US money market. The bigger problem for the Fed would be that allowing treasuries to run off will increase the share of MBS in its balance-sheet. The Fed has expressly said it would like to hold only treasuries eventually. Now the Fed's MBS maturity profit shows that barely $43 million of MBS mature this year, while a bulk of $65 billion will mature in ten years.Mortgages are typically long-term paper, and in a rising interest rate scenario pre-payments fall. This means the Fed will have to sell mortgages in the market, and this can drive up home loan rates sharply. This, then is the next-big thing to watch for the markets - how the Fed reduces its MBS portfolio in particular, and its overall balance-sheet in general.This won't be known until the (Federal Open Market Committee)FOMC’s May meeting and hence markets are probably calculating they have a clean run till then.