The stock market suffered its worst day in 2023 on Tuesday, with big losses for all three major stock market benchmarks. As we have seen many times before, is Nasdaq Composite (^IXIC) lost the most ground on a percentage basis, but is declining for S&P 500 (^GSPC 1.65%) and Dow Jones Industrial Average (^DJI 0.77%) were also significant.

Data source: Yahoo! Finance.

Even after today’s declines, the Dow, S&P and Nasdaq remain higher than a year ago. Still, there was a decidedly negative tone to investor sentiment on Tuesday, with many appearing to believe that the rebound from 2022’s dire market environment could give way to another leg down for stocks. Here’s what’s going on behind the scenes, and what may be contributing to the sour mood on Wall Street.

Bond yields are rising again

The stock market receives the most attention from ordinary investors. But on Wall Street, the bond market is getting a lot more attention, and the message it’s been sending lately has been much different from the way stocks have reacted.

Image source: Getty Images.

During January’s big market rally, investors believed the Federal Reserve would have to back off its aggressive stance on interest rates. Many forecasters expected the Fed to cut rates by the end of 2023, which would seem like an abrupt reversal given the rapid rate hike in 2022. These forecasts stood in stark contrast to the Fed’s own. predictions, with voting members of the Federal Open Market Committee suggesting that further increases to a range of 5% to 5.25% were likely by the end of the year.

Last week, however, investors in the bond market finally began to accept the likelihood that the Fed would remain disciplined rather than withdraw its hawkish stance. As a result, yields on T-bills with maturities of six and 12 months crossed the 5% mark for the first time in 16 years.

Interest rates on government bonds over all maturities went even higher on Tuesday. Yield increases of 0.1 to 0.15 percentage points were common, although these are large movements for the bond market. Even with these moves higher, however, the yield curve remained inverted, with long-term yields on 10- and 30-year Treasuries still below 4%. This state of affairs suggests that the chances of a recession are more likely than they were in the past.

Will inflation force the Fed’s hand?

One problem is that equity investors in some ways face short-term challenges regardless of what happens. If companies use their pricing power to increase their earnings, their profits should improve, but the higher prices will feed inflation that will make the Fed more aggressive in interest rate policy. If companies don’t use that pricing power, inflation could ease, but that would come with a trade-off of lower profits that could send stock prices lower.

In the long term, beating inflation will have a positive impact on stocks. If it comes with short-term disruptions that send share prices lower in the near term, it should prove to be another buying opportunity for investors who missed out on buying shares at last October’s record lows. In fact, investors with a long-term mindset should be pleased that the Fed is fighting so hard to return the economy to the favorable conditions that led to the bull market of the 2010s.