The stock market continues to hit new highs, even amid some recession- and downturn-portending news: the yield curve (a visual representation of the yield earned on US Treasuries of varying maturities) has been inverted for an entire quarter now, and lots of companies are issuing guidance warning that second quarter earnings will be below estimates.
Below is the yield curve as it currently looks (the blue line) compared to how it looked a year ago (the black line). Each point on the line represents the yield of a US government security of that particular maturity. If you buy a US t-bill that matures in a month, you will earn an annualized yield of about 2.25%. A year ago, that yield was more like 1.83%. Note the difference in the shapes of the lines: a year ago, the line, or curve, had what's considered a "normal" shape, with lower rates in the near future and higher rates later. This makes sense when you consider that you would want more of a return for a longer-term investment, since inflation will eat up some of the buying power of your money over time.
But now we're looking at a situation where rates are higher now, then lower later (or inverted). That means the market is anticipating a period of time with very low returns, partly because of very low inflation.
(image via @wsj)
But the market isn't the economy and the economy isn't the market, and stocks could continue their run for a while even if rates continue to drop. Or, something unrelated to the economic data could spark a sustained selloff. Indeed, stocks sold off on Friday when the jobs report was stronger than expected, indicating that the Federal Reserve has less of a case to cut rates at their next meeting at the end of July.
This all seems counterintuitive, and it is: if the news is good, shouldn’t the market reaction be positive? But the Federal Reserve tries to manage inflation by adjusting the Fed Funds Rate. This is not an interest rate that’s represented in the above graph, by the way - it’s the rate that banks charge each other for overnight deposits. Increasing the rate decreases the amount of money that’s available in the economy, lowering inflation, and vice versa. The Fed Funds Rate then feeds the Prime Rate, which is the rate that banks charge their most credit-worthy customers, and which in turn affects how much we, and businesses, pay to borrow money. If businesses have to pay more to borrow, they can’t expand as quickly and their short-term profits are impacted. This should only concern you, though, if you’ve built an investment strategy around trying to predict what will happen and when. Just like all other periods of uncertainty, it’s an exercise in staying disciplined and sticking to your goals.