Investors Fear 2023's Stock Market Bounce Is Over -- But You Shouldn't

The stock market suffered its worst day of 2023 on Tuesday, with major losses for all three major stock market benchmarks. As we've seen numerous times before, the Nasdaq Composite (^IXIC -2.05%) lost the most ground on a percentage basis, but declines for the S&P 500 (^GSPC -0.88%) and the Dow Jones Industrial Average (^DJI 0.56%) were also significant.

Data source: Yahoo! Finance.

Even after today's declines, the Dow, S&P, and Nasdaq all remain higher on the year. Yet, there was a decidedly negative tone to investor sentiment on Tuesday, and many seem to believe that the rebound from 2022's terrible market environment might give way to another leg down for stocks. Here's what's going on behind the scenes and what might be contributing to the dour mood on Wall Street.

Bond yields move higher again

The stock market gets most of the attention from ordinary investors. But on Wall Street, the bond market gets a lot more attention, and the message it has sent lately has been a lot different from the way stocks have reacted.

Image source: Getty Images.

During January's big market rally, investors believed that the Federal Reserve would have to back off its aggressive stance on interest rates. Many forecasters expected the Fed to have to reduce its federal funds rate by the end of 2023, doing what would seem like an abrupt about-face given the quick pace of interest rate increases in 2022. Those forecasts stood in stark contrast to the Fed's own predictions, with the voting members on the Federal Open Market Committee suggesting that further increases to a range of 5% to 5.25% were likely by year end.

Last week, though, bond market investors finally started to accept the likelihood that the Fed would stay disciplined rather than backing off its hawkish stance. As a result, yields on Treasury bills with maturities of six and 12 months moved above the 5% mark for the first time in 16 years.

Yields on Treasury bonds across all maturities moved even higher on Tuesday. Yield increases of 0.1 to 0.15 percentage points were commonplace, even though these are huge moves for the bond market. Even with those moves higher, though, the yield curve remained inverted, with longer-term rates on 10-year and 30-year Treasuries still below 4%. That state of affairs suggests that odds of a recession are more likely than they were previously.

Will inflation force the Fed's hand?

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

In the long run, beating inflation will have a positive impact on stocks. If that comes with short-term disruptions that send stock prices lower in the near term, then that should prove to be one more buying opportunity for investors who missed buying stocks at last October's lowest prices. Indeed, investors with a long-term mindset should be happy that the Fed is fighting so hard to get the economy back to the favorable conditions that prompted the bull market of the 2010s.