The Fed: two goals and its policy tools
The US central bank, the Federal Reserve (the Fed), has two goals: maximum employment and price stability (2% a year by the personal consumption expenditures price index). When inflation is above target it raises rates to cool the economy, and when employment weakens it cuts rates to support it.
- Policy rate: the FOMC meets eight times a year to set the target range for the federal funds rate (e.g. 4.00–4.25%).
- Dot plot: at the March, June, September and December meetings, members’ expected future rates are published as dots. The market watches for changes in the dot plot median.
- Balance sheet: it buys Treasuries and other assets to add money (quantitative easing), or lets them mature without reinvesting to withdraw money (quantitative tightening).
- Words: statement wording, the chair’s press conference and members’ speeches signal future policy (forward guidance).
How economic data reach stock prices
- Economic dataCPI, jobs, GDP
- Rate expectationsExpected next Fed move
- Treasury yields2-year and 10-year
- Discount rate and earnings outlookValuations change
- Stock pricesGrowth stocks more sensitive
Treasury yields and the yield curve
US Treasury yields are the benchmark for asset prices worldwide. The 2-year reflects expectations for the policy rate over the next two years, while the10-year reflects more of the long-term growth and inflation outlook and risk premiums.
- Discount rate: when the 10-year yield rises, the discount rate on stocks rises too and values fall. Growth stocks, with a large share of future earnings, are especially sensitive (chapter 7).
- Real yields: nominal yields minus expected inflation (inflation-protected Treasury yields), which often move with growth stock valuations.
- Yield curve: long-term yields are usually higher than short-term ones. An inversion, where short-term yields rise above long-term ones, has often appeared before past recessions and draws attention as an economic signal, but its timing and accuracy are inconsistent.
The yield curve: normal and inverted shapes (example)
How data change rate expectations
Economic data usually affect stocks along the path “data → expectations for the Fed’s next move → Treasury yields → stock discount rates and the economic outlook”.
| Data | Common reading when it comes in higher than expected |
|---|---|
| CPI and PCE inflation | Rate cuts may be delayed → yields rise → pressure on stocks |
| Jobs report (nonfarm payrolls) | The economy is strong. But when inflation is a worry, higher yields can make it a burden |
| Wage growth | Pressure on services inflation → toward higher yields |
| GDP and retail sales | Strong growth → positive for earnings outlooks, upward pressure on yields |
The dollar and exchange-rate effects for won investors
When you invest in US stocks with won, the exchange rate multiplies into your return. Return in won = (1 + stock return) × (1 + change in exchange rate) − 1.
- A stronger dollar in crises: when global markets are anxious the dollar often strengthens (the won/dollar rate rises). Even if US stocks fall then, the rise in the exchange rate often acts as a cushion, offsetting part of the loss in won.
- The reverse: even if US stocks rise, a stronger won (a falling exchange rate) shrinks your return in won.
- Currency hedging: Korean-listed foreign ETFs with (H) in their names are designed to reduce exchange-rate swings. In return there are hedging costs, and the cushion effect above disappears.
For US companies too, a strong dollar shrinks foreign sales when converted into dollars, weighing on the results of big tech companies with large foreign sales. That is why earnings releases separately state “growth excluding currency effects”.
When the exchange rate cushions a fall in US stocks (example)
Weaker won (stronger dollar)
0.90 × 1.08 − 1
Market-cap-weighted indexes and concentration
The S&P 500 and Nasdaq 100 are market-cap-weighted indexes, in which stocks with larger market caps (on a float basis) get larger weights. Recently concentration has grown so that about the top 10 large tech stocks make up more than a third of the S&P 500.
- Even when the index rises, most stocks may have fallen that day. Comparing with an equal-weight index holding the same stocks in equal weights shows the “breadth” of the market.
- Buying an index ETF is effectively putting a big weight on the top large caps. It may be less diversified than you think (chapter 8).
- US stocks are divided into 11 GICS sectors (information technology, communication services, consumer discretionary, health care, financials, industrials, consumer staples, energy, utilities, materials and real estate). Each sector reacts differently to rates and the economy.
Concentration in a market-cap-weighted index (example, varies over time)
- Top 10 stocks 35%
- Remaining ~490 65%
Flow calendars: expirations and rebalancing
- Options expiration: monthly options usually expire on the third Friday of each month. On the third Fridays of March, June, September and December, index futures and options and single-stock options expire together and volume jumps. With the rise of options that have one day (or zero days) to expiration, many analyses say they also affect intraday moves.
- Index rebalancing: the S&P 500 and others adjust weights and add or remove stocks every quarter. Stocks announced for inclusion face scheduled mechanical buying by index funds. These trades pile into the closing auction (chapter 9).
- Earnings season and buyback blackouts: many companies customarily pause buybacks for a period before reporting, and some analyses say demand weakens just before earnings season.
- Year end and quarter end: seasonal patterns can appear from funds’ performance dates, tax-loss selling and similar reasons.
A map for reading the day’s news
- Rates: how did 2-year and 10-year Treasury yields move? Was it because of data or Fed remarks?
- Dollar: what did the dollar index and the won/dollar rate do? How does that affect your return in won?
- Index and breadth: did the whole index move, or only some large caps?
- Sectors: how did rate-sensitive sectors (technology, real estate) and economy-sensitive sectors (industrials, materials) diverge?
- Volatility: did the VIX move a lot? It shows whether the market expects big moves ahead (chapter 13).
- Company-specific issues: was there earnings, guidance or regulatory news?
Earnings estimates and the rhythm of earnings season
Over the long run, stock indexes follow corporate earnings. Splitting an index into its aggregate earnings estimate (e.g. next-12-month EPS for the S&P 500) and the multiple on that estimate (forward P/E) separates whether market moves come “from earnings or from multiples” (re-rating in chapter 7).
- The habit of cutting estimates during the quarter: analyst estimates often drift lower as the quarter goes on, and actual results often beat those lowered estimates. So judging an earnings season only by “the share of companies that beat” can make it look better than it is.
- Concentration in large caps: when a few large tech stocks account for a big share of index earnings growth, those few companies’ reports set the mood of the whole season.
- Banks go first: big banks often open earnings season, and their comments on lending and delinquencies are the first clues to the state of the economy.
Oil, commodities and sectors
Oil prices affect inflation, consumption and energy sector earnings together. Higher oil lifts energy companies’ profits but weighs on airline and transport costs and on consumers’ real purchasing power, and affects rate expectations through inflation data.
| When this rises | Relatively favored (common reading) | Under pressure |
|---|---|---|
| Oil | Energy producers | Airlines, transport, consumer goods; inflation → rates |
| Long-term yields | Banks (interest margins), some value stocks | Growth stocks, high-dividend sectors such as real estate and utilities |
| Dollar | US domestic companies with large import shares | Multinationals with large foreign sales |
| Copper and other industrial commodities | Commodity producers | Manufacturers with a large share of input costs |
These relationships are only tendencies and don’t always hold. The same rise in oil can produce opposite reactions in the whole market depending on whether it comes from strong demand (a strong economy) or supply disruption (a cost shock).