Why Did the Stock Market Fall and What's Coming Next?

Key Concepts

• ISM PMI (Purchasing Managers' Index): A key economic indicator measuring the health of the manufacturing and service sectors. Values above 50 indicate expansion, below 50 contraction.
• Yield Curve: A line that plots the interest rates (yields) of bonds having equal credit quality but differing maturity dates. The shape of the yield curve can indicate expectations about future economic growth and inflation.
• Term Premium: The extra return investors demand for holding a long-term bond, compensating them for the risk of interest rate fluctuations and inflation.
• Trade Policy Uncertainty: A measure of uncertainty surrounding international trade policies, often impacting market volatility and economic growth.
• Real Yields: Nominal yields adjusted for inflation, providing a clearer picture of the actual return on investment.
• Basis Points: A unit of measurement used for interest rates, where 100 basis points equals 1%.

Economic Data & Market Response

The initial US economic data release doesn’t support immediate Federal Reserve (Fed) interest rate cuts, leading to a downturn in stock markets. Market participation was relatively weak, characterized by volatility.

• Stock Market Performance: NASDAQ showed no gains, S&P 500 fell 0.4%. The front end of the yield curve rose while the back end fell, suggesting weakening near-term rate cut expectations.
• Commodities: Crude oil continued to hover near the bottom of its range. Gold experienced a minor correction. The US dollar strengthened (0.1% gain against the Euro and Yen), a trend observed over several days. Bitcoin failed to break December’s range high, erasing January 5th gains and returning to late December levels.
• ISM Data: The service sector experienced a significant rebound in December, with an ISM reading of 52.3, marking a 10-month high and the highest reading since October 2024. This contrasts with a slightly faster contraction in the manufacturing sector (47.9). A composite index (70% services, 30% manufacturing) indicates overall economic growth.
• Employment: Service sector employment returned to growth (index above 50), reaching a 14-month high, the strongest since October 2024. Manufacturing employment remained weak.
• Inflation: Price indexes in both surveys suggest cooling inflation, potentially due to the impact of tariffs fading.
• New Orders: Surged to 57.9, the strongest reading since September 2024, indicating strong demand.

Fed Calculus & Policy Outlook

The strong service sector data presents a challenge to the Fed’s narrative of a slowing economy requiring rate cuts. While manufacturing remains in contraction, the robust service sector (representing 70-80% of the US economy) complicates the argument for easing monetary policy.

• Fed Expectations vs. Market Expectations: The Fed increased growth expectations in December, while downgrading inflation expectations. Markets still anticipate 56 basis points of rate cuts this year, with a preference for cuts in the first half of the year, a pace faster than the Fed’s current outlook of one cut per year.
• January Rate Cut Probability: The probability of a rate cut in January has decreased to 11.6% from previous levels.
• April as a Potential Cut Date: The market is pricing in a cut by April, potentially linked to the anniversary of the initial tariff rollouts, anticipating a base effect on inflation calculations.

Market Dynamics & Underlying Concerns

Despite the strong economic data, markets aren’t pricing in significant inflation or reducing rate cut expectations. This suggests underlying concerns about future economic conditions.

• Inflation Expectations: Inflation expectations remain subdued, despite the buoyant ISM numbers.
• Yield Curve Analysis: While yields have rebounded, real yields are also rising. The term premium – compensation for uncertainty – is at a 22-year high, indicating heightened risk aversion.
• Trade Policy Uncertainty: Elevated trade policy uncertainty, reminiscent of 2024, is a key driver of market anxiety. The trade policy uncertainty index spiked last year, causing a temporary stock market correction.
• Global Trade Slowdown: The most aggressive year-on-year decline in global trade volumes since the 2008-2009 financial crisis is fueling concerns.
• Tech & AI Dependence: The market’s reliance on tech and AI optimism, coupled with a globally dispersed supply chain, makes it vulnerable to disruptions caused by trade policy uncertainty.

Trading Strategy & Commentary

Millian Speedback outlines his current trading positions based on the prevailing market conditions:

• Long Gold: Maintaining a long position in gold due to ongoing global trade uncertainty.
• Long Dollar: Initiated long positions in the US dollar against the British pound and the Euro, anticipating potential dollar strength if the Fed remains hawkish.
• Short Risk: Maintaining short positions in the Russell, NASDAQ, and S&P 500 via put verticals.
• Bitcoin: Exited a short Bitcoin position (IBIT put spreads) with a flat result, and is looking for confirmation of a resumed downtrend before re-entering.

Notable Quotes

• “The Fed has been resistant to cut and has demanded more evidence and so we've concluded that maybe the long end is uh going to be a little bit soggy on the yields front and outperform a little bit on the prices front as more easing goes into the back end.”
• “It's not exactly a meaningful change, but we can see here the markets want their cuts and they want them for the most part toward the first half of the year.”
• “What is it that the markets are so afraid of? Is this why they want rate cuts? Because they receive a lot of uncertainty?”

Synthesis & Conclusion

The recent economic data presents a mixed picture. While manufacturing remains weak, the service sector is surprisingly robust, challenging the Fed’s narrative of a slowing economy. Markets are interpreting this data not as a signal to reduce rate cut expectations, but as evidence of underlying vulnerabilities and heightened uncertainty, particularly related to trade policy. This has led to increased risk aversion, reflected in the elevated term premium and a preference for safe-haven assets like the US dollar. The market’s insistence on rate cuts despite strong data suggests a deep-seated fear of potential economic disruptions and a desire for policy support to mitigate those risks. The upcoming jobs data release will be crucial in confirming the strength of the labor market and further clarifying the Fed’s policy path.