Up big one day, down a lot the next. What’s driving the stock market volatility?

A trader works on the floor of the New York Stock Exchange at the closing bell Tuesday.
A trader works on the floor of the New York Stock Exchange at the closing bell Tuesday.
(Justin Lane / EPA/Shutterstock)

One day the Dow Jones industrial average drops 500 points, then it shoots up 600 points and a few days later it plummets 800 points — 799 to be exact Tuesday.

What in the name of Warren Buffett is going on?

For the record:

8:20 a.m. Dec. 5, 2018An earlier version of this article incorrectly described an inverted yield curve as occurring when the yield on short-term bonds falls below those of long-term bonds. An inversion is the opposite: when short-term yields exceed long-term yields.

Financial markets have been highly volatile the last few weeks, knocked up and down by several key factors beyond the usual day-to-day movements related to specific companies.

What’s causing it?


Let’s start with trade.

The ongoing trade war between the U.S. and China has weighed heavily on investors. With the two nations slapping tariffs on each other’s products, and threatening more, investors have been wary about the effect on companies that rely on exports and imports.

But weren’t stocks just up Monday because of optimism about trade?

Yes, those worries were eased over the weekend when President Trump and Chinese President Xi Jinping emerged from a steak dinner at the Group of 20 economic summit in Argentina to announce a 90-day truce in the escalating trade battle.

Trump added to the exuberance by tweeting late Sunday that China has agreed to eliminate tariffs on U.S. auto imports. The development helped send stocks higher when financial markets opened Monday.

So what happened on Tuesday?

Questions have started to arise about how much progress was made in Argentina. Chinese officials said nothing about the auto tariffs, and top Trump administration officials said there was no specific agreement on that point.

Trump poured more cold water on hopes that the trade war was close to being resolved by tweeting Tuesday that “I am a Tariff Man” and that the U.S. was taking in billions of dollars from the levies. He indicated he’s willing to keep the tariffs in place if trade talks with China don’t produce results.

Those comments helped accelerate Tuesday’s sell-off.

“I think the market is now in a wait-and-see, and the market is trying to figure out is there going to be a real deal at the end of 90 days or not,” Treasury Secretary Steven T. Mnuchin said at an event in New York on Tuesday. “Whether we can get that to a real agreement or at least make a lot of progress over the 90-day period or not, time will tell.”

Why is everybody so worried about the U.S.-China trade dispute?

The U.S. and China are the world’s two largest economies. Their trade war has ripple effects around the globe.

The Organization for Economic Cooperation and Development recently forecast worldwide economic growth would slow to 3.5% next year from this year’s 3.7%. Trade tensions were a major reason.

Are there other reasons why global economic growth is slowing?

Yes, there’s another big reason and it’s been a factor in the financial market turmoil as well.

The Federal Reserve has been slowly raising a key interest rate over the last couple of years. It’s been doing that as the U.S. economy has strengthened to try to head off potentially high inflation.

Rising interest rates help slow the economy by making it less enticing to borrow money. Trump hasn’t been happy about the increases. Fed officials have indicated they remain on track for another small rate hike this month but could slow the pace next year based on incoming economic and financial data.

If the economy is slowing, why is the Fed still raising rates?

The short answer is the U.S. economy is still growing at a solid rate and the central bank’s benchmark federal funds rate remains historically low after it was held near zero for seven years during and after the Great Recession.

Boosted by the Republican tax cuts, the U.S. economy grew at a 4.2% annual rate in the second quarter of the year, the fastest since 2014. As the stimulus from the cuts faded, the annual growth rate slowed to a still-strong 3.5% in the third-quarter. Economists are forecasting the rate to slow further in the fourth quarter, to about 2.6%.

Still, Fed Chairman Jerome H. Powell was mostly upbeat about the economy in a speech last week, saying, “There is a great deal to like about this outlook.”

Another top official, John Williams, president of the Federal Reserve Bank of New York, told reporters Tuesday that “the U.S. economy is strong,” although he added there were “definitely … some risks on the horizon.”

So there is still room for the Fed’s interest rate to rise before it hits a level at which it would be deemed to be neutral — the point at which it isn’t speeding up or slowing down the economy.

How do the Fed’s interest rate hikes affect the stock market?

They do that in a couple of ways. First, higher interest rates make stocks a less-attractive investment than buying bonds or just saving the money.

Also, the higher U.S. interest rate draws investments that might have gone to developing economies around the world in search of higher returns. That slows the growth of those economies, which has a spillover effect on the world economy.

Don’t interest rates also have an effect on some complex thing called the yield curve? And what is that, anyway?

Yes, rising interest rates for long-term Treasury bonds compared with short-term ones factor into what’s known as the yield curve, which is the difference between those two rates.

When investors are optimistic about the economy’s long-term growth, there is a large spread between the yields on short-term bonds and long-term ones. Longer-term bonds usually have a higher yield than shorter-term ones to reflect the greater risk in stashing your money away for more time.

But when there’s a sense the economy is faltering, the yields on short-term bonds rise because investors seek to lock in current rates before they start falling, as they do when the economy slows.

When a short-term yield rises above a long-term yield, that’s known as an inverted yield curve.

Has that happened?

Yes, for some types of bonds.

On Monday, the yield on five-year Treasury bonds fell below the yield for two-year bonds for the first time since 2007. On Tuesday, the same thing happened for the yield curve between three-year bonds and five-year bonds.

And the yield curves for other combinations of short-term and long-term bonds are getting closer to an inversion.

Is an inverted yield curve a bad thing?

Usually, yes.

Over the last 60 years, every U.S. recession has been preceded by an inverted yield curve for one-year bonds compared with 10-year bonds, according to research in March by the Federal Reserve Bank of San Francisco.

“Periods with an inverted yield curve are reliably followed by economic slowdowns and almost always by a recession,” the Fed study said.

That particular yield curve hasn’t turned negative yet — but it’s moving in that direction.

The yield on one-year bonds was 2.72% on Tuesday. The 10-year yield was 2.91%.

The difference between them has narrowed significantly in the last month.

Twitter: @JimPuzzanghera