Inflation fears are sparking a big drop in markets. Here are 3 things to know

It's been a rough start of the year for Wall Street – and it keeps getting worse.

Concerns about surging inflation are keeping investors on edge, sending stocks sharply lower on Tuesday. The Federal Reserve has projected it will raise interest rates three times this year, which could raise borrowing costs across the economy, including for mortgages and car loans.

But investors fear the Fed will need to be even more aggressive given how stubborn inflation has been. Consumer prices surged 7% in December, the biggest annual increase since 1982.

Many analysts now believe the Federal Reserve will start raising interest rates in March and that the central bank may need to raise them four times this year.

As a result, bond markets have sold off and stocks have tumbled since the start of the year, with the Nasdaq down nearly 7% so far in 2022 as of early afternoon on Tuesday.

Here are three things to know about the turmoil in markets.

What's behind the falls?

The sell-off in stocks is being led by the bond markets, which have tumbled this year given that inflation can erode how much money investors make on their trades.

When bond prices fall, their yields rise. That can have an impact on all of us because bond rates help determine all kinds of interest we pay on on things like credit cards, or for car and home loans. The average rate on a 30-year fixed-rate mortgage hit its highest since March 2020.

That sell-off in bonds, with yields now at two-year highs, has spooked stock investors as well. Investors are bracing for an aggressive response by the Fed to fight inflation, but there's still a lot of uncertainty about what the central bank will do – and what the consequences will be.

Federal Reserve Chairman Jerome Powell initially suggested inflation would be short-lived or "transitory," but in recent months, he has acknowledged it has been "more persistent" than he first expected.

"All of that has created some uncertainty in the marketplace," says Julian Emanuel, Evercore ISI's chief equity, derivatives, and quantitative strategist.

What sectors have been hit hardest?

So far this year, tech companies have been among the biggest losers. Tech companies typically need fast-growing economies to do well, whereas investors are expecting the Fed to try to slow down the economy with interest rate increases in order to curb inflation.

Higher interest rates also make certain companies such as technology less attractive to investors because the highest borrowing costs can reduce future profits.

Apple, Amazon, Microsoft, Alphabet, the parent company of Google, and Meta, which owns Facebook, are each down more than 5% so far this year.

The "consumer discretionary" sector is also hurting, as uncertainty surrounding the spread of the omicron variant is raising concerns that people will stop buying what are considered non-essential goods and services, such as cars or meals at restaurants.

So what's the outlook for markets?

Things could stay volatile for a while. Investors will pay close attention to the Fed's meeting next week, hoping to gain additional insight into their thinking.

Companies are also starting to report their earnings results for the last three months of 2021 and investors are keen to see how a slew of events, including omicron, inflation, supply chain disruptions, and labor shortages, impacted companies.

In recent days, shares in some of the big banks including JPMorgan Chase, Citigroup and Goldman Sachs have fallen after they reported weaker-than-expected results.

In its earnings results, Goldman said its operating expenses were higher, thanks in part to "significantly higher compensation and benefits expenses." Like many firms dealing with a tight jobs market, the bank has had to pay more to keep its top talent from leaving.

Evercore ISI's Emanuel believes 2022 is going to be a year when Wall Street will have to look at each company individually, to see how it manages continued uncertainty and to ask sharp questions about expenses and cost controls.

But overall, how the year shapes up for markets will likely be determined by how successful the Fed is at bringing down inflation, and how COVID impacts the economy.

There's still plenty of time left for markets to turn around: Stocks haven't had a losing year since 2018.

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