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Diverging Paths: Stocks And The Market's Inflation Forecast

Published 04/10/2013, 10:10 AM
Updated 07/09/2023, 06:31 AM

Has the stock market finally broken free of inflation expectations? If so, is this a turning point for the market? For inflation expectations? For the economy? Lots of questions at this point, with no answers. At least no definitive answers. Meanwhile, there's the striking image of diverging paths: the equity market running sharply higher while the market's inflation forecast grinds lower.

The Grand Scheme
Why should we care? For those who are just joining us for the financial soap opera I like to call the new abnormal, the last several years have witnessed an unusually tight positive correlation between changes in the stock market and inflation expectations, as defined by the 10-year Treasury’s yield less its inflation-indexed counterpart. In the grand scheme of history, the bulls aren't usually inspired by rising and/or high inflation. But no one will confuse the last several years as normal from a macro perspective. As such, the market has remained anxious over the lurking threat of disinflation/deflation, which means that equity investors have generally cheered a rise in inflation expectations, and vice versa. A formal review of this twisted relationship can be found in David Glasner's study: The Fisher Effect under Deflationary Expectations.

Meantime, the question today is whether the new abnormal is ending? If so, what does it mean for the economy? For stocks? No one really knows at this point. What is clear is that the market's 10-year inflation assumption has trended lower over the last two months, falling to 2.45% as of April 9 -- down from the recent peak of roughly 2.60% in early February. During this time, the stock market has run higher, with the S&P 500 ending yesterday's session just below an all-time high.
Stock And bond Inflation Forecasts
There are several interpretations of the latest divergence between stocks and inflation expectations. One is that it's simply noise and so the new abnormal will soon reassert its authority. In other words, stocks will fall, inflation expectations will rise, or a bit of both.

Alternatively, it's possible that a fundamental decoupling is in progress, which implies that we're on the cusp of a new macro regime, at least as it relates to the link between stocks and inflation expectations.

To be fair, we've been here before and nothing came of it. Several times over the last few years we've seen what appeared to be a break in the new abnormal only to discover later on that it was noise. Will it be different this time? It will be different... one day. The new abnormal can't last forever. Much depends on the economic data, of course. If the new abnormal is destined to fade this time, surely it requires stronger, more sustainable growth generally. It's easy to be skeptical that this in fact is the new new thing for macro. Or does Mr. Market know something that isn't yet conspicuous in the economic numbers?

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