A Familiar Sight: Higher Equity Prices & Rising Inflation Expectations

August 10th, 2012 by

(August 2012) The market’s inflation outlook has popped a bit in recent weeks. The stock market has moved higher too. The new abnormal, in other words, remains intact.

The new abnormal is my label for the unusually high 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, higher inflation doesn’t normally inspire equity buying, but the standard relationship was upended after the financial crisis in late-2008 and the Great Recession. The positive link between the market’s inflation outlook and the stock market is abnormal, but it prevails until the economy returns to something approximating a “normal” state. (For the theory behind the empirical fact of late that ties the equity market with the inflation forecast, see David Glasner’s research paper on the so-called Fisher effect.)

Last month it appeared that the stock market and the inflation outlook might finally be going their separate ways. But as we now know, it was only noise. The stock market turned higher and so did the market’s inflation forecast. This abnormal dance continues, courtesy of troubles related todebt-deflation concerns in the realm of macro. In short, more of the same.

The implied inflation outlook touched 2.31% yesterday via the yield spread in nominal less inflation-linked 10-year Notes—the highest since early April. No wonder that the stock market (S&P 500) is at a three-month high.

The message (still) is that higher inflation expectations are still greeted favorably. This news comes as a shock in some corners. Inflation, runs one school of thought, is forever and endlessly evil. That’s a generally sound rule of thumb… most of the time. The mistake is assuming that there are no economic conditions under which this prudent notion breaks down.

Why has this rule cracked in recent years? One way to quantify an answer is by looking at the velocity of money, a rough measure of how fast currency is circulating through the economy. Considering that velocity has dropped to record lows relative to its history over the past 60-plus years, it’s no surprise that the crowd views higher inflation as something other than monetary Armageddon.

 

The current sentiment isn’t written in stone, of course, but it persists until further notice. What might sever this abnormal linkage? Under what conditions would we return to something closer to normality in terms of the relationship between inflation and equity prices? The answer is obvious: when economic growth is stronger. That, too, is coming… one day. The real challenge is deciding when. Good luck with that.

Meantime, the strange dance of abnormality endures. That’s another way of reminding equity bulls that inflation is still your friend… for now.

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