A Perverse Relationship - Equity Prices And Inflation Expectations

Includes: SPY
by: James Picerno

The stock market and the market's implied inflation forecast are still a perverse couple. That's no surprise, given the anxiety over the fiscal cliff, the economic outlook, the Middle East, and all the rest. The new abnormal, in short, is still with us and probably will be for the foreseeable future. That's no surprise, even if this reality shocks some observers who continue to consider inflation from a pre-2008 perspective.

Oh, well. Big changes in macro conditions can take a toll on some folks' ability to grasp the obvious. But recognized or not, the stock market and the market's inflation forecast (the yield spread for the 10-year Treasury less it's inflation-indexed counterpart) continue to move with a relatively high degree of positive correlation.

Over the past two months or so, for instance, the stock market has trended lower, and so has the yield spread for nominal less inflation-indexed 10-year Treasuries. What does it mean? For starters, the crowd still considers higher inflation as a positive. That's nothing new by the standard of the past four years. It's abnormal in the grand sweep of market history, of course, but it remains front and center in the current climate. (For a formal explanation of this relationship, see David Glasner's paper titled "The Fisher Effect Under Deflationary Expectations.")

It's a safe bet that inflation expectations will diminish further if the folks in Washington allow the economy to move closer to the fiscal cliff. In that case, one should expect the stock market to follow. Yes, the new abnormal will end one day, and inflation will again be considered with a wary eye from the vantage of equities. But that day still seems like a distant prospect until the macro uncertainty is sorted out. In the meantime, abnormality remains the new new thing in the dance between risky assets and inflation. Same as it ever was.