Why is the stock market up? Or down? There are countless theories, but one that resonates in recent years is linked to what I refer to as the new abnormal. This is the positive connection between the stock market and the implied inflation forecast via the yield spread between the 10-year Treasury note and its inflation-indexed counterpart. In the grand scheme of economic history, higher inflation isn't all that inspiring for the equity market.
But this relationship has been turned on its head in recent years. Why? Well, a few things changed in the wake of the Great Recession. As a result, higher (lower) inflation expectations have remained closely bound with higher (lower) stock prices. This odd connection won't last forever, but reviewing the latest numbers reminds that this abnormality continues to dominate ... for now.
As the chart below shows, the S&P 500 has been rising so far in 2013, echoing a similar advance in inflation expectations.
What's behind this connection? The short answer: fear of disinflation/deflation. David Glasner lays out a broader, deeper economic explanation in a 2011 paper titled "The Fisher Effect Under Deflationary Expectations."
The main takeaway for investors: Mr. Market likes higher inflation these days, but he becomes anxious when the outlook for inflation falls. That's a sign that the state of macro is, shall we say, off its game. Until that changes, it's best to go with the flow. As such, keep your eye on the market's estimate of future inflation for a clue about the future path of stock prices. In particular, a change in the trend for inflation expectations is likely to bring a similar reversal in equity prices.
On that note, expected inflation is now roughly at levels that prevailed before the financial crisis struck in September 2008 -- around 2.6%. Inflation has come full circle since the global economy had a near-death experience. The questions before the house: Can inflation expectations break through this ceiling to higher ground? If so, will the stock market continue to view higher inflation as a positive?