Is The Recent Fall In Inflation Expectations A Warning Sign?

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Includes: DIA, QQQ, SPY
by: James Picerno

Earlier this month I noted that the relationship between US equities and the Treasury market's implied inflation forecast was looking a bit unusual--unusual by recent standards, that is. Nothing's changed a few weeks down the line, other than the relationship is a bit more unusual. But keep a close eye on this dance between markets for an early warning sign of trouble. Considering the wobbly economic data of late, including yesterday's weak report on March durable goods orders, the recent slide in the market's outlook for inflation isn't productive at this stage... if it rolls on.

We're still in what I like to call a period of the new abnormal: 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. This strange link is largely a byproduct of sluggish growth and the fear that low inflation could deteriorate into outright deflation, which would probably precede/accompany a recession. As such, the crowd tends to cheer when the outlook for inflation turns up, and vice versa. That won't last forever, but for now it's still a powerful force in the macro/market universe.

That leads us to ponder the recent divergence between the stock market and the Treasury market's inflation outlook. The S&P 500 has continued to push higher in recent weeks while the inflation forecast has slipped. As the divergence widens, the chasm implies three possible scenarios. One is that the stock market will soon fall in sympathy with lesser inflation expectations. This path assumes that equities are overvalued relative to the latest macro conditions, as implied by a lower inflation forecast, a proxy for anticipating a weaker economy.

Scenario two is that inflation expectations aren't accurate after all and will soon rebound and move closer to the relatively brighter macro forecast embedded in higher stock prices.

The third possibility is that the new abnormal is no longer relevant. In this case, higher (lower) inflation expectations no longer align with higher (lower) stock prices and higher (lower) economic growth. In this case, a return to macro normality, which prevailed before the 2008 financial crisis, has regained its throne.

Scenario 3 seems unlikely at this point. One day we'll see this path reassert itself, but we're still a ways off from that point. That leaves the question of whether inflation expectations will continue to fall, which would be a dark sign.

For now, the market's pricing in inflation of 2.38% as of yesterday, based on the yield spread between nominal and inflation-indexed 10-year Treasuries, up a bit from last week's low point of 2.27%--the lowest since last September. Lower inflation expectations at this point would raise a warning flag. It's premature to say anything definitive at this point, but the margin for error is shrinking and so the crowd's capacity for absorbing bad news may be wearing thin.

Keep in mind that the Federal Reserve is eager to stabilize inflation expectations. For now, that standard hasn't been broken, but it's surely being tested. What's the outcome? Unclear at this point, but clarity is coming.