There have been a fair number of pundits suggesting the second half of this year will see a stronger economy, and thus a strong market. Some, too, have interpreted recent employment and other select economic data as proof that the economy is improving; again supporting a stronger equity market in the second half of this year. Even others have suggested that the very recent rapid rise in Treasury yields is part of the market pricing in higher growth rates in the quarters ahead. The information displayed in the chart below easily dispels each of the above, and shows that investors do not, at this time, expect a stronger second half of 2013. In addition, the rise in Treasury yields is likely a simple price adjustment as investors consider the decline in demand that would result from the Federal Reserve reducing bond purchases.
Even more important, the evidence presented shows that prior to the global impact of Japan's Abenomics, U.S. investors were becoming desensitized to the Federal Reserve's quantitative easing. It could be that even if the Federal Reserve is not out of bullets, investors have lost faith in the Federal Reserve's ability to generate a self-sustained recovery, and their response to future monetary stimulus will not be robust enough to support equity markets.
The chart below shows investors' annualized five-year inflation expectation by subtracting the yield on 5-year inflation protected Treasury (TIPS) from a 5-year Treasury note. Along with the inflation expectations (red) is the S&P 500 (dark blue) the 10-year Treasury yield (light-blue).
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Inflation Expectations, S&P 500 and 10-Year US Treasury Yield
It's important to first note that when deflation is a meaningfully greater risk than inflation, inflation is considered a good thing and the rise and fall of inflation expectations correlate positively with equity returns. The correlation is quite similar to the very early stage of a textbook post-recession four-year economic cycle, where rising inflation from a relatively low level is symptomatic of an economic recovery. That is why during the first stage of a typical four-year cycle, interest rates rise with the stock market. But in the later stage, as growth is overheating, higher inflation expectations negatively impact equity prices. This model explains why in recent years, as the slow growth economies skirt closer to deflation than harmful levels of inflation, whenever the Federal Reserve increased liquidity it bolstered investor inflation expectations with a domino effect that resulted in higher equity prices.
From the above chart it can be seen that the Federal Reserve's monetary policies have acted as a catalyst to ignite higher inflation expectations and thus support higher equity returns. It can easily be argued that the growth rate of the economy is so slow and fragile that without higher inflation expectations, higher equity prices are not probable. Considering this; note that annualized inflation expectations have continued to decline this past week, down to 1.90% from 2.0%. Because the bond and equity markets are forward looking; if, as some suggest, the economy is to strengthen in the latter half of this year, it should show up first in higher inflation expectations. It is not. If recent economic reports actually indicated the economy is moving toward a self-sustained recovery, it should show up first as higher inflation expectations. It is not. If the recent rise in Treasury yields were in response to news that hinted at a strengthening economy (and thus higher inflation) it would show up first in the above chart of inflation expectations. But none of that is the case, none.
At this time, investors don't believe a stronger economy is likely in the second half of this year, or for their foreseeable future. If they did, inflation expectations would not be declining. The fact that investor inflation expectations are negatively diverging from the trend in the equity indices indicates that the equity market is pricing in economic expectations not supported by the bond markets' inflation outlook. In addition, because there is no rise in inflation expectations commensurate with the increase in Treasury yields over recent weeks, it's likely that the bond market is simply adjusting to the lower level of expected demand that is inevitable once the Federal Reserve begins to taper off its monthly purchases. To be sure, the Federal Reserve is the most significant buyer of U.S. Treasuries. Certainly, a tapering off of their demand should have a negative impact on Treasury prices and could produce the prolonged trading range that is part of the topping process in bond prices as we have discussed often in past reports.
In addition to current inflation expectations, there is something else evident in the above chart that is, I believe, an even more significant observation. There is clear evidence that each new effort by the Federal Reserve to increase inflation expectations and thus equity prices is met with meaningfully diminishing returns. In the chart above, the impact of various QE programs was "eyeballed" with arrows. In the graphs immediately below, specific data is used to illustrate this point in more detail. To date, monetary stimulus has successfully supported equity prices at levels higher than could be justified otherwise, but has had minimal impact on the economy. If we were to hypothesize that the level of impact of each QE program on inflation expectations is directly correlated to investor's belief that quantitative easing can rescue the economy from its doldrums, we could easily conclude that investors are losing faith in the Fed's ability to reach its goal of a sustainable recovery that is absent persistent and continuous intervention.
Note that in each graph above, QE1 had the greatest impact on inflation expectations and equity prices. Since QE1, each successive program from QE2, the first Operation Twist (September 21, 2011), the second Operation Twist (June 20, 2012 announced extension) and then QE3 on September 14, 2012 had a declining impact (in price and duration) on inflation expectations and equity prices. It can be recalled that the announcement of QE3 was followed by an immediate decline in equity prices and a peak in the 30-year Treasury yield that held until this past week. If we just consider the Federal Reserve's monetary policy from QE1 to QE3 we could conclude that investors are finally becoming desensitized to Fed policy. But, then there is the stronger reaction to QE4, as announced December 12, 2012, that is the one data point not in line with diminishing returns. Considering the above history, it can be argued that the outlier performance of QE4 (in equity prices more so than inflation expectations) may have been due to its timing in relation to Japan's announced Abenomics and the rapid devaluation of the Yen. It would be logical to conclude that the impact attributed to QE4 in the above graphs is actually the combined impact of QE4 and Japan's monetary and fiscal stimulus program called Abenomics, with a greater emphasis on equity performance than economic recovery.
What can we conclude from the above data? It would seem reasonable to assert that even if the Federal Reserve were considering additional action to increase liquidity, the impact on equity prices and inflation would likely be minimal. This would almost certainly be the case if the Federal Reserve acted alone, without a global coordination of central bankers or new unexpected fiscal incentives. The exception would be if the Federal Reserve timed any new easing program to be announced after a meaningful correction in equity prices. That timing would probably have a greater positive impact than attempting to support the current trend without a healthy sell-off to rebalance equities with the economy.
Perhaps the most striking data point is the fact that although QE4 combined with Japan's Abenomics has had a strong positive impact on equity prices, these combined policy actions have barely nudged inflation expectations. The data suggests that although investors have faith in the Bernanke Put supporting equity prices, there is little or no expectation that what the central banks are doing will have a sustainable impact on the economy. The knee jerk reaction of strengthening the positive equity trend without a supporting belief in the economy gives the sense that investors have become comfortably numb to the historical drivers of the equity market. Despite comments from select reporters and market pundits, data indicates the underlying belief (within the U.S.) seems to be not so much that things will get better economically as it is that because of monetary policy equities will trend higher regardless.
Still, considering the positive correlation between inflation expectations and the trend in equities over the past five years, their recent negative divergence is the issue that stands out as most critical to the intermediate trend. We find no reason to believe that this divergence is sustainable over the long term; either the equity trend will fall in line with inflation expectations or inflation expectations will rise to support equities. Considering the fragile trend in GDP and employment, the latter appears most probable.