Inflation expectations and the US stock market are again moving in the same direction, for the first time this year since early February. The new abnormal, as I like to call it, appears to have made its return after a roughly four-month hiatus that had investors and economists scratching their heads about the implications for markets and macro. It's still early to write the final chapter on what it all means, but it looks like a return to form in recent weeks. That is, the stock market's recent gains are again accompanied by rising inflation expectations, based on the yield spread between the nominal and inflation-indexed 10-year Treasuries.
That's still a bullish signal, to the extent that the market sees higher inflation as productive. In the grand scheme of history, higher inflation isn't usually greeted with applause by Mr. Market. But five years after the worst recession (and financial crisis) since the 1930s, the crowd still views higher inflation as the lesser evil vs. disinflation/deflation.
Deciding why the relationship--the new abnormal--broke down in recent months, however, remains a work in progress, at least from a theoretical point of view. Some analysts interpret the parting of the ways between the equity market (a proxy for the economic outlook) and inflation expectations as the byproduct of a "positive supply shock," as Yichuan Wang at Synthenomics recently opined recently. "I have looked at the relationship between inflation breakevens and the SP500 and believe what we're really looking at is a positive supply shock." He goes on to explain:
I believe the most plausible supply shock could be the further discovery and development of unconventional oil and gas reserves. Therefore when compared to the counterfactual of perpetually rising oil prices, the new discoveries makes it easier for policy makers to respond to energy shocks and improve the economy's productive capacity.
By contrast, Evan Soltas considers the possibility that the recent breakdown in the positive connection stock prices and inflation expectations reflects the market's anticipation of tighter monetary policy.
I don't think either explanation fully describes what we've been seeing. For starters, oil prices have been rising lately. Although Yichuan Wang recognizes as much, he thinks that newly developed energy supplies in the US trump this empirical fact. Maybe, but higher energy costs will have economic repercussions just the same and so I'm skeptical of any energy supply shock theory that seemingly has no influence on prices in real time. Then again, if oil prices start falling, and trend lower over some period of time, the positive supply shock theory deserves another look.
As for anticipating tighter monetary policy, this doesn't look all that compelling either, at least not at the moment. As I'll demonstrate below, the year-over-year changes in the real (inflation-adjusted) monetary base are up by 20% through June, the fastest pace in more than a year.
My view is that the Treasury market was spooked by various events in recent months, including the widely publicized taper talk by the Fed, which implied that monetary tightening was imminent. But as the central bank emphasized lately, tightening is probably still a ways off, even if it inches closer each day. Even when the tapering does begin, perhaps as soon as sometime this year, that would be a positive sign because it will reflect stronger economic data. In other words, the true risk is that winding down quantitative easing begins later rather than sooner, which would be a sign of macro weakness.
In any case, what is clear today is that the stock market and inflation expectations have both turned up recently.
Consider, too, that the inflation-adjusted year-over-year changes in so-called high-powered money-M0, as some call it-have been trending higher this year, advancing 20% through last month. Why does this matter? Let's briefly review the history of changes in the real monetary base and the business cycle. As the second chart reminds, the monetary base tends to contract on an annual basis just ahead of recessions. In the chart below, the comparison ends at December 2007, on the eve of the Great Recession. Not surprisingly, the real monetary base annual change was negative by nearly 3% as 2007 ended, on the eve of the worst economic downturn in more than 70 years.
Here's how the monetary changes compare through last month. Due to the increased magnitude of changes during and after the Great Recession vs. history, it's easier to review what's been happening lately by looking at the last several years on a separate chart. As you can see, the real monetary base has been increasing, and at a higher rate, which suggests that any fears of monetary tightening have been excessive if not totally unfounded.
Meanwhile, the market's inflation expectations again seem to be aligned with the positive outlook that's reflected in rising stock prices. The new abnormal is back. The recent disconnect between equities and the market's inflation forecast were arguably based on unfounded worries that monetary policy was tightening and that the business cycle was headed for trouble. But the economy is still on a modest growth track, as I discussed on Friday in my monthly profile of the economy. In addition, the real monetary base is increasing and at a modestly faster pace this year. In turn, the market is again assuming that future inflation is likely to be somewhat higher. That's been the basic message via this year's rising stock market, and the bond market is once more in agreement.
The previous divergence in these markets that looked so mystifying in recent months (see here and here, for instance) has disappeared, at least for now. What does it all mean? The one point that's irrefutable is that the next time the new abnormal breaks down (and one day it will), it's an event that should be considered as an event that drops crucial clues about expectations for markets and macro.
The signal may have been a false alarm this time, but don't count on history repeating itself. Markets aren't perfect, but they're not stupid either, at least not as a long-term proposition. The new abnormal must end at some point, and after five years we're probably getting closer to this macro denouement. What could delay this fate? A new recession. But that risk still looks low.