A Bullish Disconnect Between Stocks And Inflation

Includes: DIA, IWM, QQQ, SPY
by: James Picerno

There's a growing list of economic clues that suggest that the moderate pace of expansion, although battered and bruised in January and February, revived last month. Consider yesterday's update on industrial output, which increased 0.7% in March - a gain that translates into a respectable 3.8% annual rise. Housing starts still look shaky, but most of the other key indicators at the end of this year's first quarter point to growth. Here's one more piece of empirical support for thinking positively when it comes to the macro trend: stable inflation expectations and a rising stock market.

Recall the discussions on these pages in recent years about the new abnormal - the tight connection between the stock market and the market's estimate of inflation (based on the yield spread between the nominal 10-year Treasury and its inflation-indexed counterpart). The high positive correlation between the two was unusual because higher inflation before 2008 wasn't normally seen as a bullish scenario for stocks. But after the near-death experience for the financial system and the global economy, there was a higher risk of disinflation/deflation. No wonder, then, that expectations of higher inflation inspired the bulls while falling inflation was greeted as an excuse to sell and assume the worst.

Fast forward to the present and the new abnormal has been dormant for much of the past 12 months. In fact, it may be dead. Deciding if we've truly turned a corner from a big-picture economic perspective will take many more months. But the numbers so far encouraging. Stocks have been rising while the market's inflation forecast has remained stable, at around 2.2%. That's a productive change because it signals that the Federal Reserve has succeeded in minimizing disinflation/deflation risk. Mr. Market, at least, thinks so.

We can debate if a higher rate of inflation at this stage would help -some economists argue in favor of just that until the economy posts a faster rate of growth, particularly in the labor market. But for the moment, the sight of relatively low and stable inflation expectations and a rising stock market is a sign that the new abnormal, if not quite dead, is no longer a threat. That wouldn't mean much if the hard data for the economy was weak. But most of the numbers for March look encouraging. The future, as always, is uncertain, but the recent past suggests that more than the temperature is warming up.