The Equity Rally Has Legs

 |  Includes: DIA, QQQ, SPY
by: Calafia Beach Pundit

The equity rally that began almost six months ago has legs, since it's being driven by improving economic and financial fundamentals, and the rise in Treasury yields is a key indication that this is the case. Yields had been (and remain) severely depressed because global investors had almost no hope that the U.S. economy would improve or that the world would avoid another painful recession. Instead, we see a steady stream of better-than-expected economic reports suggesting the U.S. economy is slowly improving. This forces investors to reconsider their love of Treasuries and their aversion to equities. In that sense, this is a rally driven not by optimism but by reduced pessimism. Treasury yields would need to be much higher before I would consider the market to be driven by optimism.

This chart shows how the improvement in Eurozone banks' ability to acquire dollar funding (as represented in a declining blue line) has led the reduction in Eurozone swap spreads, which in turn is a good indication of improved general liquidity conditions and reduced systemic risk. When financial markets are liquid they can and do function as shock absorbers for the physical economy, because they allow market participants to shift the burden of risk to stronger players. Spreading the burden of risk, in turn, facilitates economic growth, and growth is the best remedy for the problems that still plague Europe.

Financial conditions in the U.S. have returned to "normal" and Eurozone financial conditions have improved significantly, although they remain somewhat precarious. Europe needs more convincing structural reforms (e.g., lower tax burdens and a reduction in the size of the public sector) before the outlook can turn positive.

This chart shows the market's 5-year, 5-year forward inflation rate, a good measure of near-term inflation expectations. Note that expected inflation has increased by half a point since last October, from 2.0% to 2.6%. I take this to be an indication of how, on the margin, the market has become less concerned with the threat of deflation, and more concerned with the risk that the Fed's ultra-accommodative monetary policy may be exacerbating inflation risks.