What's Next For The Link Between Stocks And The Inflation Outlook?

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Includes: DIA, QQQ, SPY
by: James Picerno

The stock market and the Treasury market's inflation forecast seem to be going their separate ways. We haven't seen this movie in quite some time. Is that significant? It may be. To understand why, a brief history lesson.

In the grand scheme of the equity market and the inflation outlook, there's usually minimal correlation. In fact, it's not unusual to see the stock market move in the opposite direction to inflation forecasts when the latter moves to relative extremes on the upside. Higher inflation, at some point, goes over like a lead balloon in the stock market. But it's been several years since that negative link has been the rule.

The relationship changed with the financial crisis in late-2008 and the Great Recession. The weak recovery and the burden of working off excess levels of debt created what I like to call the new abnormal. Equity prices and the market's inflation outlook have become tightly and positively bound. That's abnormal, but it's become typical in recent years because the debt-deflation threat trumps the usual worries about nexus between inflation and the economy. (For the theory behind the empirical fact of late that ties the equity market with the inflation forecast, see David Glasner's research paper on the so-called Fisher effect.)

In short, higher inflation is greeted favorably by the stock market. That, at least, has been the prevailing theme in recent years as the economy struggled to overcome unusually strong macro headwinds and keep the red ink from sinking the ship. But as you can see in the chart below, the relationship seems to be changing, which is to say inching back toward the standard of decades past.

Consider the latest leg down in inflation expectations (the 10-year Treasury Note yield less its inflation-indexed counterpart, indicated by the black line in the chart above). This decline, which started in the spring, offered an early clue that economic growth was slowing. It remains to be seen if it will end up as another rough patch or a new recession. Economists, not surprisingly, are all over the map on where we're going. In any case, the Treasury market has recently been predicting a lesser level of inflation compared with the outlook during the early months of 2012. That's a bearish sign in the new abnormal and for a time the stock market reacted in the usual way for the post-2008 era: falling, in sympathy with the lower inflation prediction.

But starting in June, the inflation forecast stabilized at roughly 2.1% and the stock market began trending up. As a result, stocks and the inflation outlook appear to be decoupling. It's anyone's guess if it will continue, but for now let's ponder the implications of this divergence.

The optimistic view is that the new abnormal is in retreat. In other words, the macro outlook is returning to something approximating normality. If so, the positive correlation between the stock market and the inflation forecast will fade as a general rule. That would be a sign of progress generally, if the trend holds.

The alternative view is that the equity market is making one of its periodic mistakes and so stocks are overbought and the new abnormal will persist across the macro landscape. In that case, the stock market is headed for a correction. A kinder, gentler interpretation of this scenario is that inflation is set to rise, in which case the stock market may avoid a nasty selloff. In either case, the growing divergence between stocks and the inflation outlook will reverse if the new abnormal will be with us for a while longer. The only question: how much will it cost equity investors?

One thing's for sure: Only one of these scenarios awaits.