The new abnormal is still with us in the new year, but will 2013 break this strange relationship? I’m referring to the unusually close positive connection between the stock market and the implied inflation forecast via the yield spread between the 10-year Treasury Note and its inflation-indexed counterpart. Historically speaking, expectations of higher inflation haven’t been a reliable source of enthusiasm for the bulls, but the last several years have turned that rule on its head. When the Treasury market smells higher inflation these days, equities tend to rally, and vice versa. That’s been the dance for much of the past five years. Will it continue in the year ahead?
The answer depends on how the crowd perceives the state of macro in the US. To the extent that investors believe that the business cycle has returned to what might be called “normal”, the new abnormal is doomed and higher inflation will again be seen as the enemy. Exactly when this transition arrives is anyone’s guess. Based on the numbers through the first day of trading in 2013, however, it appears that the new abnormal is still with us.
One reason for remaining cautious on thinking that the new abnormal is set to evaporate in the near terms is the long-running decline and fall of inflation expectations. For instance, the Cleveland Fed’s estimates show that the 10-year expected inflation rate has been trending down rather persistently for 30 years. Its current estimate calculates the 10-year inflation rate at 1.52%–quite a bit lower than the 2.48% rate via the Treasury yield spread as of yesterday.
Relatively low and falling inflation raises the specter of deflation, which is no one’s idea of fun when economic growth generally is moderate at best. No wonder that under these conditions there’s a tendency to see higher inflation as productive. The stock market certainly sees it that way. (For a theoretical review of this connection, see David Glasner paper on the so-called Fisher effect.)
Mr. Market’s views are clear enough, but the new abnormal remains controversial if not dismissed by some analysts, including central bankers. “I do not see an overall argument for letting inflation rise to levels where we might scare the market,” Dallas Fed President Richard Fisher said last September. “We have seen a sharp rise in inflation expectations. If you let this get out of hand, then I think we will have a market reaction.”
Out of hand? Several months on, the risk continues to look fairly low that inflation is poised to become a clear and present danger. One day, and perhaps sooner than we think, the benign state of higher inflation expectations will become more threatening. At that point, the Federal Reserve’s bloated balance sheet will have to be downsized by selling off most of the bonds it bought in recent years as part of its monetary stimulus program. Yes, that’s going to be a tricky process, but handled properly it’s not inevitable that the worst fears of some analysts will be realized.
Meantime, we’re still in the new abnormal until further notice. No one will ring a bell when this strange trip ends, although a persistent divergence between changes in inflation expectations and equity prices will likely signal a change in the macro weather. But don’t worry too much. This change isn’t going to arrive suddenly. Major changes in macro unfold fairly slowly, despite what some pundits would have you believe.