Is The Recent Fall In Inflation Expectations A New Warning Sign?

The new abnormal is still with is, and that means that the recent fall in inflation expectations could be signaling trouble ahead… again. Implied inflation, based on the yield spread between the nominal and inflation-indexed 10-year Treasuries, remains tightly linked with the ebb and flow of the stock market and, by implication, the broader economy. That’s an unusual relationship in the grand scheme of financial and economic history, but it’s a relationship that rolls on in the wake of the Great Recession. It’s also a relationship that in recent weeks seems to be anticipating a new round of problems for the economy. (For the theory behind this empirical fact, see David Glasner’s research paper on the so-called Fisher effect.)

Recall that the market’s inflation outlook has been a reliable early warning indicator of macro trouble in recent years. In the new abnormal, a fall in inflation expectations is linked with a falling stock market and a general decline in economic activity. Given that history, the fall in inflation expectations to 2.16% as of yesterday from the previous peak of 2.42% in late-March can’t be dismissed. It may be noise, of course, but the change bears watching until the true trend reveals itself.

Optimists will say that the stock market has yet to confirm the recent drop in inflation expectations. Although the S&P 500 has fallen from its recent highs, there’s nothing particularly ominous about the mild retreat, at least so far. But viewed through the prism of rolling one-year percentage changes, the market’s behavior looks less reassuring.
As a quick digression, negative returns in the stock market on an annual basis tend to be associated with recessions. It’s a flawless relationship in the sense that the onset of every recession in the past 50 years has been a) preceded by a negative annual return or b) the market’s return sinks into the red early on in the economy’s downfall. The problem is that the market sometimes goes negative on an annual basis without a new recession.
In any case, the market is still positive relative to its year-earlier level, but not by much. No one will be encouraged by the sharp descent of late in the S&P’s annual performance. As the second chart below shows, the market is moving dangerously close to the zero mark. For the first time since January, the S&P 500’s year-over-year price change is under 2%.

The antidote is stronger economic news. Unfortunately, that’s been in short supply lately, judging by last week’s update on U.S. jobs growth. But the case for thinking positively isn’t doomed yet. The sharp drop in jobless claims at the end of April holds open the possibility that the labor market will strengthen this month. We’ll know soon enough, but for the moment there’s a bit more doubt about what comes next.