Mr. Market Reconsiders Disinflation/Deflation Risk

Inflation expectations have fallen moderately this year, but the stock market has trended higher. Is this a sign that the new abnormal is history?

Before we consider how to respond, let’s define our terms. The new abnormal is the bias in recent years for a tight positive correlation between higher (lower) stock prices and higher (lower) inflation expectations (the yield on a conventional 10-year Treasury less its inflation-indexed counterpart). Although that’s been typical after the financial crisis that struck in 2008, it’s unusual across the grand scheme of history. Higher inflation, in other words, hasn’t been a reliable inspiration for boosting equity prices.
The last several years have been unusual, however. In particular, worries about disinflation/deflation have been continually lurking in the shadows. The concern has been that if disinflation/deflation takes hold, the economy will suffer, which in turn inspires lower equity prices. As a result, higher inflation has been viewed as a solution, at least temporarily.
But there’s been a noticeable change in this relationship this year, which I’ve discussed previously (see here, for instance). The only difference now is that the change has become more conspicuous. As the chart below shows, inflation expectations have declined this year. The market’s current forecast: inflation of roughly 2.1%, or down from as high as 2.6% in February, based on the 10-year Treasury yield spread. In previous years, a decline in inflation expectations was usually linked with a fall in stock prices. But this year is different, or at least it has been so far. Indeed, the stock market (S&P 500) has been rising rather persistently in 2013 and is currently higher on the year by nearly 16% through September 4.

It’s obvious that something’s changed in terms of the relationship between stocks and inflation expectations. My view is that the market’s assuming that economic growth will be somewhat stronger and more reliable vs. recent history, a shift that’s reflected in the new negative connection between stocks and the inflation outlook. Yes, this is still a tenuous transition and one that could easily change again if the economic news shifts for the worse. But for now, Mr. Market’s risk outlook on macro has evolved.
It was always inevitable that the new abnormal would end… eventually. Then again, there’s no reason why it couldn’t return. The future is still uncertain, although that never stops Mr. Market from making real time assumptions about how the big picture will play out in the coming months. Heck, sometimes he’s actually right.