Still Joined At The Hip: Inflation Expectations & Stocks

The connection between the stock market and inflation expectations may not be on everyone’s radar these days, but the link remains strong. That’s unusual across the broad sweep of investment history, but it’s par for the course in the new world order of the last four years. I call it the new abnormal, and it continues to roll on. Stocks have rallied smartly since (notwithstanding Friday’s sharp selloff) and the market’s estimate of future inflation has climbed too (based on implied inflation via the yield spread in the 10-year Treasury less its inflation-indexed counterpart). Random events? Guess again.

As of October 19, expected inflation was 2.50%–near the highest levels since the financial crisis was raging in the fall of 2008. Meantime, the stock market is approaching its old pre-recession/crisis highs. Despite what you may have heard elsewhere, the crowd overall is enthused these days with the prospect of higher inflation. Falling inflation, by contrast, is greeted as trouble, as the chart below reminds.

There’s an economic explanation for the odd behavior—the so-called Fisher effect. The basic narrative can be reduced to a fear of deflation and an excess demand for money. To the extent those sentiments recede, the investment outlook improves. In short, higher inflation expectations equate with higher stock prices, and vice versa. This abnormal linkage won’t last forever, but for now it’s a key source of bullish behavior in the stock market. The sight of rising nominal prices generally, in other words, is greeted with cheers from investors.
If the new abnormal remains an influential force for the foreseeable future, it’s easy to interpret Fed policy of late as productive for promoting the bullish side of animal spirits. As Bloomberg reported last week:

Federal Reserve Bank of New York President William C. Dudley said the central bank won’t cut back record monetary stimulus too quickly when the economy begins to gain strength.

“If we were to see some good news on growth I would not expect us to respond in a hasty manner,” Dudley said in a speech today in New York.

Policy makers last month increased accommodation to boost an economy that central bankers said still faces “significant downside risks.” Fed officials announced a third round of asset purchases, agreeing to buy $40 billion of mortgage-backed bonds each month, and extended the horizon for record-low interest rates through at least the middle of 2015.

It’s anyone’s guess when Mr. Market will become wary of higher inflation expectations. But at some point he’ll see things differently and rising pricing pressures will be considered a threat to equity prices. One big clue that the end of the new abnormal may be near: the economy moves closer to what might be described as “normal’ in terms of cyclical fluctuations. The good news (or bad news, depending on your perspective) is that normal macro behavior still looks like a long shot as the year winds down. Then again, full clarity on the timing of this transition is likely to arrive only with hindsight.