Stocks & Inflation Expectations: Diverging Paths, Many Questions

The US stock market and inflation expectations have been going their separate ways for the past two months, which is something new by the standard of the last five years. Is this a sign that marks a break from the past, when higher the outlook for higher inflation was generally cheered by the market? Or perhaps it’s only a temporary divergence, in which case a correction on or both sides of this relationship will soon revive the new abnormal?

The new abnormal is how I refer to the positive link in recent years between stocks and inflation expectations (based on the yield spread between the nominal 10-year Treasury and its inflation-indexed counterpart). These two data sets have been positively correlated since the global economy had a near-death experience. The correlation is unusual in the grand sweep of market history, but it’s become the norm in the wake of the 2008 financial crisis and the Great Recession. The key driver: worries about disinflation/deflation at a time when the economy can’t escape the gravitational pull of slow growth. The result is that higher inflation is considered helpful, at least from the perspective of the stock market.
That’s been true for several years, as implied by the tight connection between stock prices and inflation expectations. But the connection has come apart rather conspicuously over the past two months. The market’s outlook for inflation has dropped and equity prices have increased to a degree that we haven’t seen for some time.

I’ve been tracking this fork in the road for over a month now, wondering what the break with the former trend implies for the economy and the stock market. A month ago I outlined several possibilities:

One is that the stock market will soon fall in sympathy with lesser inflation expectations. This path assumes that equities are overvalued relative to the latest macro conditions, as implied by a lower inflation forecast, a proxy for anticipating a weaker economy.

Scenario two is that inflation expectations aren’t accurate after all and will soon rebound and move closer to the relatively brighter macro forecast embedded in higher stock prices.

The third possibility is that the new abnormal is no longer relevant. In this case, higher (lower) inflation expectations no longer align with higher (lower) stock prices and higher (lower) economic growth. In this case, a return to macro normality, which prevailed before the 2008 financial crisis, has regained its throne.

It’s unclear which scenario will prevail, although we’ll soon find out. Something has to give, so to speak, although it’s still an open debate for now. Depending on your view, and the data you choose to highlight, you could make a case for any one of the three possibilities noted above.
And the winner is….