The New Abnormal: An Update

The market’s inflation expectations and the outlook for growth remain tightly bound. The new abnormal, in other words, rolls on. Implied inflation, based on the yield spread between the nominal and inflation-indexed 10-year Treasuries, continues to rise, right along with the stock market’s climb. This positive correlation dance confounds some pundits, although some simply ignore it. Recognized or not, this relationship endures, and it’s important to understand why.

The trend of the stock market rising in sympathy with the inflation forecast is, of course, abnormal in the grand scheme of U.S. economic history. But the relationship’s persistence is a sign of the times… still. Indeed, this abnormal state has been the rule for several years. In case you didn’t notice, something changed in the fall of 2008 and the blowback persists on a number of fronts–relations between risky assets and pricing pressures being one example, albeit a critical one.

Based on yesterday’s close, the Treasury market’s implied inflation forecast for the decade ahead was 2.37%, the highest since last August. Meantime, the S&P 500 yesterday closed well above its previous highs of last year. In fact, the S&P finished the trading session yesterday above 1400 for the first time since 2008.
What’s going on here? Economist David Glasner has the answer:

Since the beginning of 2012, the S&P 500 has risen by almost 10%, while expected inflation, as measured by the TIPS spread on 10-year Treasuries, has risen by 33 basis points. The increase in inflation expectations was at first associated with falling real rates, the implied real rate on 10-year TIPS falling from -0.04% on January 3 to -0.32% on February 27. Real rates seem to have begun recovering slightly, rising to -0.20% today, suggesting that profit expectations are improving. The rise in real interest rates provides further evidence that the way to get out of the abnormally low interest-rate environment in which we have been stuck for over three years is through increased inflation expectations. Under current abnormal conditions, expectations of increasing prices and increasing demand would be self-fulfilling, causing both nominal and real interest rates to rise along with asset values. As I showed in this paper, there is no theoretical basis for a close empirical correlation between inflation expectations and stock prices under normal conditions. The empirical relationship emerged only in the spring of 2008 when the economy was already starting the downturn that culminated in the financial panic of September and October 2008. That the powerful relationship between inflation expectations and stock prices remains so strikingly evident suggests that further increases in expected inflation would help, not hurt, the economy. Don’t stop now.