The Softer Side Of Inflation Expectations

Last week I noted that the widening spread between the stock market and the Treasury market’s implied inflation forecast looked troubling. A week later, it looks a bit more troubling, primarily because inflation expectations continue to fall. In turn, that’s a clue for thinking that equity prices will follow unless the inflation outlook stabilizes.

The stock market and inflation expectations (based on the yield spread between the nominal 10-year Treasury and its inflation-indexed counterpart) have been positively correlated in recent years—the new abnormal as I call it. It’s an unusual relationship in terms of 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 catalyst: worries about disinflation/deflation at a time when the economy can’t escape the gravitational pull of slow growth. As a result, higher inflation is interpreted as productive. The degree of worry (as quantified by the market’s inflation forecast) ebbs and flows, depending on the recent trend in the macro data. But inflation expectations are again trending down again, with a persistence that we haven’t seen in some time. That’s a dark sign—if it continues. The margin for error on this front is wearing thin.

In “normal” times, falling inflation expectations wouldn’t mean much. In fact, such a trend might be considered bullish. But not now. The economy’s still too weak and expectations for a more muscular and sustained rate of growth remain the stuff of dreams. Adding to the anxiety is the recent round of sluggish economic data, including yesterday’s news of tepid growth in private payrolls for April, according to ADP’s estimates. The manufacturing sector slowed again last month as well, based on the latest update of the ISM Manufacturing Index.
Adding to the list of worrisome data points is the slowdown in consumer inflation to 1.0% for the year through March (based on the price index for personal consumption expenditures as reported by the Bureau of Economic Analysis). This is well below the Federal Reserve’s 2.0% target. It’s also a confirming sign that the market’s inflation expectations are showing up in the hard data, albeit with a lag relative to the real-time Treasury numbers.
On the bright side, a broad review of economic and financial indicators has yet to fall off the cyclical cliff. Keep in mind that in recent years the economy has a habit of slowing in the spring, but these downshifts have given way to stronger growth later on. No one really knows if it’ll be different this time, although the risk that macro jig is finally up can’t be dismissed completely. But it’s still premature to assume the worst. Instead, the standard advice applies: watch the incoming data and reassess the outlook, one data point at a time.
That includes watching the Treasury market’s implied inflation forecast. As of May 1, this prediction has slipped to 2.30%, or close to an eight-month low. If this measure of anticipated pricing pressures drops further, it will be a signal that macro risks are deteriorating. In that case, we’ll have another clue for assuming that the April economic reports that are scheduled for release in the days and weeks ahead aren’t going to look encouraging.