The stock market and inflation expectations remain joined at the hip. As the crowd anticipates higher inflation, the stock market rallies, and vice versa. This positive correlation between inflation and stock prices (a proxy for the economic outlook) won’t last forever and it’s anyone’s guess when [that will be but I have my views on it if you are so interested]. Words: 557
So says James Picerno (www.capitalspectator.com) in edited excerpts from the original article* which Lorimer Wilson, editor of www.munKNEE.com (Your Key to Making Money!), has further edited below for length and clarity – see Editor’s Note at the bottom of the page. (This paragraph must be included in any article re-posting to avoid copyright infringement.)
Picerno goes on to say, in part:
The market’s inflation forecast (the yield spread for the nominal 10-year Treasury less its inflation-indexed counterpart) and prices for the S&P 500 have both been rising steadily over the past month. The stock market has regained all it lost in last year’s selloff and the 10-year Treasury market’s inflation forecast has climbed to 2.3%, the highest since last August [as can be seen in the chart below].
Par for the course in the new abnormal and so anticipating higher inflation has been accompanied by a rebound in economic activity… but my guess is that when the crowd believes that economic growth is sustainable without extraordinary support from the central bank, the new abnormal will fade. At that point, inflation expectations and the stock market will go their separate ways, which is the historical norm.
There’s no sign of a break yet, which implies that investors remain wary of the economic outlook, despite the good news of late.
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* The above comments came from: http://www.capitalspectator.com/archives/2012/02/inflation_expec_4.html#more
In the past, rising inflationary expectations often were negative for equity valuations, while falling ones were positive. There relationships have turned topsy-turvy since early 2007, when falling yields and inflation rates started to be associated with falling rather than rising P/Es. That’s because yields and inflation rates are so low that investors fear that they may be harbingers of deflation and depression.
Bond yields have not risen along with the P/E since late last year because the Fed’s Operation Twist has distorted the bond market. Without it, yields would have undoubtedly risen. They still could if the program is terminated on schedule at the end of June. Meanwhile, the expected inflation rate embodied in the 10-year TIPS market has risen from a low of 1.7% on October 3 to 2.2% in early February. So far, that’s been bullish for the P/E.
Scott Grannis looks at the relationship between stocks and Treasury yields directly (without adjusting for the inflation-indexed yield) and wonders if something’s about to give. He’s referring to the equity market’s strong rise in recent months while Treasury yields have remained flat. Grannis observes:
It just doesn’t make sense for the economy to be doing better while bond yields languish near all-time lows. My money is on higher yields, since the evidence of continued economic improvement is pervasive.
Higher yields would be a sign that the crowd thinks the new abnormal is ending. If so, that would constitute progress, although at what point will higher inflation expectations become the enemy? The transition could be rocky.
Editor’s Note: The above article has been has edited ([ ]), abridged, and reformatted (including the title, some sub-titles and bold/italics emphases) for the sake of clarity and brevity to ensure a fast and easy read. The article’s views and conclusions are unaltered and no personal comments have been included to maintain the integrity of the original article.
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