From TheCapital Spectator:
Inflation expectations have fallen moderately this year, but the
stock market has trended higher. Is this a sign that the new abnormal is
history?
Before we consider how to respond, let’s define our terms. The new
abnormal is the bias in recent years for a tight positive correlation
between higher (lower) stock prices and higher (lower) inflation
expectations (the yield on a conventional 10-year Treasury less its
inflation-indexed counterpart). Although that’s been typical after the
financial crisis that struck in 2008, it’s unusual across the grand
scheme of history. Higher inflation, in other words, hasn’t been a
reliable inspiration for boosting equity prices.
The last several years have been unusual, however. In particular,
worries about disinflation/deflation have been continually lurking in
the shadows. The concern has been that if disinflation/deflation takes
hold, the economy will suffer, which in turn inspires lower equity
prices. As a result, higher inflation has been viewed as a solution, at
least temporarily.
But there’s been a noticeable change in this relationship this year, which I've discussed previously (see here,
for instance). The only difference now is that the change has become
more conspicuous. As the chart below shows, inflation expectations have
declined this year. The market’s current forecast: inflation of roughly
2.1%, or down from as high as 2.6% in February, based on the 10-year
Treasury yield spread. In previous years, a decline in inflation
expectations was usually linked with a fall in stock prices. But this
year is different, or at least it has been so far. Indeed, the stock
market (S&P 500) has been rising rather persistently in 2013 and is
currently higher on the year by nearly 16% through September 4.
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