Friday, May 24, 2013

The Disappearing Correlation Between Inflation Expectations and Stock Prices

From the Capital Spectator:
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.

HT: Historinhas