The new abnormal is alive and well, or so it appears. Exhibit A: 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 won’t last forever, and earlier this month I wondered if the new abnormal was on its last legs. But for the moment, at least, reports of this relationship’s demise are premature.
Consider 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. Both have 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.
It’s anyone’s guess when the positive correlation between inflation and stock prices (a proxy for the economic outlook) will end. 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. But there’s no sign of a break yet, which implies that investors remain wary of the economic outlook, despite the good news of late.