Yesterday’s announcement by the Federal Reserve that it will embark on a new and open-ended bond-buying program until job growth is stronger has many implications for the markets and the economy. One is deciding what the latest chapter in monetary stimulus means for the new abnormal.
That’s my phrase for the unusually high positive correlation between changes in the stock market and inflation expectations, as defined by the 10-year Treasury’s yield less its inflation-indexed counterpart. Higher inflation doesn’t normally correlate tightly with equity buying, but the standard relationship was turned on its head after the financial crisis in late-2008 and the Great Recession. The positive link between the market’s inflation outlook and the stock market is abnormal in the grand scheme of history, but it rolls until the economy returns to something approximating a “normal” state. (For the theory behind the empirical fact of late that binds the equity market with the inflation forecast, see David Glasner’s research paper on the so-called Fisher effect.)
At some point, the new abnormal will die an ignominious death, but there’s no sign in the latest numbers that mortality is near. As the chart below shows, the stock market (S&P 500) and inflation expectations have taken wing lately, moving in virtual lockstep once more. The S&P has again risen above 1400 in recent weeks and the market’s outlook for inflation has climbed to 2.47% as of yesterday, based on the yield spread between the nominal and inflation-indexed 10-year Treasury notes.
That’s the highest level for the inflation outlook since May 2011 and Mr. Market is clearly ecstatic. Par for the course in the new abnormal. Rising inflation expectations will eventuallyl be a problem for equities. But based on Mr. Bernanke’s comments yesterday, it seems that abnormality will be with us for some time. The stock market, at least, is on board with that view.