The source of this line of questioning comes by way of the market's inflation forecast—the yield spread between the nominal and inflation-indexed 10-year Treasuries—and its relationship with the stock market (S&P 500). Normally, Mr. Market has a contentious reaction to rising inflation expectations. But the last several years have turned that relationship on its head and so equities prices and the inflation outlook are positively correlated—the new abnormal. That relationship appears to have stabilized in recent weeks. As the chart below shows, the market's inflation forecast has remained in a range of roughly 2.1% for the past month. Meantime, the stock market's spring sell-off has reversed course.
It's tempting to think that this combination is setting us up for a new new virtuous cycle where inflation expectations gradually rise and the stock market follows. That future would look a lot more plausible if 1) the euro crisis was truly resolved rather than merely in remission; 2) the potential for a conflict with Iran was fading rather than rising; 3) and there were clear signals in the latest economic numbers that the U.S. economy was improving as opposed to stumbling.
But hope springs eternal. "If the ECB offers loud support this Thursday with a rate cut and a signal of more to follow in the face of lower growth and inflation, there may be enough fuel for a summer rally in stock markets," Bill O'Neill, EMEA Chief Investment Officer for Merrill Lynch Wealth Management, tells Reuters. Maybe, but let's not forget that the June employment report for the U.S., scheduled for release on Friday, awaits. Some economists are already managing expectations down on this front. "The recent weakness in hiring is a combination of seasonal issues and the underlying slowdown in U.S. and global economies," warns Yelena Shulyatyeva, a BNP economist, via MarketWatch. "This week should bring more disappointing news."
Then again, the consensus forecast for private-sector employment calls for a modest improvement: a gain of 100,000 jobs for June vs. the 82,000 previously reported for May, according to Bloomberg. Assuming that the 100,000 forecast is accurate, will that suffice to encourage the crowd? Stay tuned....