The stock market and the market's implied inflation forecast are
still a perverse couple. That's no surprise, given the anxiety over the
fiscal cliff, the economic outlook, the Middle East, and all the rest.
The new abnormal, in short, is still with us and probably will be for
the foreseeable future. That's no surprise, even if this reality shocks
some observers who continue to consider inflation from a pre-2008
perspective.
Oh, well. Big changes in macro conditions can take a toll on some
folks' ability to grasp the obvious. But recognized or not, the stock
market and the market's inflation forecast (the yield spread for the
10-year Treasury less it's inflation-indexed counterpart) continue to
move with a relatively high degree of positive correlation.
Over the past two months or so, for instance, the stock market has
trended lower, and so has the yield spread for nominal less
inflation-indexed 10-year Treasuries. What does it mean? For starters,
the crowd still considers higher inflation as a positive. That's nothing
new by the standard of the past four years. It's abnormal in the grand
sweep of market history, of course, but it remains front and center in
the current climate. (For a formal explanation of this relationship, see
David Glasner's paper: The Fisher Effect under Deflationary Expectations.)
It's a safe bet that inflation expectations will diminish further if
the folks in Washington allow the economy to move closer to the fiscal
cliff. In that case, one should expect the stock market to follow. Yes,
the new abnormal will end one day, and inflation will again be
considered with a wary eye from the vantage of equities. But that day
still seems like a distant prospect until the macro uncertainty is
sorted out. Meantime, abnormality remains the new new thing in the dance
between risky assets and inflation. Same as it ever was.