In Focus: Inflation Expectations and the Stock Market Rally

March 21st, 2012 by

Treasury bond prices have fallen sharply in recent weeks, sending US bond yields sharply higher. Does this really mean that we should be worried that inflation will move sharply higher in the not-too-distant future? Fed policymakers remain resolute in insisting that they plan to keep key lending rates at rock-bottom levels for another two years or more; they, at least, seem to see no sign of inflation in the wings, or at least, not enough to cause them concern.

To understand what is happening, it makes sense to take a look at the chart below, which depicts the relationship between the US stock market and inflation expectations. As is immediately visible, the two are closely correlated, with the stock market tending to lead inflation expectations very slightly.

Refresh Chart   Edit Chart

It’s clear that investors in the U.S. market have decided that they don’t want to miss out on the stock market rally, however late in the day they may be and however precarious and short-lived some of these gains may seem to be. Since the financial crisis ebbed about three years ago, investors have swung back and forth between “risk on” and “risk off” strategies – either embracing risk in hopes of earning some kind of return higher than the skimpy yields on dividend-paying stocks and most corporate bonds, or fleeing to safe havens in response to news of the economic plight of Europe, for instance. Since last fall, and most notably since the first days of trading in 2012, the mood has definitely tilted in favor of “risk on”. As a result, the Standard & Poor’s 500-stock index is, as of this writing, 11.7% higher than it was on New Year’s Eve 2011.

Stock market investors are calculating that the signs of improvement in the economy – ranging from a declining unemployment rate to higher housing permits – will be sustainable, and that a stronger economy will fuel further growth in corporate profits. That, in turn, should be reflected in higher stock prices and higher market valuations. To capture some of that upside, investors have tended of late to sell off their Treasury bond holdings – their safe haven, low-yielding investments – in favor of stocks. That asset allocation call results in lower bond prices and higher yields – and higher apparent inflation expectations.

To some fixed income market veterans, this apparent rise in inflation expectations shouldn’t be interpreted as something ominous, but merely as more of a “reflation” – a return to more normal levels. Indeed, this pickup in inflation expectations comes from a very base level, thanks to the widespread fears of recession and deflation, rather than inflation. The increase in inflation expectations therefore seems more likely to reflect improved consumer and investor sentiment and the increased levels of economic activity we now are beginning to witness.

Learn more about how Datastream can help you better analyze macro data and quickly identify data trends and relationships. Request a free trial today.