James Picerno | Mar 06, 2013 12:21PM ET
The Dow Jones Industrial Average reached an all-time high yesterday, and the S&P 500 is within shouting distance of a new peak too. But a soaring equity market is no reason to assume that the new abnormal has ended, at least not yet. The positive correlation between the market's inflation forecast and the stock prices appears a bit looser these days, but it's premature to declare that the link has been broken.
For those who are new to the story, the new abnormal, as I call it, is 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. Normally, rising/high inflation doesn't inspire the bulls. But the last several years have been less than normal in terms of the macro backdrop. The crowd has remained worried about disinflation/deflation, which means that signs of higher inflation in the future have soothed anxious traders, as the chart below reminds.
The question, of course, is simply: When does abnormality end? To be precise, when will higher inflation no longer be greeted with open arms by the stock market? No one knows, at least in terms of precise dates. But the conditions that will promote this return to normality are likely to reflect something approximating stronger growth, diminished demand for liquidity, rising interest rates, and relatively high confidence that these changes have legs.
All will be obvious in hindsight, of course, but looking for the signals in real time is more art than science. That said, the stock market (S&P 500) has recently trended higher while the market's inflation prediction has been reluctant to follow. Is this a sign of regime change? Or is it just another case of short-term noise? Hmmm….
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