Friday, September 17, 2010

The equity/inflation connection


This chart compares the S&P 500 index (orange line) with Bloomberg's calculation of the market's 5-yr, 5-yr forward inflation expectations (white line; as derived from TIPS and Treasury prices). There's a pretty decent correlation (0.7) between the two, and that implies that whatever causes inflation expectations to rise (though I think it makes more sense to say whatever causes fears of deflation to fall) also causes equity prices to rise, and vice versa.

The correlation has been especially strong in the recent rally. Inflation expectations have risen (deflation fears have fallen), and that has been expressed via a rise in nominal 10-yr Treasury yields and relatively flat TIPS real yields. Rising inflation expectations have moved hand in hand with equity prices. As I mentioned in yesterday's post, the market really believes that weak growth and deflation risk go hand in hand. The news this month has not been as bad as the market had expected, so the market has revised up its outlook for the economy (which is good for stocks) and revised up its outlook for inflation (which is bad for Treasuries).

6 comments:

Family Man said...

PIMCO bets against deflation
http://www.bloomberg.com/news/2010-09-15/pimco-makes-8-1-billion-bet-against-lost-decade-of-deflation.html

John said...

Fam,

A wise bet. Totally consistent with what Scott has been presenting here for many months.

septizoniom said...

TO WHAT END YOUR TIRELESS CHEERLEADING?

larry said...

So, Scott if I read you right inflation is beginning to rear its ugly head and it seems the mainstream media is focused on deflation. Would this be the appropriate time to buy some inflation protection? Maybe in the form of TIPS, REITs, floating rate bank notes. I am a little confused by the flat real rates that TIPS are yielding (ten year is flat @ 1%)while the 10 yr inflation swap rates are about 2.1%.

Thanks for your good work and insight.

Scott Grannis said...

larry: I had a post on TIPS not too long ago. They are not obviously cheap, since 10-yr real yields are just under 1%, which means demand for TIPS is pretty strong. TIPS are best thought of as a conservative way to bet on or get protection from rising inflation. But they do carry some risk of loss on a mark-to-market basis.

larry said...

Scott,
Thanks, I went back and read the August 12, post and see where my confusion lies. It seems to be valuation as TIPS are richly priced.