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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).

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