Is the New Abnormal on Its Last Legs?

The recent rise in the stock market has been accompanied by an increase in inflation expectations. That’s a healthy sign while we’re trapped in the new abnormal. One day the stock market and inflation expectations will go their separate ways, but not yet. Meantime, the economy’s still struggling to break free of post-crisis gravity and so it still requires the assistance from higher inflation expectations.

As the chart below shows, the S&P 500 and the market’s inflation outlook (10-year Treasury yield less its inflation-indexed counterpart) remain tightly correlated. They’ve been joined at the hip for several years now. That’s abnormal in the long run, but for now it’s still reality. The dance will end once stronger economic growth returns, and the crowd believes something approximating a normal business cycle has revived. Meanwhile, inflation and the stock market (a proxy for the overall economic outlook) are entwined.

Ed Yardeni recognizes the new abnormal in a blog post from last week:

In the past, the market’s valuation multiple tended to rise when bond yields decreased, and vice versa. In the past, rising inflationary expectations often were negative for equity valuations, while falling ones were positive. There relationships have turned topsy-turvy since early 2007, when falling yields and inflation rates started to be associated with falling rather than rising P/Es. That’s because yields and inflation rates are so low that investors fear that they may be harbingers of deflation and depression.

So why haven’t bond yields risen along with the P/E since late last year? The Fed’s Operation Twist has clearly distorted the bond market. Without it, yields would have undoubtedly risen. They still could if the program is terminated on schedule at the end of June. Meanwhile, the expected inflation rate embodied in the 10-year TIPS market has risen from a low of 1.7% on October 3 to 2.2% in early February. So far, that’s been bullish for the P/E.

Scott Grannis looks at the relationship between stocks and Treasury yields directly (without adjusting for the inflation-indexed yield) and wonders if something’s about to give. He’s referring to the equity market’s strong rise in recent months while Treasury yields have remained flat. Grannis observes:

It just doesn’t make sense for the economy to be doing better while bond yields languish near all-time lows. My money is on higher yields, since the evidence of continued economic improvement is pervasive.

Higher yields would be a sign that the crowd thinks the new abnormal is ending. If so, that would constitute progress, although at what point will higher inflation expectations become the enemy? The transition could be rocky.

Meantime, this week’s is scheduled to bring some fresh clues on where we stand on progress, starting with the update on retail sales for January. The consensus forecast is looking for some improvement, with a 0.8% gain last month vs. December’s meager 0.1% increase, according to Briefing.com. If that forecast turns out to be accurate, it’ll be tempting to think that the days of the new abnormal are numbered. Then again, we’ve been here before only to have the rug pulled out from under our reviving expectations. As such, it’s still one data point at a time. Yes, it’s a still a recover… if we can keep it.

This post originally appeared at The Capital Spectator and is posted with permission.