What Stocks May Need: A Bit of Inflation

Russ discusses the divergence between rising stock prices and falling bond yields. What gives and can it continue?

Back in February I highlighted the interesting–read: troubling–divergence between stock prices and bond yields. Bonds were signaling an economic slowdown while persistent equity gains suggested a near perfect balance between growth and low inflation. Since then the divergence has only widened.

Equities hit a five-month high late last week, while bond yields fell to their lowest level since January of 2018. To be sure, much of the recent drop in interest rates reflects a rapid shift in Federal Reserve policy, one that suggests an abrupt end to the Fed’s tightening cycle. That said, with a dovish Fed already reflected in both bond and equity markets, can this divergence continue?

In answering the question, it is helpful to focus on one particular aspect of interest rates: inflation expectations. Nominal interest rates can be broken down into a real, or after-inflation component, and inflation expectations, captured by the break-even (BE) rate in Treasury Inflation Protected Securities (TIPS).

In the post-crisis environment long-term BE rates (derived from the 10-Year TIP) and U.S. equities have been closely correlated. Weekly changes in 10 Yr. BE’s have explained nearly 30% of the variation in S&P 500 returns (see Chart). To my mind this makes sense. In the post-crisis environment investors have constantly been worried about too little growth. In this context a positive relationship between inflation expectations, which are driven by growth, and stocks is intuitive.

S&P 500 Weekly Returns vs. Change 10-Year BE

However, since late November there has been a pretty significant divergence between stocks and BE rates. While inflation expectations have recovered from the December bottom, the 10-year BE is basically flat compared to where it was around Thanksgiving. During the same period, however, the S&P 500 has gained roughly 8.5%. Most of this divergence occurred in the immediate aftermath of the December low, but in recent weeks it has re-emerged. Inflation expectations have been flat during the past month while the S&P 500 has rallied another 2.5%.