On Wednesday, July 25, the S&P 500 closed at 1337.89. On Wednesday, August 8, the S&P 500 closed at 1402.22, a gain of just under 5%. Care to guess why the market rose?
Well, it’s been a while since I’ve mentioned the stock market, but long-time readers of this blog already know that the stock market loves inflation (see here, here, and here), there having been a strong positive correlation between movements in inflation expectations and the direction of the stock market since early 2008, as I showed in my paper “The Fisher Effect Under Deflationary Expectations.” The correlation between inflation expectations and asset values is not a general implication of financial theory, which makes a strong and continuing correlation between inflation expectations and movements in stock prices something of an anomaly, an anomaly that reflects and underscores the dysfunctional state of the US and international economies since 2008, when monetary policy began to exert a deflationary bias even as the economy was sliding into a contraction. Using Bloomberg’s calculations of the breakeven TIPS spread on 1-, 2-, 5-, and 10-year Treasuries between July 25 and August 10, I calculated correlation coefficients between the Bloomberg TIPS spreads at those maturities and the S&P 500 of .764, 915, .906, and .87. Calculating the TIPS spreads on 5- and 10-year constant maturity Treasuries from the Treasury yield curve website, I found correlation coefficients of .904 and .887 between those TIPS spreads and the S&P 500. So the correlations are robust regardless of the specific TIPS spread one uses.
In the chart below, I draw a graph plotting movements in the 5-year TIPS spread (as calculated by Bloomberg) and in the S&P 500 between July 25 and August 10 (with both series normalized to equal 1 on August 2).
Get the picture?
Ever since March 2009, after the stock market hit bottom, having lost more than 50% of its value in the summer of 2008, the Fed has periodically signaled that it would take aggressive steps to stimulate the economy. The stock market, yearning for inflation, has repeatedly responded to signs that the Fed would respond to its desire for inflation, only to fall back in disappointment after it became clear that the Fed was not going to deliver the inflation that it had earlier dangled enticingly in front of desperate investors. Recently, as the signs of recovery that had been visible in the winter and early spring started to fade, the Fed has been sending out signals — faint and ambiguous, to be sure, but still signals — that it may finally provide some inflationary relief, and the stock market responded predictably and promptly. Will the Fed, perhaps relying on recent favorable employment data as an excuse, once again snooker the market? Stay tuned.
Uneasy Money 
David, thanks for another interesting post. I think you need to add Mario Draghi’s “promise” to do what it takes to save the Euro, which played a role in alleviating anxieties about a meltdown, and which may have also had a secondary effect on inflation expectations in the U.S. Small changes in inflation expectations seem like small potatoes alongside fears of European chaos, though Draghi may not have the means to make good on his “promise.”
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Agree, but proof seems to me insufficient.
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Until anyone with a stake in investment or business is absolutely sure that the malinvestment has been purged from the books, nobody is willing to lend out much money, hire, or invest. This, in my view, is the problem with any steps the Fed takes to “control” the economy. Everyone remains spooked, and not just because Europe is a mess. How many more derivatives are out there sitting on balance sheets, waiting to implode?
The media jumps from mess to mess…but no one with a brain thinks we are done dealing with more foreclosures and more bad investments on the bank’s books. What else explains why they are hoarding all the free money they got.
No matter what Wacky Bernacke does, he can’t force them to loan out any money. Talk about a slap in the face considering he filled up their gas tanks.
I’d say odds are good that our current fiscal policy of trying to overcontrol markets, you can expect years of this kind of boom and bust cycling. The core problem of poorly directed resources and absence of any moral hazard is going to continue to produce more bubbles and permanent deficiencies in investment confidence. For all the sins a private market can commit, the Fed-controlled economy has left us permanently disabled.
Humans thinking they can pinpoint and control the economy is the height of arrogance. We’d be better off eschewing the central bank meddling and allow the private markets to run their course. Banks that deserve to go under should go under. Bankruptcy laws exist for a reason. No bailouts means you reward those who succeed and let those who fail suffer the consequences.
GM is thriving because of a bailout? How many other companies that you bailout will not thrive? Is Gm the smoking gun? Or is it the faulty evidence that these policies do more damage in the long-run.
When people are certain of the exact nature of the damage still left from the housing disaster, you’ll start to see everything loosen up (credit, markets, housing, etc.) That SHOULD have meant having to sell off all these bad investments at a great loss. Sorry if that is painful, but we have to live with our choices.
And then, I would predict, you’ll see the bull market you have been waiting for. At least until the next bubble emerges.
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David,
I always enjoy your blog posts. This one is very good, even if it builds upon those previous posts on the relations between monetary effects and equity prices. I guess it all has to do with expected values with an insufficient or better monetary policy.
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Fed subsidizing low interest rates on federal debt? Silly argument.
http://socialmacro.blogspot.com/2012/08/fed-subsidizing-low-interest-rates-on.html
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Wow…a whole 3 weeks of data….Reinhart/Rogoff eat yr heart out
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My latest post, just out today… where I try to bring a lot of things together on Paul Ryan’s false virtue:
http://socialmacro.blogspot.com/2012/08/paul-ryans-false-virtue.html
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Greg, You are right, it’s not just the Fed; the ECB is also playing a big role in this mess.
Luis, Perhaps not, but remember the relationship of the couple of weeks merely exemplifies a relationship that has obtained since the spring of 2008 as I have shown in previous posts and in my paper “The Fisher Effect Under Deflationary Expectations.”
Mark, At the time I actually proposed that Congress make all mortgage backed securities and derivatives unenforceable unless sold to the Treasury which should have paid something like the 20 cents on the dollar that they were worth at the time. Banks that would have gone bankrupt should have been recapitalized under the normal rules for recapitalizing insolvent banks while the Fed provided them with short term credit to keep them in operation pending recapitalization. No one was paying attention.
Julian, Thanks
Christian, Not even! A mere 13 days.
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Thank you for the response David. I don’t mean to drag this post on, but I had a question. How do you remove bad derivatives (or any bad investment) for that matter from the “books.” If you are suggesting that the Treasury should have bought them up to clear the banks ledgers, doesn’t the government then own the cancer? I guess I don’t understand the process. I only know from my limited understanding that many of these bad investments are still out there (in fact, are still being manufactured) as we speak.
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Mark, The government would have paid the banks what the assets were worth at the time about 25 cents on the dollar. It is only fear of a write-down that makes the assets toxic. Once the write-down, takes place, the assets become very desirable.
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David,
Thanks for the response again.
So the banks wouldn’t “sell” the muck in their books to the Fed Government because…they are holding out hope these concoctions recover? Or they fear that if they write down the debt everyone will want their mortgages forgiven? Are the banks trying to save face here when they could cut their losses and reboot?
I got a theory here I’d like your opinion on. Does U.S. fiscal policy possibly having something to do with driving the value of the dollar lower so that our national debt shrinks too?
Appreciate your thoughts. I’m just so jaded about the whole system that I can’t help but think corruption is at the root of it.
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David, could you please offer an opinion, or direct me to links, that would explain why we seemed to rush to buy all the toxic assets at 100% of face value, as opposed to the 20-25% you say they were worth. This seems to be a very important question, in the vein of “follow the money”, and I asked it myself back at the time these events were taking place, but I have never found an answer to my satisfaction that didn’t involve some very grim conspiracy theory conclusions.
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Inflation = higher returns on stocks. The result is that QE was great for equity investors and alike.
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If there was a more adequate explanation to this bias conversation, then think about my notion, what does another wave say to another? nothing, they just wave.
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