For weeks, pundits have noted with bemusement that the markets have been pretty calm about the ongoing struggle over raising the debt ceiling, notwithstanding warnings of catastrophic consequences should the ceiling not be raised. The conventional wisdom has been that the markets simply could not imagine that Congress and the President would allow themselves to cause a catastrophe. Eventually someone has to blink. So the markets seem to have been treating all the ups and downs in the negotiations for the last month as inconsequential, yields on US debt and stock prices having generally traded within a narrow range over the past two or three months.
In my paper “The Fisher Effect Under Deflationary Expectations” available here, I presented evidence that since early 2008, shortly after the downturn began, stock prices have been strongly correlated with inflation expectations as reflected in both TIP spreads and the dollar/euro exchange rate. These correlations, not implied by economic or finance theory under “normal” conditions, did not begin to appear in the data until after the Little Depression started.
In updating the empirical results in my paper to include the data since the end of 2010, I have found that the unusual correlation between stock prices and inflation expectations continues to show up in the more recent data. However, on Monday the TIPS spread (reflecting the expected rate of inflation over 10 years) increased by .04 percentage points and the dollar depreciated by half a percent against the euro, both of which changes having been associated with rising stock prices. According to my regression estimates, the S&P 500 should have increased by almost half a percent on Monday. Instead the S&P 500 fell by over half a percent. On Tuesday, the model seemed to be working, perhaps because it looked like an agreement might be in sight. But today Speaker Boehner seemed unable to deliver a majority, the S&P 500 fell 2 percent, and the process of raising the debt as if it may really be unraveling.
Here are the actual values for the S&P 500 and my predicted values since Monday
Date Actual S&P 500 Predicted S&P 500
7/25 1337.43 1350.76
7/26 1331.94 1330.47
7/27 1304.89 1334.48
Here’s a chart with the actual and predicted values of the S&P 500 since last week.
Maybe this is starting to get serious.
On the other hand, maybe there’s a silver lining. If people start dumping Treasuries, the Fed may feel constrained to start buying them, and voila! Inflationary monetary expansion. Problem solved. Go figure.
UPDATE: When I made my calculations I used the wrong value for the yield on the constant maturity 10-year Treasury. Fixing that slight glitch changes my little table as follows:
Date Actual S&P 500 Predicted S&P 500
7/25 1337.43 1350.76
7/26 1331.94 1335.28
7/27 1304.89 1329.71
Here’s the revised chart:
UPDATE 7/29: I used 3.00% percent as the yield on the 10-year constant maturity Treasury for 7/27 when it should have been 3.01%. So the predicted value for the S&P500 was slightly understated for 7/27. Yesterday, the predicted value for the S&P500 fell sharply, almost as low as the actual value, so there no longer seems to be any residual to attribute to the debt-ceiling. Economic conditions seem to be getting worse all on their own, thank you very much. This will probably be my last update on this topic, even if the world doesn’t come to an end next Tuesday.
Date Actual S&P 500 Predicted S&P 500
7/25 1337.43 1350.76
7/26 1331.94 1335.28
7/27 1304.89 1330.90
7/28 1300.67 1302.21
Uneasy Money 
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