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.