One of the criticisms we hear from bearish investors is that the Federal Reserve has set us up for massive inflation. Personally, I tend to be pragmatic on these issues. If there is inflation coming, it’s certainly hiding itself well. While commodity prices are on the rise, we have yet to see a large surge in consumer prices. That may change soon.
But I’m not concerned with the political implications of inflation — hyper or not. I’m much more concerned with inflation’s impact on equity prices.
The danger of inflation is that it hurts bond prices and that, in turn, hurts stock valuations. Generally speaking, inflation doesn’t impact the stock market until it reaches a 5% annualized rate.
Once inflation passes 5%, stocks have historically been lousy investments. The only thing worse than inflation is deflation. What the market likes best is a low, boring rate of inflation,
One of the goals of the Fed’s policies has been to increase the market’s inflation expectations. The chart below shows the spread between the yield on the 10-year Treasury bond and the yield on the 10-year TIPs. In other words, this is the market’s view on the inflation premium.
Since last summer when the Fed announced QE2, the inflation premium has risen about 100 basis points. That’s a big rise. According to the market, however, inflation is far from being problem. For now.
I’m not always willing to accept the market’s judgment as correct. I find it very curious that the market doesn’t see much acceleration in the inflation premium.
While the spread between the 10-year Treasury and the 10-year TIPs is about 256 basis points, at five years, it’s only 232 basis points. That means the market expects inflation of 2.32% for the next five years and then 2.8% for the five years after that. That seems very optimistic.
Ed Elfenbein is editor of Crossing Wall Street, a Web site about stocks and the market designed to help individual investors. Check out his free Buy List of stock recommendations.