The Yield Curve, Inflation and the Stock Market

In the first phase of an usual economic recovery the stock market marches on the "growth and low inflation" theme. I cannot say that the current economic recovery is usual but the theme seems to have been the same; especially since low inflation has implied very accommodative monetary policy. Eventually however, this theme becomes "old- fashioned" and the markets correct.

We can gauge if the markets are playing this theme by looking at a long term yield curve chart (yield curve defined as the difference between 10 y rates and 3 mo rates):

When the yield curve steepens (the series rises) the "growth and low inflation" theme is what the markets are pricing in. It happened in 2003-2004 and it has also happened until recently.

However, a time comes when the economic recovery goes on to the next phase: "growth and rising inflation". This is visible on the chart after the beginning of 2004 as the series started falling. This second theme still means rising stock market prices over the long term but the transition involves a correction.

Here is what the SPX did after January 2004, when the yield curve started falling:

Since the yield curve has steepened (risen) a lot lately and has reached levels that represented turning points in the past (black line on the first chart), I wondered if we could expect the same shift between themes now.

One gauge is the inflation trend. Inflation is much lower now, but by looking at trends in sticky CPI prices (a kind of a core CPI concocted by the Atlanta Fed), I concluded that we might be at a turning point.

Notice how the series has fallen in both cases. In 2004 after turning to the upside it continued rising. If this were also the case from here on, short term rates would start rising more (or falling less) than long term rates, thus, the yield curve would start falling and the stock market would find itself mostly in the context prevailing at the beginning of 2004.

It seems that the current recovery got at this point late, but it it did, and this has bullish implications over the long term (several years). Over the intermediate term, however, the implications are bearish.