Tuesday, January 28, 2014

Inflation Expectations/ Equity Performance Correlation Breaks Down

I was highlighted to the relationship in the below chart just recently, but not only does it pass the visual check but also by the numbers. The chart below shows the inflation expectations, here shown as the Ishares TIPS fund (Ticker: TIP) relative to the TLT or the Ishares 20-year Bond ETF, superimposed against the S&P 500 on a rolling 6-month change since the beginning of 2008.

What stands out to me is the rather tight relationship, visually and mathematically. Addressing the last, the correlation between inflation expectations and the S&P 500 comes in above the 60% level, which is good for an explanatory power of about 40%. This suggests a definitive relationship between the two metrics.

What striking to me is that following the start of QE3 in September 2012, the relationship has broken down or at the very least devolved into a weak leading relationship. In my mind this suggests that the effectiveness of QE since QE3 has broken down and also slightly increases the risks of an equity market pullback in the next few months.

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