The link between nominal interest rates, inflation breakevens, and stocks has changed; especially with regard the last few years' seemingly increased dependence on the Central Bank to keep an anti-deflationary floor on breakevens (or conversely the Bernanke Put under stocks). UBS' macro team, while humbly professing not to be experts in corporate earnings (which have been dismal) or balance sheet ratios (which are positive but have deteriorated in recent months) believe in a big picture macro perspective that we have been vociferously commenting on for a year or two now.
SPX (green) vs 10Y Treasury rates (red) and 10Y TIPS Breakevens (blue-dots)
As official policy rates are frozen near zero and the Fed is likely to keep them there for at least two more years, one would need to look for different indicators quantifying market expectation of a future success or failure of the Fed’s stimulative effort. Breakeven inflation is a good candidate. The logic is pretty straightforward: we have been living in the low inflation environment for the past several years, and the Fed is quite intent on preventing deflation, so “successful” monetary policy should boost future inflation. The TIPS market reflects changing inflation expectations by repricing breakevens. Breakevens have reacted to the introduction of traditional and non-traditional policy measures, from new bond purchase announcements to extending the language regarding super low policy rates.
Specifically, they have noticed a potentially curious link between the way the market interpreted monetary policy signals and the large cap stocks in the US: the breakeven inflation rate on 10yr TIPS has tracked the S&P 500 very closely this year.
When the Fed is perceived to be successful in stimulating the economy, stocks benefit and breakevens also rise.
When the Fed’s potency is called into question, stocks fade and breakevens decline.
We have checked historical data to see if a similar pattern existed for the relationship between SPX and the nominal 10y Treasury yield in 2012. We found that relationship to be very statistically weak. We can point out to a pair of dates in 2012 when the 10y benchmark yield was essentially the same (1.83% vs.1.88%) while the S&P500 was 158 points higher on one date than the other.
Nominal Treasury rates have lost their 'signal' as UBS agrees with the point we have been making for a long time: central bankers and politicians, not economic fundamentals and inflation expectations, currently drive the nominal rate and equity markets.