Markets as forecasters

We often talk about inflation in our posts. Why? The level and direction of inflation has a very important impact on interest rates. And interest rates are a key input for valuing the stock market. Last week's dip in the market is evidence of that linkage - the CPI was worse than expected and investors sold stocks.

Thus it makes sense that if there was a way to forecast inflation with some degree of accuracy, we could make better investment decisions. Where can we find such a forecast? The usual suspects, economists, government experts, the Fed, have a spotty forecasting record which could result in some nasty surprises. So we look to the market for help. Here is a chart of the spread between 10yr US Treasury TIPS (inflation protected bonds) and traditional 10yr US Treasury bonds.

The spread provides important insights into inflation expectations. When it is rising, the market fears accelerating inflation. When it falls, the market is expecting stable to falling inflation. Notice that this spread has remained in a narrow band for about three years. And at the moment it looks like the market is not expecting a worsening inflation situation. That's good news for stocks!