This chart shows that we have passed the peak of inflation, supporting the stock rally

New York Stock Exchange traders.

Source: NYSE

One of the biggest fears investors have faced this year is the threat that inflation could run wild and thwart the post-pandemic economic recovery.

But over the past month, those fears have eased considerably, and a chart showing the trend could signal the next rise in the stock market.

A common measure of the market’s anticipation of inflation is the difference between Treasury yields and inflation-linked bonds of the same duration. The measure is known as the “break-even” rate, and investors and economists most often look at 5- and 10-year spreads.

After reaching their highest levels in about eight years in May, these breakeven rates have steadily declined, indicating that investors are no longer seeing inflation hold. its current frantic pace far into the future. The 5-year equilibrium rate is now at 2.45% while the 10-year rate stands at 2.33%, indicating that markets are seeing inflation fall over a longer period.

“For us, this signals that the markets are starting to abandon the idea of ​​structurally higher US inflation,” wrote Nick Colas, co-founder of DataTrek Research. “Looking into the second half of 2021, this might just be the most important data point to watch.”

Inflation is important to investors because higher prices can reduce company profits.

But these price pressures can also indicate that the economy is too hot, which in turn may cause the Federal Reserve to start tightening monetary policy. This would mean higher interest rates and the likelihood that the central bank will turn off its taps. monthly bond purchase program, which is currently running at a rate of at least $ 120 billion.

Fed officials, however, have been unshakeable in their eyes that the current wave of inflation is “transient”. the assertions come even though the personal consumption expenditure price index, which is the Fed’s preferred inflation indicator, rose 3.4% year-on-year in May, excluding food and energy prices. Big title Consumer price index inflationna ran at a 5% clip for the month.

These levels are well above the Fed’s 2% target, and some officials have admitted that inflation has been higher and more persistent than expected.

Richmond Fed Chairman Thomas Barkin said on Monday that market-based inflation measures such as breakeven rates “at least give me some comfort” that expectations are for a cooling off long-term. But he added on Tuesday that the current pace is “reasonably” meeting the Fed’s “further substantial progress” inflation target, even if the labor market is falling short.

Market vision

Of course, the issue of inflation is far from being resolved.

Mohamed El-Erian, Chief Economic Advisor of Allianz, warned Monday on CNBC that the Fed is falling behind the inflation curve and could be forced to tighten policy quickly, which could lead to a recession down the road. Market heavyweights like hedge funds billionaire Paul Tudor Jones and Bank of America CEO Brian Moynihan called on the Fed to take its foot off the pedal as inflation rises.

But from a market perspective, Treasury yields have steadily declined and stocks have continued to rise. set a succession of new records.

“If inflation expectations start to rise again, markets will rightly worry if the Federal Reserve will have to raise rates sooner. If they continue to fall, then the market expectation of a rate hike in 2022 will be a safe assumption, “he added. wrote.

At their June meeting, Fed officials discussed advance their expectations for the next rate hike until 2023, but it was a narrow failure for 2022 and market participants believe a hike could come sooner than expected by central bank forecasters.

Colas sees a solid trajectory for equities, based on a low inflation environment combined with an accommodating Fed and a solid earnings picture.

Analysts collectively see a 12.2% gain for the S&P 500 over the next 12 months. Colas said he remained the most optimistic on energy and financials.

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