Yesterday, we saw the signal of our six-month model retract to a more bearish territory. This was caused mainly by the return of our inflation variable. We look at the combination of inflation rates (measured by Consumer Price Index (CPI)) and the breakeven rate (BER). The BER is the difference in yield between government bonds and inflation protected government bonds. CPI inflation measures realized inflation and the BER can be thought of as a forward-looking rate of inflation implied by the financial markets. We also subtract a long term moving average of our inflation variable to obtain a more stationary metric.
The debate on the relationship between inflation and market returns has been raging for years. Fama and Schwert (1977) found empirical evidence of a statistically significant negative relationship. Fisher’s hypothesis states that stock returns depend on the discounted value of future cash flows and an increase in inflation leads to higher discount rates. However, the lead/lag relationship and timing of this change can go either way. Azar (2010) allows for regime switching and finds that the relationship is significant and negative in one subsample and insignificant in others, but concludes that heteroscedasticity and non-stationarity of the inflation variable could have contributed to these findings. It has also been suggested that inflation becomes more relevant and negatively correlated toward the end of a business cycle (and, likewise, more relevant and positively correlated after a contraction in economic output).
One of the more convincing narratives surrounding this month’s market tremors has been tied to investors’ expectations about rising inflation and a subsequent increase in nominal interest rates. Therefore, it seems appropriate that our models are paying attention to inflation.
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