Deflation fears that gripped the market over recent months highlighted price stability as a significant confidence mover. Deflation's emergence and abatement led to correlative movement in investor fear.
But the effect isn't just limited to this period. The general price level in the economy has been a longstanding driver of sentiment.
Consider our regression analysis below, and its corresponding equation: Y = 62.871 -19.412(X) + 5.8565.
We use the VIX index to measure market sentiment ("Y"), and the TIPS spread to gauge price stability ("X"): see explanations below.
For every ten basis-point change in inflation expectations, the VIX index moves 1.94 points the opposite direction. High (inverse) correlation indicates a strong relationship between the two variables.
No doubt, other factors contribute to sentiment, and we by no means recommend our analysis as a rule of thumb. It does, however, suggest a meaningful association over a six-and-a-half year period (1600 days).
Since its March 9th low, the S&P 500 has gained 34% while the VIX index has declined 36%. This denotes a substantial turnaround from the prior six month period, when the market shed half its value, the VIX reached a high of 80, and the TIPS spread bottomed at 4 basis points. Over the previous five years, the VIX and TIPS spread had averaged 16.95 points and 237 basis points, respectively.
The chart below compares the VIX index (right-hand scale, green line) with the TIPS spread (left-hand scale, blue line) over the complete period.
- The TIPS spread marks the difference between the 10-year inflation-indexed Treasury and the conventional note. A deflationary spiral began immediately in September, and continued through December.
- The VIX index measures expected annualized change in the S&P 500. At its worst, the VIX anticipated an 80% move in the S&P 500. The level has since "improved" to 30. Over the last ten years it's averaged 15.
- Correlation between the two lines is -86%, indicating just how much market participants fear deflation, and don't mind a mild, predictable price increase.
Why so fearful? The prospect for a 1930s-style deflation weighed down hard, and so too the uncertainty over whether fiscal and monetary policy would reverse its course. The September-to-March period also coincided with a change in government, and a corresponding shift in economic policy, from Friedman to Keynes.
Of course, the great unknown today is the potential for accelerating inflation. And while the market clearly favors a modest rise in prices as a sign of pricing power, a rapid increase would re-ignite fear. The VIX index, perhaps anticipating this, remains elevated despite its retracement.
Recent news suggests we could retest an inflation rate similar to what occurred in the late 70s and early 80s – or even worse. (Unfortunately, TIPS and the VIX don't date back to this period, so we can't apply the same analysis.)
In contrast to the deflation scare, inflation – ugly as it could be – is a more familiar beast, and, now, so too is the government that would fight it.
For market participants, the truth is this: better the devil you know than the devil you don't.