Despite the relentless rise in markets, worried investors have no shortage of reasons to fret that it's all going to end in tears. But perhaps inflation, the one danger that has been largely banished, is what we should fear the most. Now broaching this subject requires some caution. After all, doom mongering analyst investors that have continually warned about inflationary dangers, have rightly ended up with more egg on their face then mediaeval unfortunates locked in the town squares stocks. Even after years of low interest rates and a tightening labour market, the Fed's preferred inflation measure stands at just 1.4%.
Markets are also relaxed about the longer term outlook, given the seismic, secular, and global deflationary forces caused by factors like demographics and technology. Long term swaps and inflation proof bonds indicate that investors think US inflation will average about 2% over the next decade. But an obscure but nearly trendy inflation measure launched by the New York Fed this autumn is raising eyebrows on parts of Wall Street. The underlying inflation gauge climbed to an 11-year high of 2.8% in September. This measure is designed to look through temporary blips and incorporate labour and financial market dynamics as well as prices.
And Bank of America notes that it does seem to have some predictive power. This is disconcerting, as inflation above the 3% mark has historically been a bit of a "toggle switch" for Wall Street. And that's Jim Paulsen of Leuthold Group.
For inflation rates below the 3% level, rising prices are typically associated with higher stock market valuations. But for every percentage point increase above that level, the US price to earnings multiple falls by 2.7 points. The bond market is even more vulnerable. Below a 3% inflation rate, a percentage point increase in the inflation rate pushes up bond yields by about 88 basis points. But for every 1 percentage point rise in the inflation rate above 3%, bond yields climb by almost 150 basis points.
Given how high bond and equity prices are now, faster inflation could easily do even more damage than the historical data implies. For now, inflation still seems an unimaginable danger. But investors should keep a wary eye on the New York Fed funky new inflation gauge.