At these times of market consternation, the Pavlov’s Dog response has become one in which the clamoring for central bank policy action grows considerably, almost anticipating that central banks will attempt to ride to the rescue once again. Domestically, Friday’s disappointing non-farm payrolls figure is likely to lead to increasing expectations that the Fed may be moving closer to further quantitative easing. Certainly, the Fed will not be encouraged by the souring of economic data and appears to be very concerned with the potential fiscal cliff approaching at the beginning of 2013 (mentioned in the last release of FOMC meeting minutes and by various Fed Regional Presidents); however, one key aspect that has yet to fully materialize has been a drop in inflation expectations to a point that may signal deflationary fears. As the chart below depicts, using 5-year/5-year forward breakeven rates, which projects what consumer prices will be in 5 years without the effects of oil swings and seasonal factors, although equity prices have fallen dramatically the current levels of inflation expectations have not reached levels that have corresponded to previous Fed interventions.
Read it at Raymond James
By Zach Berg
(h/t perpetual neophyte in comments)
My own observation from the above chart is that equity investors are becoming increasingly complacent due to the supposed “Bernanke put.” While inflation expectations have fallen to similar levels prior to each round of easing, the S&P 500 has been making higher lows. Since expectations for Operation Twist became ingrained in markets last fall, the S&P 500 has been perpetually above inflation expectations. Though expectations of further easing (and possibly further easing itself) can maintain this gap for quite some time, the risk of a sharp drop from any disappoint continues to grow.