Despite future concerns about potential inflationary fallout from excessive government spending and monetary accommodation, the stock/bond correlation (remaining solidly positive) continues to suggest the primary focus of the financial markets is deflation. Until this changes, Exhibit 2 suggest the yield curve will have little relationship to future economic performance and the economic cycle will tend to be constrained less by slower money growth and higher yields compared to historic economic recoveries. Moreover, Exhibit 3 implies rising yields are likely to prove less damaging to the stock market.
Even if conventional measures of inflation expectations begin to rise, inflation risk should not become too problematic until the stock/bond correlation nears a sign change. At that time, however, as Exhibit 4 illustrates (providing early warning signals in 1999 and 2006 of potential stock market/economy risks), the risk of significant economic relationship changes and a tougher stock market will be enhanced.
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