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Are billions of liquidity driving equity markets away from the real economy again?

Posted on 14-Feb-2011

During his February 3, 2011 speech at the National Press Club., US Federal Reserve Chairman, Ben Bernanke reiterated his defense of the Fed’s plan to lower long-term interest rates by buying $600 billion in Treasury securities. He called the bond-buying plan, which began in November and is to last through June, an appropriate response to high unemployment and low inflation.

Meanwhile, US investors poured $1.4 billion into US domestic stocks funds, according to the Investment Company Institute. That was the fourth straight week of net inflows for U.S. equity funds and a big reversal from 2010, when investors yanked an average of $7.3 billion out of U.S. stock funds each month.

Last week U.S. mutual fund investors added a net $2.54 billion to equity funds the majority of which went into US domestic-focused funds (source: Thomson Reuters' Lipper service).

Inflation expectations and aggregate demand

By increasing liquidity Ben Bernanke has probably managed so far to increase expectations for higher inflation and hence for aggregate demand: if buyers expect higher prices in the future, then they increase their demand for goods and services in the present.

The rise of inflation expectations in 2010 was a strong explanatory factor for equity market returns until September 2010 but how long can it work?

A proxy of break even inflation can be obtained by buying inflation protected bonds ETFs such as iShares Barclays TIPS Bond Fund (ETF) (AMEX:TIP) and selling iShares Lehman 7-10 Yr Treas. Bond (ETF) (NYSE:IEF) to obtain what we call below a Break Even Inflation (BEI) trade.

Equity returns and breakeven inflation trades correlation

How the equity market is responding to positive inflation expectations?

Correlation (calculated using PRISM SaaS platform) between S&P 500 proxy (SPY ETF) and the Break Even Inflation (BEI) factor went up to 65% end of August 2010. Since then the equity index has grown at a rate of 46% annual return (23% in six months) losing clearly its anchor to the BEI factor: the correlation has been divided by three in a few months. Furthermore the Sharpe ratio of the SPY return over the last 6 months is above 4; which is clearly not sustainable.