Equities rise with inflation expectations

As a follow up to my post yesterday, the chart below provides strong support for my belief that equities are responding more to inflation expectations than they are to real growth expectations. That is consistent with the monetarist view that the Fed has very little control over real growth—you can't print your way to prosperity.

The chart compares the S&P 500 to the market's forward-looking inflation expectations, the 5-yr, 5-yr forward implied inflation rate embedded in TIPS and Treasury prices.

Equities benefit from QE3 because it is likely to boost nominal GDP growth, but not necessarily real growth. Inflation is now much more likely than deflation, and future cash flows are likely to be better than expected.

This is all good news for now, but lurking in the shadows is the issue of how the Fed is going to reverse its quantitative easing in the future, and whether they can do it in a timely fashion to avoid inflation going too high.

Meanwhile, it's good to see Treasury bond yields and equities on the rise. Higher yields are symptomatic of an improved outlook.