The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. - The board of directors of the Federal Reserve - Federal Open Market Committee (FOMC) meeting statement this week
This week The Conference Board released their leading and coincident indicators for August 2009. Their Leading Economic Index (LEI) is still rising like a rocket ship, and their Coincident Economic Index (CEI) is strangely flat even though it has been five months since the LEI went ballistic.
The reason for the differences between the LEI and CEI is their targeting of completely different fundamentals. The Coincident Economic Index is half based on non-farm payrolls while the leading indicator is half based on monetary issues (M2 money supply, equity prices and treasury spreads).
The Coincident Economic Index requires real jobs and output growth (the other 50% in the coincident indicator is personal income, manufacturing production and manufacturing / trade sales).
It should not be surprising that the fundamentals of the indexes are different. History has demonstrated that the elements used in LEI foretell a recovery.
As the LEI is improving so rapidly, why has this not begun to manifest in our coincident data? Off the top, I can think of two obvious reasons:
- We are so far in the hole in this recession, that the Leading Economic Index is under-estimating the timing and over-estimating the intensity of the recovery; and / or.
- The Federal Reserves quantitative easing (liquidity) programs have created false readings in the Leading Economic Index.
The Fed introduced liquidity into the system in an unprecedented manner and in quantities beyond normal.
Where Did the Liquidity Come From?
All this began with toxic assets. The banking industry was supposedly full of them. Today, they have been renamed as bad loans. TARP was supposed to pull these assets from the banks – but as usual the money went astray and the toxic assets remain in the banks.
The Federal Reserve came to the rescue with all the unconstitutional powers they could muster printing money to buy or loan money against the good bank assets so the toxic banks could remain afloat.
This graph from Zero Hedge is over a month old and the balance sheet has changed a little – but graph dramatically displays what the Fed purchased or loaned to add the liquidity necessary to keep the economy moving.
- The Fed has printed $1.3 trillion to create liquidity.
- The banks currently contain $0.75 trillion of bad loans which many expect to grow over $1.5 trillion dollars.
- The M2 money supply has grown $0.860 trillion since December 2007. I find no evidence this M2 growth came from anywhere but the Fed’s liquidity insertion through their balance sheet.
The increase in liquidity is not available for growth – it is needed to offset losses inside of the banking system. The banks know this.
And the Fed Induced Liquidity Is Temporary Anyway
One of the benefits of a fiat currency is that you expand and contract it to control your economy. This worked until our Great Recession.
Excess liquidity to stimulate the economy is always temporary. It is used to create low interest borrowing environment for a credit driven recovery. In the short term, both business and consumers are unwinding their credit positions. A credit driven recovery is not in the cards.
Regardless, in our Great Recession this liquidity was used to keep the financial system from collapsing. The liquidity introduced was specifically targeted at the economic failure points.
The great question from the beginning of this economic train wreck was how the Fed was going to disengage without causing the fragile economy to again fall into a recession. As the Fed disengages, this liquidity will be withdrawn.
And if the Fed begins to reduce its balance sheet anytime soon, it will be coincident with bank losses.
The FOMC policy (after being continuously confirmed in the last several meetings) is planning to unwind the trillions of liquidity added to the Federal Reserve balance sheet. Without this liquidity, much of our banking system would have failed.
There are even some rumors about how they intend to dispose of certain elements of their balance sheet.
But we are now talking about moving over a trillion dollars from the Fed’s Balance sheets to the private sector. Instead of using a trillion to foster growth, we will use a trillion of private money to backstop our current position.
The Treasury Spreads Are Currently Manipulated
The interest rate difference between the yield on the 10 year Treasury note and the Fed’s Rate is part of the Leading Economic Index.
The spread is currently oscillating between 300 and 350 points. A high spread has historically indicated that an economic growth cycle is coming. But the Fed rate has never been set at an artificial rate of zero before, and the Fed has never purchased treasuries in such quantities before.
The spread may have no meaning under these conditions.
The amazing (and presumably unintended) side effect of the Fed’s overall liquidity program is that it plays directly into the elements that are used to forecast economic growth. There is no evidence that this will translate into real growth.
Any growth We Are Seeing Is Government Growth
Stimulus is supposed to enlarge the economy. It is temporary inorganic growth. The perverted Keynesian logic is that a seed of growth will multiply. Although there is some truth to this, empirically it has never come at the right time. or in the right amounts, or even in the right areas.
In the case of our stimulus, it was a shotgun approach with little targeting on the main problem – jobs. So we will see the elements of the leading indicators advance, but the stimulus will never be seen in the Coincident Economic Indicator as it creates no jobs.
The LEI Does Not Measure Wealth
The LEI measures whether the equities market is rising or falling. Although this indicator will be telling you that wealth is increasing for those that own stock – it ignores most of the population whose wealth is in their house.
It always humors me that the LEI uses the equities market to foretell recovery – like the investors have some big crystal ball. They are guessing the future using the leading indicators. This becomes a reinforcing cycle.
The Great Recession was defined by the significant wealth destruction caused by the housing bubble. America has never faced a recession with housing price declines. The LEI totally ignores wealth because it has never been an issue.
The question is whether we are at the bottom of the housing price decline. There is a pig’s breakfast of opinions. For this crisis to be over, we need sales volumes to return to normal. Normal is between 6 to 7 million home sales a year – the New Normal is around 5 million. At 5 million sales per year, it means the average home is owned over 25 years.
I use mortgage applications to get real time data on volumes as most home sales require mortgages.
The rate of new mortgage applications improved this past week but the rate of new applications is at a five month low. The four week moving average of mortgage loan application volume (which includes refinancing) increased 4.3% WoW, and increased almost 14% compared with the same week one year earlier. The average interest rate for 30-year fixed-rate mortgage increased 9 basis points to 4.97%.
But as the mortgage data was suggesting for the last few weeks, the National Association of Realtors (NAR) now says existing home sales fell 2.7% MoM for August 2009.
Lawrence Yun, NAR chief economist, said a little bit of everything:
Home sales retrenched from a very strong improvement in July but continue to be much higher than before the stimulus. The first-time buyer tax credit is having the intended impact of bringing buyers into the market, allowing them to take advantage of very favorable affordability conditions. Some of the give-back in closed sales appears to result from rising numbers of contracts entering the system, with some fallouts and a backlog contributing to a longer closing process, but the decline demonstrates we can’t take a housing rebound for granted.
September home sales volume will disappoint also. Lawrence Yun knows full well that mortgage applications have fallen. But what is he supposed to say, “Crap, sales don’t look good for the rest of the year”? He is the cheerleader for the housing industry.
My concern is that without volume, there is no recovery possible in the housing industry. With the amount of foreclosures in various stages, the supply of property for sale most likely is 3 times higher than stated.
This fall in sales takes the wind out of home price recovery this year. The government may be able to build a price floor under the market through incentives, but they will not be able to push the market higher.
There has been a lot of conversation on blogs concerning housing data as we are in the low season for housing sales. The NAR housing data is seasonally adjusted to try to compensate for the lower sales this period. But for the purists out there, here is a graph from Calculated Risk showing non-seasonally adjusted data – and prior to our Great Recession, August was a higher sales month than July.
My position is that if a recovery were under way (we even have government rebates for first time buyers in play) – this discussion would not be taking place. The increase demand would be clear and obvious, and we would not be debating the significance of a few percentage points.
Slightly off topic but reinforcing the seasonal data discussion, the data for new home sales volumes for August 2009 was also released this week showing a 0.7% increase MoM. I consider this to be statistically insignificant – and confirming home sales volumes overall (even with incentives) do not look promising.
And if this is true, there will be no restoration of wealth.
The LEI Measures Increases in New Orders for Goods
It is not clear what specific indexes the LEI uses for its new order data but I suspect it is the ISM manufacturing survey as it appears a month before real quantitative data. I have warned in the past that relying on ISM information is dangerous because it does not meet statistical sampling methodology we all expect from surveys.
Everyone knows this defect, but ignore it because it usually works out as being close to the real data – this time it was not.
The August 2009 durable goods report shows seasonally adjusted new orders down 2.4%, while the August 2009 ISM survey which was released a month ago showed new orders were UP a statistically large 9%. This is more than a little disconnect and good reason the market is confused.
It should also be pointed out that there is volatility in data in manufacturing, and that seasonally adjusted data needs to be analyzed. At the trough of a recession, these seasonal adjustments are suspect also.
The LEI Measures Consumer Sentiment
There is consumer sentiment, and there is consumer sentiment. Most indexes use the consumer sentiment results of the University of Michigan who released their September 2009 data this week. They claim consumer sentiment is rising and is now higher than January 2008.
And then there is the ABC consumer confidence results issued this week which says the consumer still feels he is in the toilet.
Which would you believe?
Unemployment, Not Employment, Is an Element of the LEI
The 4 week moving average for initial unemployment claims continues to drift downward for week ending September 19. This downward trend will cause the Leading Economic Index to improve – it does not matter whether people are being employed or not. Prior to 1990, recessions ended when employment started improving.
With the massive employment downturn during this recession, combined with a forecast of a jobless recovery – would initial claims tracking send a proper signal to the leading index?
The economy is not creating jobs.
The surprising data this week was the increase in mass layoffs in August 2009. Because it was believed the worst was behind us, this spike leaves a nagging sensation in the back of your head that unemployment remains volatile.
The LEI Should Be Improving
The LEI’s rate of improvement is suspect. The LEI is geared for the type of recessions prior to 1990.
Conversely, it could also be argued that the Coincident Economic Index (CEI) is also geared for recessions past. It is based an industrial based society.
Our Great Recession is a wealth and debt driven recession which turned into a enormous world wide recession. Structurally, recovery is dependent on wealth restoration and resolution of credit defaults.
However, it is not difficult to believe the CEI is properly indicating our conditions today. The average Joe is not seeing any green or purple shoots. It is showing a flat line recovery, and that is what Joe is seeing.
But just because the CEI is giving you the answer you expect, does not mean it is properly structured to measure the economy we have today.
It is the specific elements of the LEI and CEI which do not reflect the economic dynamics of this recession.
Additional Economic Data This Week
Economic Forecasts Published this Past Week
The Economic Cycle Research Institute (ECRI) released their Weekly Leading Index which again gained slightly on its all-time high. Lakshman Achuthan, Managing Director at ECRI added:
With WLI growth climbing to a fresh record high, the economic recovery is far from fragile
Hat tip to Steve at MEMETICS & MARKETING for editing support.
Disclosures: long MMF's, GLD, IOO, EWZ, EWY, EWA, EWC, EWM, EWS, THD, FXI, PIN, UUP, Physical Gold - as well as numerous puts & calls which comprise less than 1% of my portfolio.