Now that the first half of 2016 is over, it's time for a detailed update of the long leading indicators - and it's a good thing I waited a few days, because the landscape has significantly changed!
Geoffrey Moore, who for decades published the Index of Leading Indicators, and founded the Economic Cycle Research Institute (ECRI) in 1993, wrote Leading Economic Indicators: New Approaches and Forecasting Records describing and explaining what he called "long leading indicators," that is, economic metrics that reliably turn a year or more before the onset of a recession. He identified 4:
- housing permits and starts
- corporate bond yields
- real money supply
- corporate profits
A variation of the above is Paul Kasriel's "foolproof recession indicator," which combines real money supply with the yield curve, i.e., the difference in the interest rate between short and long-term treasury bonds. This turns negative a year or more before the next recession about half of the time.
Another long leading indicator has been described by UCLA Prof. Edward E. Leamer who has written that "Housing IS the Business Cycle." In that article, he identified real residential investments as a share of GDP as an indicator that typically turns at least 5 quarters before the onset of a recession
Doug Short has identified real retail sales per capita as another important metric. This metric tops out at least a year before the onset of a recession about half of the time.
Finally, it appears that the Fed' Labor Market Conditions Index also turns negative serves as a long leading indicator, typically turning negative at least one year before the onset of a recession.
That gives us a total of 8 long leading indicators. All of these economic series have a long-term history of turning a year or more before a recession. Let's look at them:
CORPORATE BOND YIELDS:
With the sole exception of the 1981 "double-dip," corporate bond yields have always made their most recent low over 1 year before the onset of the next recession. This is the first big reset in the indicators, because on Monday, BAA corporate bonds yields made a new all-time low, and AAA bonds tied their all-time low:
This is a big positive. What is particularly encouraging is that bond yields have moved in tandem with Treasuries, as shown in the below graph of the spread between BAA corporate yields and 10-year treasury yields:
If corporate bond yields had blown out to the upside as treasury yields plummeted, that would be a sign of recession. But the co-movement, near one-year lows in spreads, means that investors do not fear US corporate debt. It is especially noteworthy that spreads typically increase going into a recession. To the contrary, this year spreads have declined.
I recently pointed out that both single-family housing permits, and single-family home sales, made new highs two months ago. That makes housing positive to begin with. But while mortgage rates haven't yet moved below their 2013 lows:
they are very close:
As a result, purchase mortgage applications have already been increasing (courtesy Calculated Risk):
That trend is almost certain to continue in the near future as a result of these near-record low rates.
REAL MONEY SUPPLY:
No recession has ever started without at least real M1 or real M2, minus 2.5%, turning negative. I won't bother with a graph, but both have remained relentlessly positive.
THE YIELD CURVE:
This is an excellent long-range forecasting tool in times of inflation. Typically, a recession begins after the Fed raises rates to combat inflation, sufficiently so that the yield curve inverts. Much has been made of its recent tightening. This is ridiculous. Below is a graph of 10-year minus 2-year, and 10-year minus 5-year spreads, normed to zero as of Monday:
The yield curve remains as positive even now, with the same slope as it had in the middle of the 1970s, 80s, and 90s expansions. The 5-year spread is even wider than it was during most of the 1960s.
I do want to caution that the yield curve did not invert during the deflationary 1930s and lowflation 1940s, and several recessions happened anyway. So while I am including it, I suspect this is the long leading indicator most likely to signal falsely before the next recession.
REAL RETAIL SALES PER CAPITA:
These peaked more than a year before the onset of the last two recessions. Here's what they look like through May:
This is yet another positive.
Typically, corporate profits peak at least one year before a recession. Here they are through Q1:
These are a qualified negative. They have not made a new peak in a year, but it is possible that they made a bottom in Q4 2015. We'll have a better read on this when Q2 GDP is released.
THE LABOR MARKET CONDITIONS INDEX
This is a recently compiled index of 19 indicators from the Fed. This too typically turns negative at least one year before the onset of a recession:
It turned negative at the beginning of this year, and has been sinking. This is a negative.
BONUS: The US$
I would be remiss if I did not take into account the question of whether the strengthening of the US$ will undo the good that Brexit has done for US interest rates. Here is the spot index of the US$ through Wednesday:
As you can see, it has not broken off the range it has been in for the last 16 months. In fact, it is lower now than it was one year ago!
So, to summarize:
- There is only one outright negative: the labor market conditions index, and one qualified negative - corporate profits.
- Positives include corporate bond yields, housing, real money supply, the yield curve, and real retail sales per capita. The fallout from Brexit has made a big positive difference to the first two of those metrics.
- Although this could change, the US$ has not strengthened enough so far due to Brexit to create a significant new drag on the economy.
While in the near term I expect the US economy to remain weak, barring a huge reversal the big decline in corporate and mortgage interest rates give me a lot of confidence that the US economy will have a second wind by midyear 2017.
New Deal Democrat, XE.com