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Wednesday, May 20, 2009


LEI constituents

i earlier commented on the potential signal of the four-week average of weekly claims for unemployment insurance in conjunction with the yield curve and consumer confidence differential in calling a possible turn in the economy (but not the stock market, as CXO makes clear). in truth, though, yield spreads and weekly claims are already constituent members of the conference board leading economic indicators, which is related to (by virtue of sharing the same developer) the ECRI weekly leading indicators (WLI). the LEI also tracks consumer confidence, though not the differential measure i look at.

  • Average number of initial applications for unemployment insurance
  • Number of manufacturers' new orders for consumer goods and materials
  • Speed of delivery of new merchandise to vendors from suppliers
  • Amount of new orders for capital goods unrelated to defense
  • Amount of new building permits for residential buildings
  • The S&P 500 stock index
  • Inflation-adjusted money supply (M2)
  • Spread between long and short interest rates (the yield curve)
  • Consumer sentiment
  • Average weekly hours worked by manufacturing workers

caroline baum again got me thinking about how the LEI components, tested and adopted in large part in normal recessions, might vary in reliability in a balance sheet recession.

The April LEI, due tomorrow, is expected to show a 0.8 percent increase, according to the average forecast of 56 economists surveyed by Bloomberg News. That would be the first increase since June, with stock prices, the spread between the federal funds rate and 10-year Treasury note yield, and consumer expectations contributing to the expected increase.

One month does not make a trend. Nor does it reverse the gloomy message reflected in the six-month annualized change in the LEI and the six-month diffusion index, measures preferred by Conference Board economists to the monthly change. Then there’s the possibility historical revisions will change the leaders’ outlook: January’s 0.4 percent initial increase became a 0.2 percent decline with subsequent revisions.

For the moment, the financial, or intangible, indicators -- the interest-rate spread, the stock market and real M2, which probably didn’t show an April increase but has soared since September -- are showing hopeful signs. And they typically lead more concrete measures, such as jobless claims, building permits and orders for capital goods.

Raw materials prices are sending a similar message. The CRB Spot Raw Industrial Price Index, which excludes oil, bottomed in December and went nowhere for three months before heading higher.

it's these "intangible" leaders that i want to examine. i've already discussed the yield curve.

“If you think monetary policy matters, you should care about the spread,” says Jim Glassman, senior economist at JPMorgan Chase & Co.

glassman is exactly right, but the contraction of loan demand means precisely that monetary policy has lost its efficacy. while a steep curve and the resulting fat spreads are fine for recapitalizing banks, if banks aren't expanding lending -- or, more importantly, can't lend for an aggregate lack of borrowers -- it means precious little for credit growth and economic activity.

the change in m2 is mostly a function of the change in m1, which is a function of excess reserves being deadheaded on the fed's balance sheet. this may represent potential inflation, but it does represent a current inability to lend out funds. while contributing to the upturn in LEI, this isn't a real economic positive unless loan demand is healthy. and loan demand isn't.

the S&P has rather a mixed record of leading the end of recession, particularly out of deep recessions that tend to shell-shock investors. what's more, much of what we've seen to date may best be characterized as a massive short squeeze that many styled 'the dash for trash'. given further stumbling earnings for the S&P, it seems likely that at minimum a retest of the march lows is in our future -- and thereby the optimism that the S&P conveys to the LEI may be somewhat discounted.

of the real economy leaders, i've already discussed the tenuous optimism of weekly claims. what of the others?

if you can paint a positive picture out of this lot, you're doing better than me.

furthermore -- to return to the conference board's page for a moment -- note the standardization factors of the various indicators. these are nominally employed to adjust for the volatility of the series so that the scale of changes in one do not wash out the signal of others, so the size of the factor should be inversely related to the standard deviation of the series in relation to that for all the series. the heaviest signal weighting is for m2 -- and m2 has of course experienced an unprecedented period of volatility as a result of federal reserve machinations in comparison to the sample period fo 1984-2007 used to calculate the factors.

this is to say that not only is the linkage between m2 and economic growth likely broken by the nature of a balance sheet recession -- it also is disproportionately skewing the LEI to the upside thanks to the fed's suddenly expanding balance sheet and the volatility thereby recently introduced. this is best seen in the march report addendum showing the adjusted contributions of each indicator (table 2).

in march, the LEI was reported as 98.1, down (-0.3). the combined contributions of the yield curve and m2 were +0.6; the sum of the other eight indications was (-0.91).

if the yield curve and money supply indications are rendered null thanks to the collapse of loan demand inherent in a balance sheet recession, what is the LEI really saying about economic conditions?

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Kasriel has in the past used the LEI to construct his Kasriel Recession warning indicator (KRWI). He continues to speak positively about the growth in real M2 for the economy while also making allowance for the government filling in for the demand destruction.

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I correct myself. He used his KRWI based on the yield curve and real M2 in parallel with the LEI .

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This is excellent analysis, GM, and one which is overdue--have conditions changed so much that the old measurements (or charms) simply will not work anymore. This "magic" LEI catagories smacked of curve-fitting and not causation, with a bit of circular reasoning thrown in. But given the decline in US manufacturing, and the Fed manipulation of both the long and short ends of the yield curve, do the corresponding parts of the LEI reflect a measurement of the economy or simply irrelevant numbers?

Of course, I also worry that I (for one) want to talk myself into my investment stance--not a good thing.

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