Leading Index gives early warning

One of the better composite indicators in the US, the Leading Index from the Philadelphia Fed, points to a slow-down in the US economy. A dip below 1.0% is often early, as in July 2000 and May 2006, but serves as a reliable warning of an economic slow-down.

Leading Index for the United States

The Leading Index predicts the six-month growth rate of the Philadelphia Fed Coincident Index. In addition to the Coincident Index, it includes variables that lead the economy: housing permits (1 to 4 units), initial unemployment insurance claims, delivery times from the ISM manufacturing survey, and the interest rate spread between the 10-year Treasury bond and the 3-month Treasury bill.

The Coincident Index combines four indicators: nonfarm payroll employment, the unemployment rate, average hours worked in manufacturing and wages and salaries.

Coincident Index for the United States

The Leading Index signal does seem early. Low corporate bond spreads and VIX near record lows continue to indicate low market risk, typical of a bull market.

Corporate Bond Spreads and VIX

Monetary policy remains accomodative, with money stock growing at close to 5% p.a. (MZM = cash in circulation, travelers checks, money market funds and deposits with zero maturity).

MZM and Yield Differential

The yield curve has flattened, with the spread between 10-year and 3-month Treasuries falling to 1.0% on the above graph. That is what one would expect when the Fed hikes interest rates in a low inflation environment: short-term rates will rise faster than long-term rates. But a negative yield curve, where short-term rates are higher than long-term rates, is a reliable predictor of recessions in the US economy. Each time the yield differential on the above graph crossed below zero in the last 50 years, a recession has followed within 12 months.

Underlying inflation remains low, with average hourly earnings growth below 2.5% p.a., and the Fed should be careful about single-mindedly raising interest rates without considering the yield curve.

Annual Growth in Average Hourly Earnings

The bull market continues but investors need to keep a weather eye on interest rates and the yield curve.

How long will the bull market last?

US markets are clearly in a bull phase, with the Dow, S&P 500 and Nasdaq making strong gains. A rising Freight Transport Index highlights the broad up-turn in economic activity.

Freight Transport Index

Low corporate bond spreads — lowest investment grade (Baa) minus 10-year Treasury yield — and VIX below 15 both reflect bull market conditions.

Bond Spreads

Real GDP is growing around a modest 2 percent a year. Low figures are likely to continue, with annual change in hours worked (total payroll * average weekly hours) falling to 1.2 percent in September.

Real GDP

Money supply (M1) growth recovered to a balmy 7 percent (p.a.) after a worrying dip below 5 in early 2016.

M1 Money Stock

The Fed may be reluctant to tighten monetary conditions but will be forced to act if inflation starts to accelerate. Annual growth in hourly wage rates turned above 2.5 percent in September, signaling underlying inflationary pressure.

Average Hourly Wage Rate - Annual Growth

Another dip in M1 below 5 percent growth would warn that monetary conditions are tightening. From there, it normally takes 12 months to impact on the broad market indices.

M1 Money Stock and Fed Funds Rate

At this stage it looks like another 2 years of sunshine before the storm. But one false tweet and we could face an early winter.

Australia: Housing, Incomes & Growth

A quick snapshot of the Australian economy from the latest RBA chart pack.

Disposable income growth has declined to almost zero and consumption is likely to follow. Else Savings will be depleted.

Disposable Income & Consumption

Residential building approvals are slowing, most noticeably in apartments, reflecting an oversupply.

Residential Building Approvals

Housing loan approvals for owner-occupiers are rising, fueled no doubt by State first home-buyer incentives. States do not want the party, especially the flow from stamp duties, to end. But loan approvals for investors are topping after an APRA crackdown on investor mortgages, especially interest-only loans.

Housing loan approvals

The ratio of household debt to disposable income is precarious, and growing worse with each passing year.

Household debt to disposable income

House price growth continues at close to 10% a year, fueled by rising debt. When we refer to the “housing bubble” it is really a debt bubble driving housing prices. If debt growth slows so will housing prices.

House price growth

Declining business investment, as a percentage of GDP, warns of slowing economic growth in the years ahead. It is difficult, if not impossible, to achieve productivity growth without continuous new investment and technology improvement.

Business investment

Yet declining corporate bond spreads show no sign of increased lending risk.

Corporate bond spreads

Declining disposable income and consumption growth mean that voters are unlikely to be happy come next election. With each party trying to ride the populist wave, responsible economic management has taken a back seat. Throw in a housing bubble and declining business investment and the glass looks more than half-empty.

Every great cause begins as a movement, becomes a business, and eventually degenerates into a racket.

~ Eric Hoffer

VIX hits record low

The CBOE Volatility Index (VIX) made a new low of 9.30 indicating record low levels of stock volatility. High levels of stock buybacks and large ETF fund inflows may both have contributed, but this is only the third time in its 27-year history that index has broken below 10%. The first was in late 1993. The second, in late 2006, was followed a year later by a massive market snap-back. This time is no different. Volatility is unlikely to remain at such low levels and eventually we will see a market down-turn, accompanied by high volatility, but there is no crystal ball that can tell us whether this will be in one year or five.

CBOE Volatility Index (VIX)

Corporate bond spreads are also falling, with the spread between lowest investment grade Baa (10-year) and equivalent Treasury yields at their lowest point since 2008.

Corporate Bond Spreads

Source: St Louis Fed & Moody’s

The yield curve is flattening but remains comfortably above a flat or negative yield curve when
the yield differential (10-year minus 3-month yields) falls below zero. A negative yield curve is a reliable warning of recession within 12 months.

Yield Differential

Source: St Louis Fed

The Freight Transportation Services Index displays a steady increase in economic activity.

Freight Transportation Services Index

Source: St Louis Fed & US Bureau of the Census

And the S&P 500 continues its advance towards 2500.

S&P 500

Target 2400 + ( 2400 – 2300 )

More evidence of a bull market, except in Australia

One of my favorite indicators of financial market stress is Corporate bond spreads. The premium charged on the lowest level of investment-grade corporate bonds, over the equivalent 10-year Treasury yield, is a great measure of the level of financial market stress.

Moodys 10-year BAA minus Treasury yields

Levels below 2 percent — not seen since 2004 – 2007 and 1994 – 1998 before that — are indicative of a raging bull market. The current level of 2.24 percent is slightly higher, reflecting some caution, but way below elevated levels around 3 percent.

The Financial Stress Index from St Louis Fed measures the degree of stress in financial markets. Constructed from 18 weekly data series: seven interest rate series, six yield spreads and five other indicators. The average value of the index is designed to be zero (representing normal market conditions); values below zero suggest low financial stress, while values above zero suggest high market stress.

St Louis Financial Stress Index

Current levels, below -1, also indicate unusually low levels of financial market stress.

Leading Index

The Leading Index from the Philadelphia Fed has declined slightly in recent years but remains healthy, at above 1 percent.

Philadelphia Fed Leading Index

Currency in Circulation

Most recessions are preceded by growth in currency in circulation falling below 5 percent, warning that the economy is contracting.

Currency in Circulation

Current levels, above 5 percent, reflect healthy financial markets.

Australia

On the other side of the Pacific, currency growth is shrinking, below 5 percent for the first time in 7 years. A sustained fall would warn that the economy is contracting.

Australia: Money Supply

Further rate cuts, to stimulate the economy, are unlikely. The ratio of Household Debt to Disposable Income is climbing and the RBA would be reluctant to add more fuel to the bonfire.

Australia: Household Debt

There is no immediate pressure on the RBA to raise interest rates, but when the time comes the impact on the housing market could be devastating.

Bond spreads bullish for US, less so Australia

Yield Curve

The yield curve is one of the best predictors of US economic recessions. Every time the yield curve has turned negative in the last fifty years, a recession has followed.

First of all, what is a yield curve? It is the plot of yields on bonds, normally Treasuries, against their maturities. Long maturity bonds are expected to have higher yields than short-term bills, to compensate for the increased risk (primarily of interest rate changes). If you tie your money up for longer, you would expect a higher return. Hence a rising yield curve.

A rising yield curve is a major source of profit to the banks as their funding is mostly short-term while they charge long-term rates to borrowers, pocketing a healthy interest margin.

When the Fed steps into the market, however, restricting the flow of money into the economy, then short-term rates rise faster than long-term rates and the yield curve can invert (referred to as a negative yield curve).

Bank interest margins are squeezed — it is no longer profitable to borrow short and lend long — and they restrict the flow of new credit.

Credit is the lifeblood of the economy and activity slows.

The chart below compares US recessions to the yield differential: the difference between 10-year Treasury yields and the yield on 3-month T-bills. The yield differential falls below zero when 3-month T-bills yield more than 10-year T-notes.

Yield Differential: 10-year Treasury yields minus 3-month T-bills

You can see that every time the yield differential dips below zero it is followed by a gray bar indicating a recession. There is one exception: the phantom recession of 1966 when the S&P 500 fell 22%. This was originally certified as a recession by the NBER but they later changed their mind and airbrushed it out of history.

You can also see that the yield differential is declining at present but, at 2.0%, it is a long way from a flat or negative yield curve. This supports my argument last week that current Fed rate hikes are more about normalizing interest rates than about monetary tightening.

That could change in the future but at present the bull market still appears to have plenty in the tank.

Corporate Bond Spreads

Corporate bond spreads — the yield difference between high-grade corporate bonds and the risk-free Treasury rate — are another useful indicator of the state of the economy.

Wide bond spreads indicate increased risk of corporate default. Investors are concerned about the state of the economy and demand a higher premium for taking credit risk.

Narrow spreads suggest that credit premiums are low and confidence in the economy is good.

If we examine the chart below, bond spreads are declining, indicating confidence in the US economy, with even the lowest investment grade BBB dipping below 150 basis points (or 1.50%). This is synonymous with a bull market.

US Bond Spreads

Australian corporate bond spreads are higher than the US, with BBB still at 200 bps. They have also declined over the last year but seem to be trending upward from their 2013 low. This is not conclusive as the current trough is not yet complete, but a higher low would warn that credit risk is rising.

Australian Bond Spreads

Only when the tide goes out do you discover who’s been swimming naked.

~ Warren Buffett

Household debt indicates confidence improving

Good news for the US economy is that household credit has started to grow, recovering above zero after a protracted contraction. Not only does this indicate a recovery in consumer confidence, but it will fuel additional expenditure and stimulate income growth.

US Household Credit Growth

The ratio of household debt to personal disposable income continues to contract, indicating that debt is growing at a slower rate than disposable income. This is likely to continue for some time as households recover from the credit binge leading up to the GFC, but is a healthy sign provided credit growth remains positive.

Household Debt over Disposable Personal Income

Declining corporate bond spreads and historically low readings on the CBOE Volatility Index (VIX) suggest a healthy bull market ahead.

CBOE Volatility Index

Australia

Australian household debt remains elevated at 150% of disposable income, almost 50% higher than US levels.

Australian Household Debt to Disposable Personal Income

While household debt levels will need to be addressed in the long-term, declining corporate bond spreads indicate there is no immediate cause for alarm.

Australian Bond Spreads

All who are able, may gain virtue by study and care, for it is better to be happy by the action of nature than by chance. To entrust to chance what is most important would be defective reasoning.
~ Aristotle