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.

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 )

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

Flattening yield curve & low bank interest margins

The Yield Differential, calculated by subtracting 3-month from 10-year Treasury Yields, is trending lower. This warns that the yield curve is flattening but we are still above the danger area below 1.0 percent.

Yield Differential: 10-Year minus 3-Month Yields

A flat yield curve squeezes bank interest margins and often precedes a credit contraction.

Large US Banks: Net Interest Margins

But there is little sign of slowing credit growth so far.

US Bank Loans & Leases: Annual Growth

The St Louis Fed Financial Stress Index (STLFSI) continues to indicate low market stress.

St Louis Fed Financial Stress Index

The STLFSI measures the degree of financial stress in the markets and is constructed from 18 weekly data series: seven interest rate series, six yield spreads and five other indicators. Each of these variables captures some aspect of financial stress. Accordingly, as the level of financial stress in the economy changes, the data series are likely to move together.

Why is the Yield Curve Flattening? | PRAGMATIC CAPITALISM

Interesting view from Cullen Roche:

Most fixed income traders view long rates as a function of the economy and short rates as a function of the Fed’s views on the economy. So, when the Fed increases rates it means that the Fed thinks the economy is improving and needs some tightening so it doesn’t cause the Fed to create too much inflation and overheat the economy. But fixed income traders account for this and front-run the Fed’s thinking by trying to anticipate their views on the economy. Said more simply – long rates are a function of short rates for the most part. And the fact that long rates are remaining low means that fixed income traders increasingly believe that we’re in a permanent state of low interest rates.

Read more at Why is the Yield Curve Flattening? | PRAGMATIC CAPITALISM.

FT Alphaville » Negative rates as a precursor to the death of banking

Izabella Kaminska: The [European research] team at Morgan Stanley concludes:

Banks earnings have already come under significant pressure from the flattening of the yield curve. Unless negative real rates came with a material steepening of the curves (not our rates colleagues’ view), banks earnings would come under even greater pressure. In fact, the greatest risk our rates colleagues see would be for negative rates 2-3 years down the curve, in which case banks would need to re-price credit further. In our view, as banks’ confidence in loan growth and margins fell, so would their confidence on their capital plans and so lending would remain weak. We see Japan’s experience as good case study in this.

via FT Alphaville » Negative rates as a precursor to the death of banking.

The Power of Cheap Money | Puru Saxena | Safehaven.com

Mr. Bernanke is intentionally suppressing the nominal risk free rate of return and he is forcing investors to search for yield. By keeping interest rates artificially low and well below the rate of inflation, the Federal Reserve has engineered this impressive rally in American stocks.

Figure 2 captures the real US Treasury Yield Curve [after deducting inflation] across various maturities. As you can see, the real yields of the entire US Treasury Yield Curve (except the 30-Year US Treasury Bond) are currently negative.

Real US Treasury Yields

via The Power of Cheap Money | Puru Saxena | Safehaven.com.