DB: Do Not Ignore the Downward Trend in the LEI
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Although market participants tend to give the index of leading economic indicators (LEI) short shrift because most of the subcomponents are already known at the time of its release, the series tends to capture turning points in the economy.
Last month, the LEI increased 0.3%, mainly due to a decline in jobless claims. However, the year-over-year growth rate of the LEI fell to 0.7%, the lowest level since November 2009 (-2.6%). While consumer spending was relatively sturdy in Q2 and nonfarm payroll growth rebounded solidly last month, the downward trend in the growth rate of the LEI indicates that near-term risks to growth remain to the downside.
The year-over-year growth rate of the LEI leads the trend in real GDP growth by one quarter. Last quarter, the former averaged 1.1%, the lowest level since Q4 2009 (-2.7%). However, in the latter period, the economy was just emerging from a long recession and jobless claims were averaging around 500k. Last quarter, claims averaged 267k, the lowest level since Q4 1973 (262k).
This is important because initial jobless claims are one of the 10 components of the LEI and accounted for 15 basis points (bps) of the aforementioned 30-bp gain in the latter series last month. Yesterday, we learned that claims for the July employment survey period fell to 253k, which lowered the four-week trailing average 1k to 258k. Hence, the recent trend in claims remains supportive of growth.
However, the next-largest contributor to the increase in the index last month was the Treasury yield curve, which was responsible for 14 bps. The yield curve is defined as the difference between the 10-year Treasury yield and the fed funds rate.
While this component has been a steady contributor to the LEI over the past several years, the positive impact of the yield curve has diminished significantly since the Fed hiked interest rates in December. Further compression of the yield curve will put downward pressure on the growth rate of the LEI going forward, all else being equal. In our view, the ongoing flattening of the yield curve is one reason why the Fed needs to be very cautious with respect to hiking interest rates.
Against the weakening backdrop that is evident from the year-over-year trend of the LEI, we continue to expect below-trend real GDP growth over the next couple of quarters. If the annual growth rate of the former were to turn negative, then we would become meaningfully more concerned about the overall growth outlook. In the past two business cycles, an outright year-over-year decline in the LEI after a prolonged period of growth has presaged recession.
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