The Leading Economic Indicator (“LEI”) came in at +.2% in the most recent read. There was a time that I looked at this data set pretty seriously. Not any more. I think it produces a false read. A key component comes from the Interest Rate Spread. Drawing any conclusions about the current economic status quo and or predicting future economic activity based on the LEI read is a mistake in my opinion.
The following graph tracks the components of the LEI. It is rather messy. I want you to focus on just the green line at the top of the graph. This measures the yield curve (“YC”). It is consistently the highest numeric component in the index.
To be sure a positive and steep yield curve has historically been a good indicator of an expanding economy. The steeper the slope, the better the prospects. Similarly a negative or flat yield curve is a sign a slowdown is coming. The folks who came up with the LEI index were wise to include the shape of the yield curve in their index. It has been a reliable barometer for many years. Up till now.
We are now two years into ZIRP. There can be no doubt but that this policy will last a minimum of another 12-18 months. We have gone through 1.75 Trillion of QE-1. The QE-2 that Bernanke wants to bring us will probably double that.
We are living through a period where the credit markets are a dirty float. From overnight to 30-years it is all managed by the Fed. The magnitude of Fed POMO purchases distorts supply and demand. Short rates at zero are a joke. The objective is to devalue savings and force consumption. There has never been a time in history where this level of intervention in the capital markets has been undertaken.
The NBER says the recession ended 15 months ago. Short-term rates would normally be rising at this point in the cycle. But the Fed still has the cost of money set at zero. A more reasonable level for Fed Funds would be 2%. On paper that would eliminate most of the steepness we currently see.
With this in mind it is a mistake to study the entrails of the credit market and draw conclusions about the future.
The LEI is not going to change. The shape of the YC will continue to support the index. The question is, “How much should one discount the impact of YC when evaluating the LEI?“
-If you were on talking head on TV you wouldn’t consider any change. If you were a bullish pundit you would be touting the result as an excuse to buy more.
-On the other hand if you were a guy like me you would just ignore YC altogether. There is a strong case to be made that in 2010 it is just noise, not reliable data.
-Others might just haircut the YC by 50% and see what the index is saying based on that.
This is a graph of the LEI from the Conference Board that tracks the index.
This is my graph of the data from August 2009 on. It assumes (1) YC unchanged, (2) YC cut by 50% and (3) YC is excluded from the index.
That YC is overstating the LEI is not a new observation. But I think it is interesting that the index trajectory has turns flat in the 50% YC adjustment and has gone decidedly negative for the past four months if YC is excluded.
Make what you like of this, but here is a bet. At the all-important next Fed meeting the only sane reasonable person in the room, Thomas M. Hoenig will say:
“The LEIs are still pointing up. Do we really need to take this extraordinary step (QE-2) at this time?”
And Bernanke will pull out a slide that looks something like mine and he will say:
The end result will be a very big “QE-2 Celebration Bash” on November 5th for Bernanke and the other “deciders” at the Fed.