Introduction
Business cycless and economic indicators
Multiple indicators were developed by NBER to better understand and track business cycles. There are three types of indicators. Leading, coincident, and lagging indicators predict, date, and follow turning of economy from expansion to recession and from recession to recovery respectively. Since 1995, The Conference Board published composite indices of leading, coincident, and lagging indicators.
Leading indicators
Leading indicators are infamous among economists who tend to ignore them. Some even call these variables misleading indicators.
While coincident indicators give information where the economy is at the moment, leading indicators predict where the economy will be after several months. Not all leading indicators are created equally; strategists and economists distinguish two types of leading indicators — long leading and short leading. Some of them, especially those related to financial markets, such as yield-curve spread, are long leading which means they have longest leading effect on the economy. For example, since 1969 each inversion of the 2s10s yield curve (the difference between 10-year and 2-year Treasury bonds’ yields) resulted in a recession. But the average time it takes to be followed by a recession is 13 months.
On the other hand, with the real economic activity indicators, it typically takes less time to be followed by a recession. That’s why these variables which include but are not limited to building permits, and unemployment claims, are short leading indicators.
The Composite Index of Leading Indicators (LEI) is made up of the following ten variables:
Manufacturing average weekly hours. To understand why this indicator is a leading one, recall that manufacturing is more cyclical than the overall economy. When the economy starts to grow and get out of a recession, producers tend to not expand their workforce because they are not sure that this positive economic trend will continue. So they continue their current employees to work more hours. But eventually, as the economy continues to improve, producers will add to their workforce. The exact opposite happens when the economy goes into a recession. Producers tend to reduce hours worked of employees, not to directly lay-off them. But as the recession deepens, more and more employees will lose their jobs which reinforces the negative trend of the economy.
Average number of initial applications for unemployment compensation
Average consumer expectations for business conditions
Manufacturers’ new orders, consumer goods and materials. Fall in manufacturers’ orders is followed by an economic weakness.
Manufacturers’ new orders, nondefense capital goods, excluding aircraft
Institute of Supply Management (ISM) Index of New Orders
New building permits, private housing units. Residential investment is among the most cyclical sectors of the economy. From the chart we see that building permits tend to fall before recessions.
The remaining three indicators are financial market-related:
S&P500 index. The stock market is a leading indicator because it anticipates the turning points of all sectors making up the global economy.
Leading Credit Index. Tightening credit conditions tend to predict a recession. On the other hand, if credit conditions are easing, we can expect an economic expansion.
Yield curve spread.
Whenever long-term government bonds have lower yields than short-term bonds, it portends a recession.
Current state of leading indicators
United States ISM Manufacturing New Orders
Manufacturers’ New Orders: Nondefense Capital Goods Excluding Aircraft
10-Year Treasury Constant Maturity Minus 2-Year Treasury Constant Maturity
Building permits
Average Weekly Hours of All Employees, Manufacturing
We see that almost all leading indicators are falling which is the sign of economic weakness. When the yield spread, housing industry (building permits), manufacturing (new orders), and labor market (average weekly hours) are all aligned and point to a recession, we can be confident to expect that it is inevitable.