INSIGHTS

On January 09, 2018

AAM Viewpoints- What the Yield Curve is NOT Saying and How the Leading Economic Indicators Index Helps You Listen More Closely

If positive revisions to Q3 (3rd quarter) 2017 Gross Domestic Product weren’t enough for the optimists, at least there was the rest of December. The passage of the Tax Cut and Jobs Act of 2017 launched a flurry of tweets, blogs and discussions of how this most recent tax bill will – or won’t – drive growth higher in 2018 and potentially make this the longest lasting expansion in the modern era. Growth sentiments and recent robust economic activity also drove the Federal Open Market Committee (FOMC) to raise rates for the third time this year citing “above trend” growth. To top this off, the Dow Jones Industrial Average (DJIA) climbed 2% during the month with the S&P 500 Index rising nearly 1% as both indices continued to touch new record highs in December. Certainly, that’s enough good news for the recent holidays but there’s still more. Small businesses are more optimistic than at any time in recent history.

The National Federation of Independent Businesses Optimism Index reached a level last seen in 2004. Chief Economist Bill Dunkelberg couldn’t contain his enthusiasm when he wrote in December’s report, “(T)he change in the management team in Washington has dramatically improved expectations as the survey hit the second highest level on record.” Pretty heady stuff from a man who was unusually dour throughout the prior administration’s entire time in office.

Ebullient optimism aside, this expansion has been more tepid than those prior. With growth averaging 2.2% per quarter versus a long run 3.2%, it is second nature for us to try to understand why this, the second longest expansion on record, has not kept pace with historical growth rates. Persistently low inflation, inflation expectations capping wage growth, and the lukewarm growth of personal incomes are examples of perennially frustrating issues which have generated volumes of debate over the past 10 years. However, these will not be resolved with a single positive survey nor a single piece of legislation, but we still continue to feel that the economy has the wind in its sails for 2018 and perhaps beyond.

At Advisors Asset Management, we tend to use a handful of carefully selected indicators due to their historical veracity and ability to provide insight into future economic activity. We consistently point to some of these trusted indicators when discussing our views on how to tactically manage fixed income assets throughout the distinct phases of the business cycle. If you are familiar with our discussions, one recurring theme is the importance of the yield curve.

The U.S. Treasury Yield Curve is notably accurate at forecasting economic activity 12-18 months hence. It has consistently flattened and inverted prior to each of the past seven recessions and has predictably steepened as the economy moves from contraction into expansion. To adulterate a phrase from the great Paul Samuelson originally used to reference the equity markets, “The yield curve’s forecasting ability is better than some of the economists I know who have predicted 15 of the past seven recessions."

Historically speaking, the slope of the yield curve at present is clearly flatter than it has been this entire expansion. This has induced a sense of worry that this flatness portends markedly weaker economic activity in the coming year. However, alarmist and shallow analysis does nothing but add anxiety to investing. A fundamental understanding of how the yield curve behaves throughout the business cycle, especially expansions, will help provide context to what a flattening yield curve does not mean. As an expansion continues, the yield curve is supposed to flatten. There are very specific reasons for it to do so which we can share at another time. However, these times we augment our analysis by also monitoring the Conference Board’s Leading Economic Indicators (LEI) Index. At present, it is more important what the LEI is NOT indicating which is most compelling.

Briefly, the Conference Board is an organization that has been publishing robust economic and business cycle analysis for approximately 100 years. They have a variety of indicators for several countries, but for our purposes we are going to take a closer look at the Leading Economic Indicators Index for the United States. The LEI is an index is constructed from 10 broad U.S. economic indicators. These inputs include “real” economic goods and production such as average hours worked, manufacturer’s new orders & building permits. The LEI also includes more sentiment and monetary measures such as equity prices and the yield curve (surprise!). These 10 economic data points are then weighted and results released the third week of the month for the month prior.

When coupling the monthly LEI releases with an analysis of the year-over-year change, we can make some clear observations about future economic activity. The first of these is an old rule of thumb.

Three months of negative LEI indicates a slowdown is coming. To be more specific, following three consecutive, negative monthly reports from the LEI, GDP declines by an average of -2.24% within one quarter.

A second observation is if these negative monthly releases from the LEI occur when the economy is not in a recession, a recession has followed within three quarters with only one exception. In 1981, the 3rd negative monthly reading from LEI occurred one month after the recession had begun.

Federal Reserve activity at the short end of the curve has historically been the driver of its slope. The most recent FOMC dot-plot illustrates a continued increase in the Fed Funds Rate through 2018. As a result and to the consternation of many, we expect rate activity at the short end of the curve to continue to drive the curve flatter through 2018. However, interpreting the current shape of the yield curve as anything other than indicating the economy is mid-expansion ignores the combined fundamental forces still at work in the economy which the LEI captures monthly.

Our final observation of the LEI relates to its movement in the months surrounding a very flat yield curve; 1973, 1979, 1988, 1999 and 2006.

In each of these cases, both the yield curve and the LEI were clearly indicating a slowdown in economic activity.

Neither of these events are happening at present and the environment in the economy is such that we do not expect them to occur this coming year. The LEI has posted positive monthly results for the past 15 months and is increasing at its fastest pace in three years. We feel that the handwringing over the flat yield curve is misplaced and encourage investors to augment their analysis with input from the LEI. We believe the context it provides to the yield curve is invaluable.

CRN: 2018-0109-6312 R



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