How To Evaluate Leading Economic Indicators
The leading economic indicators are a set of factors that provide information that is current and foreshadows future changes to the US economy. This compares to lagging indicators such as job growth or GDP. Leading indicators can help economists predict changes in the US economy before they occur. Leading indicators are not always accurate predictors of future economic activity but they can work in conjunction with other indicators to provide data about the future expansion or contraction of the US economy.
What are the components of the Leading Economic Index
The US Conference Board created an index of leading economic indicators, that are part of a broader analytic system that is geared to point to inflection points in economic growth. There are three different indicators including leading, coincidental and lagging economic indicators. The conference board was established in the US in 1916. The group is a non-profit organization that can be described as a think tank.
The index of leading economic indicators is constructed to summarize future economic performance. The goal is to reveal inflection points in economic data that show when the US economy is poised to turn.
The ten components of The Conference Board Leading Economic Index include:
- Average weekly hours, manufacturing
- Average weekly initial claims for unemployment insurance
- Manufacturers’ new orders, consumer goods, and materials
- ISM Index of New Orders
- Manufacturers’ new orders, nondefense capital goods excluding aircraft orders
- Building permits, new private housing units
- Stock prices, 500 common stocks
- Leading Credit Index
- Interest rate spread, 10-year Treasury bonds less federal funds
- Average consumer expectations for business conditions
The goal of the Index of the leading economic index is to forecast potential changes to the trajectory of US economic growth. The 35-year chart of the leading economic indicators shows that the leading indicators begin to decline ahead of the 3-most recent recessions.
The recessions are reflected by a gray bar. The leading economic indicators show a dip in performance ahead of a recession and then a rebound as the US economy begins to expand. Recessions occurred in 1991, 2001/2002, and 2008/2009. Not only do the leading economic indicators forecast a recession, but it also helps determine when the US economy is poised to rebound.
What Does Each Component Tell You?
Many of the components of the leading economic index describe employment. Average weekly hours in manufacturing, as well as weekly unemployment claims, are employment components. Although both of these components are helpful, jobs data is generally a lagging indicator. When companies begin to hire or layoff people it is because business is either running at a brisk pace or declining sharply. Rarely due companies foresee that there is a need for expansion or contraction before it affects their business.
The second grouping of components that are associated with the leading economic index is orders related. These data points are very helpful in predicting future economic activity. The three orders components are Manufacturer’s new orders of consumer goods and materials. The ISM index or new orders and Manufacturer’s new order of nondefense capital goods excluding aircraft orders. This last component is a proxy for business capital investment.
US Housing Building Permits is the next component and it provides the index with information about future housing starts. Prior to building a home, a builder needs to secure a building permit which will provide him with the proper licenses to build in that area.
The next component is stock prices. The leading economic index uses the S&P 500 index prices to determine market sentiment. The leading index also uses a leading credit index to determine if people are attempting to increase or reduce their borrowing, which provides the index with information about future spending.
The next component of the index is the yield curve. The index calculated the difference between the 10-year US treasury yield and the Federal Funds rate set by the US Federal Reserve. The yield curve tells the index if borrowing costs increase or decrease with time. In general, a borrower will pay higher interest rates for longer tenor loans. This is because there is more uncertainty for longer periods of time. If you are looking to trade debt or currencies the yield curve is very important.
If short term yields are higher than long term yields, such as the fed funds rates at a higher level than the 10-year treasury yield, the yield curve is inverted. An inverted yield curve means that the investor believes there is more risk in the short-term than over the long term. This type of scenario usually points to a recession. The last component is the average consumer expectations for business conditions. This is a measure of sentiment and can be very helpful in determining the short term movements in economic activity.
How to You Trade Around the Leading Economic Index
The leading economic index has 10-subcomponents that can be gauged ahead of the release. Similar to other economic releases, this index will provide opportunities if it comes out above or below expectations. Since most of the subcomponents can be calculated by analysts in advance, a surprise should not be taken lightly. Both better than expected or worse than expected numbers should tell you that the market might be positioned incorrectly, which could generate a move in many underlying securities.
The leading economic indicators are a set of ten individual data points that are used by the US Conference Board to forecast future changes to the US economy. Leading indicators can help economists predict inflection points in the growth of the US economy before they occur. Leading indicators are not always accurate predictors of future economic activity but they can work in conjunction with other indicators to provide data about the future expansion or contraction of the US economy. The components consist of jobs data, manufacturing orders, housing information, stock and bond prices as well as credit and consumer sentiment information. Since most of the sub-indices can be calculated before the number is released, a report that reveals a greater than or less than expected index should be taken seriously.
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