You can use leading economic indicators to see where the economy is heading. These indicators can help you predict whether the economy is heading towards a recession.
The yield curve, durable goods orders, the stock market, and housing starts are some of the best indicators to use when trying to determine where the economy is headed.
Key Takeaways
- An inverted Treasury yield curve has occurred before the last seven recessions, although it does not always predict a recession.
- Increases in new durable goods orders, like washing machines, cars, and business equipment, typically mean the economy is trending in an upwards direction.
- The U.S. Conference Board's Leading Economic Index is a leading indicator which uses many different economic indicators to determine where the economy is headed.
Top Leading Indicators
The yield curve, durable goods orders, the stock market, manufacturing orders, and building permits are some of the best indicators to use when trying to determine where the economy is headed.
Note
There are three types of economic indicators: leading, coincident, and lagging. Leading indicators occur before the trend, coincident indicators show you what's happening right now, and lagging indicators show what has just happened.
The Yield Curve
An inverted Treasury yield curve is a leading indicator for recessions. It predicted all of the last seven recessions: 1970, 1973, 1980, 1990, 2001, and 2008. The yield curve also inverted before the 2020 recession.
The yield curve shows the return on short-term Treasury bills compared to long-termTreasury notes and bonds.In a normal yield curve, returns on short-term notes will be lower than the longer-term bonds. Investors need a higher yield to invest their money for longer.
When the yield curve inverts, it often foreshadows a recession, but the timing of the ensuing pullback is highly unpredictable. Incidentally, an inversion occurs when short-term Treasury bills and notes offer a higher yield than longer-dated Treasury bonds. If investors are willing to accept a lower return for the long-term bonds, then you know they are very uncertain about the near future.
Note
Go to the U.S. Department of the Treasury's Daily Treasury Yield Curve Rates.
The yield curve also tells you whether interest rates are rising or falling. Low interest rates make loans cheaper. It allows businesses to expand, and families to buy cars, homes, and education. Wheninterest rates rise, you know the economy will slow down soon. It costs more to take out a loan, making everyone buy less.
The yield curve is not perfect. It inverted in 1966, although no recession occurred afterward.
Durable Goods Orders
Thedurable goods orders reporttells you when companies and consumers order new big-ticket items. Consumer durable goods include furniture, cars, and long-lasting appliances like washing machines. Business durable goods include industrial equipment as well as trucks, boats, and planes. When there is an increase in durable goods orders, that typically means that the economy is trending upwards.
Orders for durable goods began to decline in January 2008. In December 2008, the Bureau of Economic Analysis declared that the 2008 recession effectively began in January 2008.
The Stock Market
Thestock marketcan be a good predictive indicator. A company's stock price is affected by the firm's expected earnings. If earnings estimates are accurate, the strength of the stock market should show the general direction of the economy. For example, if the stock market is up, most companies earnings estimates should also be up, which would mean the economy will be doing well. If the stock market is down, most companies earnings estimates would also be down, which would mean the economy will be doing poorly.
Note
The most well-known stock indices are the Dow Jones Industrial Average, the S&P 500, and the Nasdaq.
Housing Starts and Building Permits
A housing start is new residential construction. When more building permits are issued - which leads to construction - or more construction begins on housing, it's a sign that demand for housing is up. If housing construction or permits begin to decline, it's a sign of shrinking demand for new housing.
When permits start to fall, it's a clue that the demand for new housing is also down. When that happens, it usually also means something is wrong with the resale market.Real estateis a significant component of the economy, as are construction jobs. When this sector weakens, everyone feels it.
For example, economists made that mistake in the 2008 recession. They thought the subprime mortgage crisis would be contained withinreal estate. As early as October 2006, building permits for new homes were down 28%from October 2005. It was anearly indicatorof the housing crisis and the 2008 global financial crisis.
The Conference Board Leading Economic Index
The U.S. Conference Board publishes a Leading Index that is a good indicator of what's going to happen in the economy.
The Conference Board Leading Economic Index (LEI) measures 10 economic indicators. These indicators are not all leading indicators. The unemployment rate, or weekly claims for unemployment, is a lagging indicator.
Here are the ten economic indicators that the LEI uses to determine where the economy is headed:
- Average Weekly Manufacturing Hours: This shows how much demand there is for labor workers. This sector of the economy is very sensitive to business cycle fluctuations.
- Average Weekly Unemployment Insurance Claims: This shows how many employees are requesting unemployment insurance that week. You can see how many people are newly out of work.
- Manufacturer's New Orders, Consumer Goods and Materials
- Manufacturer's New Orders, Excluding Defense Capital Goods and Aircraft Orders
- ISM Index of New Orders: This surveys more than 400 purchasing executives in the manufacturing sector. If the new orders report is above 50, it's an indicator that manufacturing and the economy are growing.
- Building Permits
- Stock Prices
- Leading Credit Index: It measures six financial indicators, such as margin account balances, bank credit, and security repurchases.
- Interest Rate Spread, 10 Year Treasury Bonds, Excluding Federal Funds:
- Consumer Confidence: This is based on a survey of consumers. It asks for their futureexpectations.It tells you whether consumers think business conditions, jobs, and incomes will improve in six months.
How to Use Leading Indicators
Leading indicatorsare the first data point in a new phase of the business cycle. They occur during the old cycle but give a preview of what's about to happen. Here's how to use these indicators.
Yield Curve: Keep an eye on the yield curve, but remember that it can invert months before a recession actually occurs, and has not always proven to be infallible. For that reason, monitor it but don't take action until other leading indicators confirm the yield curve's trend.
Durable Goods Orders: The monthly durable goods order report can vary significantly month to month. A large portion of it is commercial aircraft, mostly Boeing, and its orders swing wildly. Also, look at the portion of the report called "Capital Orders Without Defense and Transportation." It eliminates the unevenness of commercial and defense aircraft orders.
Stock Market: The stock market can fluctuate a lot, for a variety of reasons. Pay attention to why changes in the stock market are occurring - are there a lot of losses or gains across the board, or in certain sectors of the economy, or is it simply a temporary fluke?
Building Permits and Housing Starts: The building permits report is released monthly. A quick review will tell you how developers feel about the future of housing. Housing demand can affect the entire economy.
Frequently Asked Questions (FAQs)
What should I do if economic indicators point to a recession?
You can prepare for a recession by paying down debt as much as possible, focusing investments and retirement accounts on long-term growth, building an emergency fund, and finding places to cut back on your spending.
How long do recessions last?
While recessions can last from several months to several years, the average length of recessions that have taken place since 1945 is 10 months.
When does a recession become a depression?
There are some key ways to tell the difference between a recession and a depression. In the United States, recessions have lasted an average of 10 months, and typically last between two and 18 months. A depression lasts for years. The Great Depression was 10 years long, and the depression that came after the panic of 1837 lasted six years.
