If asset bubbles can be leading indicators of recession, that begs the question what assets are the most important? Several studies have shown that housing prices are critical. They were important in Japan and in 2008 in the United States. Babecky (2012) showed that housing prices consistently predict asset bubbles, minus the occasional false positive. Intuitively this makes sense since any sort of bubble will result in more investment in real estate.
There is a further question that is raised in light of the contagion of the 2008-2009 crisis. Prior to that, as Evanoff (2013) notes, several asset bubbles were effectively contained by monetary policy and did little damage. Most bubbles that cause damage do so in the developing world -- Southeast Asia and Russia in the late 1990s for example -- but in the developed world the damage is usually contained. Frankel and Saravelos (2011) examined the indicators that might shed light on which countries are more likely to experience an economic crisis. Their work identified other variables, including level of reserves and real exchange rate appreciation as being statistically-significant valid leading indicators.
The Babecky (2012) study found that the nominal effective exchange rate, and global inflation are also indicators of bubbles that can be used to predict recession, along with house prices. There are lags associated with these figures, but they can still be used as leading indicators, if they rise quickly during what appears to be an asset bubble. Appreciation remains the key term here -- when asset values are appreciating too quickly there is risk of recession. The intensity of such a recession may still be dependent on the underlying causes of the bubble and the possible contagions that exist within the economies. Nevertheless, the findings show that where an asset bubble appears, inflation rates are likely to increase and the currency is likely to increase in value -- the latter more quickly than the former. At least in developed countries over the past forty years, these leading indicators do presage a recession.
Inverted Yield Curve
Returning to the issue of interest rates, the market for Treasuries in particular is incredibly liquid. Therefore, market movements in Treasuries are considered to be fairly reliable. One market condition that is often cited as a critical leading indicator of recession is the inverted yield curve. Briefly, this occurs when long-term interest rates are lower than short-term rates. Normally, investors need higher returns on long-term bonds because of the time risk. Thus, an inverted yield curve is a predictor of lower rates in the future than exist today. The way that lower rates will occur in the future than today is if the central bank lowers the rate at some point in the future to head off inflation. This again indicates that when inflation breaks through a certain threshold, the economy is probably heading towards recession. The move by the central bank to lower the rate might head off the impending recession, but it may not. The market, which at this point would be speculating on the future rates in advance of confirmed central bank action, is betting that the rates will fall, not that a recession will occur, but there have been correlations established that show a connection between the two. The connection is not causal, but the inverted yield curve does appear to be a leading indicator of recession.
Chinn and Kucko (2010) note that the predictive power of the inverted yield curve has diminished over time. There is a good explanation for this. The inverted yield curve has become famous as a leading indicator, therefore actions that create the inverted curve may spur a response from the central bank. or, more likely, the presence of an inverted yield curve could spark a reaction from investors. Either way, the inverted yield curve could become more likely to appear as investors respond to changes in the environment more quickly. A sustained inversion of the yield curve thus holds more weight than a temporary inversion.
It is also worth considering a reason why the inverted yield curve would still be powerful. Being that is a rather famous leading indicator for recession, the market should react quickly and powerfully to the emergence of the inverted yield curve, bringing about correction without time lag for example. However, this is not the case, mainly because many investors are caught up in the euphoria of the bubble and will seek to explain away the inversion rather than excepting that interest rates are expected to drop, which itself is an indicator of at least a slower pace of growth (Pasha, 2005).
There are other economic variables that are considered to be leading indicators. Many minor indicators have not proven to be reliable in the way that housing prices, currency exchange rates or inverted yield curves are. These indicators are often grouped into aggregate leading indicators, which make for more reliable measures and better headline numbers. The OECD has its Composite Leading Indicators and in the U.S. The Conference Board has the Composite Index of Leading Indicators. The latter has ten different indicator that have had at least some measurable correlation with the future direction of the economy. These are the average weekly hours worked by manufacturing workers, since factories schedule production in advance of expected demand. Another is the number of initial applications for unemployment insurance, perhaps for the same reason, as is manufacturer's new orders for consumer goods and materials. The speed of delivery of new merchandise to vendors from suppliers is another indicator, as is the amount of new orders for capital goods unrelated to defense. New building permits for residential buildings, the S&P 500, the inflation-adjusted money supply (M2), the yield curve and consumer sentiment are the other components of the Composite Index of Leading Indicators (Investopedia, 2013).
Of these, the S&P Index is quite well-known. Its logic is similar to that of the variables related to manufacturing in that it reflects the sentiment of market participants. Investors in equities -- if we assume rationality -- are investing based on the expected value of future cash flows. A decline in the S&P 500 therefore means that overall investors are expecting fewer such cash flows. The caution here is that these are expectations of unknown future performance. The yield curve and consumer sentiment are similarly based on market expectations. Industry participant indicators are probably stronger, which is why so many are included. The use of the index, however, lends the benefits of diversification to the analysis. Manufacturer orders could vary based on inventory levels, for example, rather than expected production levels -- or production estimates could prove to be well of the actual demand. Thus, diversification produces an composite indicator that is frequently used to gauge the direction of the economy.
There are a number of different leading indicators of economic crisis, but studies have shown a few to be fairly consistently reliable. The inverted yield curve is always popular, though it may be losing its predictive powers, or see the lag between its appearance and the onset of recession shrink as it becomes a self-fulfilling prophecy. Nevertheless, the track record of the inverted yield curve is good, as Treasury investors appear to recognize risks before the broader market does.
There is also strong evidence to support the idea that the housing market is an excellent predictor. While there is the risk of a false positive, a large bubble in the housing market usually serves as a leading indicator. There are two main reasons for this -- one is that it reflects broad-based growth in the economy that runs the risk of becoming overheated. The other is that the typical monetary policy response to this overheating is to raise interest rates, which is precisely the action that will burst a housing bubble entirely. The baskets of leading indicators that exist are also considered reliable. While any one given indicator could be subject to issues, these composite indices benefit from diversification, and adds value to the Composite Index of Leading Indicators as one to watch.
However, the challenge is for policy makers to understand these different indicators and react to their moves in a manner that does not explicitly signal that recession or crisis is imminent. Already, Fed watchers seek guidance in every line of text from the Open Market Committee, seeking to close the information asymmetry that exists between the central bank and the market. Surely any monetary or fiscal policy, especially in reaction to the appearance of key leading indicators of recession, will be met with panic and will only hasten the process of slowdown. Thus, the biggest challenge for policymakers is to understand the leading indicators that are not published, and not understood as leading indicators. Alternately, government can only set in motion methods of lessening the damage from the slump, rather than trying to pre-emptively battle against the appearance of recession. After all, it is not…