Deeper into Leading Indicators

The Conference Board’s Leading Economic Index (LEI) continued to rise – the tenth consecutive rise in January 2010. Five of the ten components made positive contributions and on year-on-year basis, it rose from 6.7% in November 2009 to 8.1% in December and to a very healthy 8.7% in January 2010 – is approaching a high level by historical standing.

Having said that I note that six-month percentage change has weakened from 6.2% in December 2009 to 4.8% in January 2010 – what does all of this mean?

While the big economic picture is still looking good, the bounce will probably continue for a least another two quarters, thus supporting a continuation of the medium-term stock market rally. But thereafter the outlook isn’t so bright.

When look deeper into beneath the surface of the Leading Economic Index, the picture is becoming even more ominous, especially the contribution of the positive spread between short-term and long-term interest rates. Without it, the index would have been down 0.1% last month. There is nothing wrong with long-term rate moving higher than short-term rates, but in a post-bubble world, monetary policy has much less traction than under normal conditions. If too much debt and too many bad loans are weighing on the banking sector’s balance sheet, monetary policy becomes a rather toothless tiger.

It is very important to watch the particulars of the LEI. I think the weakening in the six-month rate of the LEI has to be treated as a first warning sign. A warning sign telling us that the economy is not on a durable growth path. A warning sign that the second half of this year may become very disappointing.