Anirvan Banerji
This column was originally published on RealMoney on April 24 at 6:52 a.m. EDT. It's being republished as a bonus for TheStreet.com readers.
Panic has passed and markets have recovered smartly in recent weeks, but recession fears linger in some quarters. With subprime problems and the industrial slowdown widely recognized, growth is now the obvious concern. The economy's current performance is right in line with what I wrote based on the Economic Cycle Research Institute's leading indices in June 2006: that "home prices will keep falling" and "a cyclical slowdown in industrial growth is likely to hit in the coming months." Remember, the dominant concern at the time was inflation, not growth, and the Federal Reserve was still in rate-hiking mode. It was not until early December, with the ISM manufacturing index dropping below 50, that the reality of the industrial slowdown dawned on most economists. Economic indicators that seem to predict the scariest outcomes often attract the attention of pessimists. One such indicator is the Conference Board Index of Leading Economic Indicators, whose growth rate has dropped to its worst reading since the last recession. Some forecasters point to this as a recessionary omen. But the factors behind the drop in LEI growth aren't widely understood. Let's not forget that in 1996, the year after it took over the LEI's computation, the Conference Board altered it to include the yield spread. That was also the year the New York Fed's Arturo Estrella and Frederic Mishkin published a seminal paper relating the inversion of the yield curve to recession probabilities. By spring 2005, thanks in part to a tighter yield spread, the LEI had declined in 10 out of 11 successive months. Typically, such a sequence of back-to-back declines would be followed by a recession. Against that backdrop, in July 2005, the Conference Board then replaced the yield spread with the cumulative yield spread as a component of the LEI. What's that, and why use it in place of the regular yield spread? I don't know the theoretical rationale, but here's an example of how such a cumulative yield spread, or CYS, would work. Suppose that the yield spread is 0.5% in January and that the CYS is also 0.5%. If the yield spread falls to 0.4% in February, the CYS will actually rise to 0.5% plus 0.4%, i.e., 0.9%. So as long as the yield spread stays positive -- even if it continues to tighten -- the cumulative yield spread will keep rising.| Yield Spread Measures |
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| Click here for larger image. |
| Source: Economic Cycle Research Institute |
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