Staking claims as a leading indicator
admin | August 23, 2019
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
The inversion of key parts of the yield curve recently has focused financial market participants on possible harbingers of recession. While the curve has an impressive record as a leading indicator of the economy, massive QE purchases in key government bond markets both here and abroad may have distorted long-end yields. Many economists would say that if they could only have one data series as a leading indicator of the business cycle, it would be initial unemployment claims. This gauge has been a timely and accurate precursor in past business cycles and is certainly flashing a far different signal than the yield curve about the current expansion’s staying power.
The case for initial claims as a leading indicator
Labor market data is a good candidate for summarizing the state of the economy as it encompasses all sectors and regions. A firm’s decision to hire and fire also is one of the most fundamental that it makes and usually is well correlated with the state of demand that the firm is seeing. Market participants have been quite focused on manufacturing of late, but this sector accounts for less than 10% of employment. The goods sector, which is somewhat broader than manufacturing, accounts for about 30% of GDP. And there are plenty of examples where the factory sector contracted while the overall economy continued to expand, most recently 2015-16. Financial market indicators are increasingly driven by global forces. So, a labor market measure makes a good target for an indicator to watch. Initial claims are reported weekly and are fairly reliable and seasonally adjusted—there is, of course, noise with any weekly series, but monthly or quarterly averages for claims tend to smooth those out—so they are generally thought of as the timeliest read of labor market conditions.
The 1990-91 recession
I will limit the discussion to the past three recessions, though the claims figures also did a good job of warning about a downturn in prior episodes as well. Initial claims began to inch higher in the first half of 1990, but surged in the second half of the year, reflecting the shock to the economy from the oil spike that accompanied the first Iraq War (Exhibit 1). Interestingly, the first rate cut from the Fed came in July of 1990, just as the economy was beginning to turn down and initial claims were beginning to move decisively higher, but that early move came for other reasons. The primary rationale provided by the Fed at the time for the July 1990 rate cut was a credit crunch. Of course, soon after, the Iraq War spiked oil prices and delivered a blow to consumer confidence, pushing the economy into recession.
Exhibit 1: The 1990-91 recession
The 2001 recession
Those who are too young to have been in the business during the 2001 recession may associate it with the 9/11 terrorist attacks, but in reality the economy turned down early in the year, perhaps driven by the collapse in the NASDAQ stock index in 2000. Initial jobless claims began to move up noticeably in the second half of 2000, while the economy was still growing and well before the Fed’s first rate cut in January 2001 (Exhibit 2).
Exhibit 2: The 2001 recession
The 2007-09 recession
The most recent recession was the worst since the 1930s, earning the moniker the Great Recession. That downturn was driven mostly by financial forces, as the ripple effects of the bursting of the housing bubble in 2006 looked contained for a while but eventually began to broaden and intensify in the summer of 2007 and again in the spring of 2008 before the worst of the Financial Crisis hit in the fall of 2008.
Initial unemployment claims were arguably a little late in signaling economic trouble in 2007, as they held broadly steady until the fourth quarter of the year. However, in fairness, the Fed easing in the fall of 2007 was viewed at the time as pre-emptive and responsive to tighter financial conditions rather than a weakening economy. Indeed, while the Committee was obviously wrong in retrospect, the statement after the October 2007 easing noted that: “Today’s action, combined with the policy action taken in September, should help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and promote moderate growth over time…The Committee judges that, after this action, the upside risks to inflation roughly balance the downside risks to growth.” One might say that the FOMC at that time viewed the first 75 bp of easing in that cycle as a mid-cycle adjustment.
It was only after the December 2007 25 bp cut that the FOMC began to acknowledge some softening in the economy, and only after a massive 75 bp easing in January 2008 that the Fed officially acknowledged a downside tilt to the balance of risks.
While initial claims may have been a little late in signaling an imminent economic downturn, the number of new filers began to back up in October 2007, two months before the official start of the recession (Exhibit 3).
Exhibit 3: The 2007-09 recession
The 1995-96 mid-cycle adjustment
It is also worth looking at what the initial claims data were saying during two other episodes in the 1990s that did not lead to recession. After an intense rate hike cycle in 1994-95, the economy slowed sharply in 1995, and the Fed lowered rates by 75 bp to help stave off a downturn. Initial claims backed up substantially in the first half of 1995 and were already running in the high-300K’s by the time the FOMC began to recalibrate (Exhibit 4). The number of new filers continued to creep higher through the entire period when the Fed was gently lowering rates, and the steep drop in the pace of layoffs in Q2 of 1996 was undoubtedly one signal to policymakers that they had done enough.
That 1995-96 episode stands out as an exemplary result for the Fed. Everything worked out just about perfectly, as the Fed’s aggressive hiking in 1994 staved off inflation, and its modest adjustment in 1995-96 got economic growth back on track and helped to extend the expansion for several more years. Still, while things turned out alright, the pace of initial claims in late 1995/early 1996 was pretty consistent with the levels seen at the beginning of recent recessions, so one might argue that the absence of a mild downturn in the mid-1990s was a narrow escape.
Exhibit 4: The 1995-96 slowdown
The 1998 mini-easing
In 1998, the Fed also eased by 75 bp, but the nature of that episode was different. In 1998, global financial markets came close to melting down, as the 1997 Asian Currency Crisis and the Russian debt default in the summer of 1998 led up to the failure of Long-Term Capital Management and a swoon in equities prices and bond yields in the summer and fall of 1998. The FOMC eased three times in rapid succession.
As it turns out, the economy never slowed down in a noticeable way and the Fed eventually ended up having to take back the easing (and then some) in 1999 and 2000. As Exhibit 5 shows, initial claims never rose significantly in 1998, an accurate signal that the economy would not be damaged by the financial market turmoil.
Exhibit 5: The 1998 mini-easing
The current situation
So, given this history, what are the initial claims data telling us currently? Initial claims have not risen at all, despite widespread fears of an economic downturn (Exhibit 6). In fact, if anything, the number of new filers has been gently falling this year. It is also worth comparing the level of initial jobless claims now with the other periods detailed above. The number of new filers is running close to 100,000 lower than at the beginning of virtually every one of the previous cycles explored.
At this point, at least so far, one could make the case that the current episode most closely resembles the 1998 period. This is my base case scenario at this time. Others might argue instead that what we have seen so far is not all that different from how things were playing out through this point in 2007, with financial market stress providing a leading indicator and economic data not yet fully reflecting the impending restraint. However, at least so far, the two periods do not seem analogous to me, as the Bloomberg Financial Conditions Index dropped from +1 to -3 in a month during August 2007, while at this time the gauge is only about half a point below its recent high.
Exhibit 6: The current episode
As always, only time will tell. However, if initial claims remain an accurate precursor of an economic downturn, then the signal right now would be “so far, so good.”