Why is the US economy supposed to be weak? Because manufacturing and consumer surveys have been weak for some time. And yet the hard data continue to surprise on the upside. What is going on? I think that at least some of weakness in the manufacturing surveys was the result of supply-chain disruptions after the Japanese quake and fears about the economy arising from the European situation and the debt-ceiling debate, and the weakness in consumer sentiment was also partly the result of the latter two factors. The actual economy was genuinely weakened by special factors in H1, and is now having something of a bounce. Consumers are feeling low partly also because they are being squeezed by higher energy and healthcare costs while also maintaining their spending on other things while income growth is essentiallly zero, and thus bringing down their saving rate.

Leading indicators of manufacturing, particularly new orders for capital goods and average weekly hours, continue to indicate expansion. This reflects the fact that firms are investing, which presumably reflects the fact that the consumer has remained robust for all this time. This is the kind of virtuous cycle that can become self-sustaining, but to do so it will require real income growth in the household sector (the saving rate cannot fall forever). At present, a weak labour market is keeping income growth low, and the fading of the government stimulus package (whose peaks have coincided with stronger consumer spending) means that households are no longer enjoying a boost from that source. So leading indicators of the economy point to continued expansion; consumers are maintaining their spending but their situation is precarious (and they know it, hence the weak sentiment surveys); and if there is no income growth then spending growth cannot continue.

I have done some more work on adjusting the yield curve to account for the fact that it has to slope upwards when short-term rates are at zero. My adjusted curve is either quite shallow or flat, depending on how you do it. But what does an adjusted yield curve tell you? To answer this, one has to answer the question: why is the yield curve a leading indicator of the economy? I have seen it argued that an inverted yield curve makes it harder for banks to make money, so credit becomes less available; but banks generally lend at a spread over their funding cost and are usually happy to extend credit at declining margins at the top of the cycle. Sometimes the yield curve has inverted because long rates have fallen, indicating declining economic expectations, but in every case of inversion it has also been true that short rates have been rising. I think the key point here is that the yield curve inverts when short rates rise above the market’s long-term rate expectation, which indicates that monetary policy is relatively tight. So adjusting the yield curve to get the market’s long-term rate expectation should produce a leading indicator that is as useful in the present environment as the unadjusted yield curve has been in the past. 

The adjusted yield curve indicates that monetary policy is tight. This fits with my fundamental analysis: short-term interests are too high at 0%; the end of QE2 was a monetary tightening; and Operation Twist was also a tightening, not a loosening, of policy.


German ZEW falls again, d.e. EZ ZEW shows the same picture.
EZ flash GDP 0.2% a.e.
EZ trade balance turned positive in September, b.e. Imports and exports both fell, but imports fell further. This is more evidence of Eurozone weakness.
Retail sales 0.5% b.e. Core 0.6% b.e. Oct. Further evidence of the robustness of the US consumer.
PPI -0.3% d.e. Core 0% d.e. Oct. Inflation pressures in the US appear to be abating, as expected.
Empire State rises to 0.6 — still a weak reading.
UK claimant count change 5.3k b.e. Oct
UK unemployment rises to 8.3% in Sep, d.e. Unemployment has spiked up over the past three months.
Eurozone CPI 3% a.e. Core 1.6% a.e. Oct. Europe does not have an inflation problem and it was ridiculous to raise interest rates.

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