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Do last week’s economic releases support the Fed’s tapering stance?

Part 7
Do last week’s economic releases support the Fed’s tapering stance? (Part 7 of 10)

The Leading Economic Index: Consumption is the key to recovery

The Leading Economic Index

As mentioned in the previous section, the Conference Board releases three composite economic indices, based on leading, lagging, and coincident economic indicators. All three indices recorded increases in February, with the Leading Economic Index (or LEI) increasing the most. The LEI increased 0.5% in February to 99.8, compared to an increase of 0.1% in January.

Part 7Enlarge Graph

This increase implies economic activity will accelerate over the coming months and almost all sectors of the economy should benefit.

According to a Conference Board Economist, Ataman Ozyildirim, “The U.S. LEI increased sharply in February, suggesting that any weather-related volatility will be short lived and the economy should continue to improve into the second half of the year. The strengths and weaknesses in the LEI were balanced in February, with large increases in housing permits and the interest rate spread more than offsetting decreases in the workweek in manufacturing, consumer expectations and rising initial claims for unemployment insurance.”

The interest rate spread between the ten-year Treasury bonds and the federal funds rate is one of the ten leading indicators used to determine the LEI. With the Fed funds rate at 0-0.25% level since December, 2008, an increase in the spread would imply that the ten-year Treasury note rate has increased. Keeping the supply of money constant, interest rates would increase if the demand for money is expected to increase. Demand for money would increase if the economic growth is expected to accelerate and firms borrow funds to increase investments in order to capitalize on the boom.

An increase in Treasury rates would decrease bond prices. Some of the ETFs investing in Treasuries include the iShares 7-10 Year Treasury Bond ETF (IEF), the iShares 20+ Year Treasury Bond ETF (TLT), and the iShares 1-3 Year Treasury Bond ETF (SHY).

The increase in housing permits should benefit companies in the housing sector. The State Street SPDR Homebuilders ETF (XHB) tracks the performance of the S&P Homebuilders Select Industry Index. The Index is an equal-weighted market cap index and part of the S&P Total Markets Index, representing homebuilding as the sub-industry category. Top ten holdings in XHB include high-end, home-builder Lennar (LEN) with 3.53% of assets. For its fiscal first quarter ended February 2014, Lennar (LEN) reported better than expected Earnings Per Share (or EPS) of 35 cents, beating consensus estimates by 7 cents and up from 26 cents reported in the comparable quarter last year.

However, the increase in the LEI should be taken with several caveats. According to another Conference Board Economist, Ken Goldstein, “While the CEI shows the pace of economic activity remained slow at the start of 2014, the trend in the LEI remains quite positive. The biggest challenge continues to be weak consumer demand, pinned down by weak wage growth. These conditions were still in evidence the first two months of the year, but will likely improve as spring arrives.”

Growth in consumer demand, in turn, will depend on employment and increases in real wage levels. To find out whether existing home sales contributed to the housing sector boom, move on to Part 8.

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