The Business Cycle Works Like a Swiss Clock

Special Edition 02

The economy works like a Swiss clock despite its organic and dynamic nature. It is very logical: if x then y. Yet it’s not always linear. We have created a business cycle gauge to help navigate the speculation and guessing going around.

In this Special Edition, we will break down the macroeconomic leading, coincident, and lagging indicators to understand where we stand and provide an outlook for Q2.

Let’s dig in!

---

For those interested in receiving updates on the developments of the charged macro environment and our proprietary Business Cycle Gauge, please join the waitlist below. 

---

Brushing up on the Business Cycle and our model

The Business Cycle is defined by a series of economic phases ranging from an expansion (peak) to a recession (trough), linked by two intermediary phases: slowdowns and recoveries. Using the abundance of information available today, we can expand this concept beyond GDP and other coincident indicators. We can analyze the leading indicators (LEI) to forecast changes in coincident indicators (CEI); as well as track the changes in lagging indicators (LAI) for confirmations.

The end result is a robust Business Cycle Gauge that removes the guessing element from the economy. We can predict a coming recession and forecast structural changes like declining rates in the coming months. The model behind the gauge has been backtested and has accurately predicted recessions (figure 1).

Business Cycle Gauge Interpretation

• A recession is most likely coming in Q3 - Q4 2023, considering the recession signal triggered by our model.

• Recession signal: leading indicators (LEI) have rolled over - forcefully - and are below the equilibrium line.

Figure 1

Leading Indicators (LEI)

Taking the money stock’s (M2) rate of change (figure 2) as one of the leading indicators, we can observe that something massive is looming. The rate of change has plummeted stronger than anything we have seen in the last 40 years.

Figure 2

Figure 3

It becomes clear that the coincident indicators are to follow suit as reinforced by the deep inverted yield curve (US10Y - Fed Funds Effective Rate). This has served as a key recession signal in the past (figure 3).

Bear in mind that there is a lag between leading and coincident indicators. The inverted yield curve and M2 rate of change are hinting at what’s to come, but it won’t happen immediately. The coincident indicators must cave first, which according to our model are beginning to deteriorate.

Coincident Indicators (CEI)

Take non-farm payrolls (NFP) as an example, they tend to deteriorate before coincident indicators turn negative, triggering a recession. The process tends to take over 12-18 months to develop into a recession, but it’s inevitable as soon as it’s confirmed by the leading indicators. Currently, NFPs suggest that a recession is coming as the job market begins to slow down (figure 4).

Figure 4

Industrial production - another coincident indicator - reinforces our view (figure 5). It plummets during a recession as demand slows. We are closing in on the pivotal point, where the decline in industrial production accelerates (figure 5).

Figure 5

In the same way leading leads coincident, coincident indicators lead the lagging. This is the logic that enables us to forecast declining rates (LAI) in the coming months. The current structure suggests that the lagging indicators’ decline is further out than the coincident.

Lagging Indicators (LAI)

30YR mortgage rates have rallied faster than any time since the late 1970s, but our model suggests that they will revert - LEI rolling over triggering the beginning of the end. This view coincides with a structural setup, where mortgage rates have been shaping up a Declining Expanding Diagonal. The last decline is still pending and momentum is turning negative (figure 6) – which fits perfectly with the strong decline in rates forecasted by the business cycle mode.

Figure 6

The US02Y shows a similar structure for shorter-duration yields. The US02Y is closing in on a major top and the technical setup hints at a coming plunge (figure 7). Similar can be said about the shorter rates. US 2YR is closing in on a major top – and the technical setup tells us they are about to plunge.

Figure 7

Tick-Tock

All in all, we can forecast the development of the economy with our business cycle gauge due to its Swiss clock-like mechanical structure. The recession will very likely come at the end of 2023. Unemployment (LEI) will rise, and industrial production will plunge, dragging rates lower. At this point, the Fed will be forced to pivot.

The move has begun.