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In some quarters, to even raise the question of whether the economy is getting better is close to heresy. Housing foreclosures are soaring. The financial system is still writing off billions in bad debt. Job losses continue to pile up. Economic growth is slowing sharply overseas. Wages are stagnant. Pessimism is the order of the day.

And yet, there are several important leading indicators that are pointing to a better economy ahead. The amount of commercial paper outstanding is rising, the slope of the yield curve is steepening and energy prices have fallen sharply. All three point to stronger growth.


Don’t Look Back
The current crisis started in the financial sector. More than a year ago, banks started having trouble rolling over their commercial paper. Commercial paper is a reflection of trust in the banking system. Without access to this source of short-term financing, the banks faced a liquidity crisis. From July to December 2007, the volume of commercial paper outstanding shrank by more than $500 billion, forcing the Federal Reserve to step up to its role as the lender of last resort to the banks.

Over the last month, the commercial paper market has come back to life. The amount of commercial paper outstanding has risen by nearly $75 billion. It may be just a blip — we saw a similar false recovery in January — but the rebound does reverse the entire decline that has occurred this year. An improvement in the commercial paper will make it easier for the banks to raise additional capital, which should help lending.

The slope of the U.S. Treasury yield curve has the single best record as a leading economic indicator. The yield curve can be thought of as a proxy for bank margins. When it is small, bank profits suffer. When it is inverted, the banks have no incentive to lend. When the yield curve is steep, as it is now, bank profits improve. Even with all of the billions in write-downs the banks took in the second quarter of this year, they still managed to earn $5 billion in profits in addition to adding $50 billion to their future loan reserve losses.

As banks and credit creation goes, so goes the economy. In the past couple of months, the yield curve for U.S. Treasuries has steepened significantly, which should help bank profitability, reducing some of their need to raise additional capital.

U.S. Treasury Yield Curve - 10 Year Bond Less 3 Month T-Bill Yield; Red areas are recessions.


While an inverted yield curve has preceded every post-WWII recession, a steepening of the yield curve over the past 18 months is very similar to what happens in anticipation of an economic recovery.

Finally, energy prices have come down sharply. After peaking near $150 a barrel, oil prices have fallen more than $30 a barrel, bringing gasoline prices down with them by roughly 40 cents. For every penny decline in the price of gas, households free up roughly $20 million every week in additional purchasing power.

For retailers, the past year has been a difficult one. The industry has been racked by bankruptcy and widespread store closings. Employment in the industry is down, real sales growth has been negative, and profitability has suffered. Expectations for the holiday season are modest at best, grim at worst. And yet, the financial markets are signaling a recovery in our future. It may not happen. This time may really be different. But the historical track record of the yield curve, coupled with the increased purchasing power from lower energy prices, suggests that the worst may actually be behind us.

To comment on this article or pose another topic for this columnist, contact Dr. Carl Steidtmann at csteidtmann@deloitte.com.