Recent US economic weakness was predicted by a significant slowdown in real narrow money in late 2011 / early 2012 – see March post. Some series have been notably soft – gross domestic income (an alternative GDP gauge) rose by only 0.1% in the second quarter, the household survey jobs measure has been stagnant since early 2012, non-defence capital goods orders fell sharply in June and July, while industrial output tumbled 1.2% in August (of which 0.3% is attributed to the impact of Hurricane Isaac).

Such news has given fresh hope to stale bears such as the Economic Cycle Research Institute (ECRI), which claims that further weakness in upcoming reports together with downward revisions to earlier data will cause the National Bureau of Economic Research (NBER) cycle-dating committee to pronounce that a recession began around mid-year. (This would, however, invalidate ECRI’s September 2011 call that a recession was then imminent.)

While not impossible, such a development is judged here to be unlikely. Real narrow money slowed but never contracted, as it did before 10 of the 11 NBER-defined recessions since World War 2 – see previous post. Its six-month growth rate, moreover, bottomed in May and moved up over June-August – see first chart. Allowing for the normal half-year lead, this suggests that industrial output momentum will trough in November and recover into 2013.

Such a scenario would imply an upturn in the key ISM manufacturing new orders index from a bottom reached over August-October. An improvement is suggested by a sharp recovery in equity analysts’ earnings revisions in September: the “revisions ratio”, i.e. net forecast upgrades as a proportion of the number of earnings estimates, correlates with ISM new orders – second chart.

With real money growth already reviving, last week’s launch of QE3 was unjustified on monetary / economic grounds – except perhaps as a pre-emptive strike against the (unlikely) scenario that Congress fails to mitigate planned fiscal tightening after the November elections. It may even prove counterproductive – additional liquidity may boost commodity prices and inflation, thereby neutralising or outweighing the real impact of any further pick-up in nominal money expansion resulting from the action.

Recent strength in US – and global – stock prices can be partly attributed to investors correctly anticipating last week’s Fed decision to restart QE (i.e. balance sheet expansion financed by reserves creation, as opposed to duration extension of the existing balance sheet under “operation twist”). A key issue, therefore, is the extent to which the “good news” has already been discounted.

US stocks have loosely correlated with the monetary base – now dominated by bank reserves – since the Fed launched QE1 in late 2008. The chart compares the Dow Industrials index with the level implied by contemporaneous bank reserves, based on a simple regression run on data since the start of 2009. The regression “predicts” that a $100 billion injection of reserves is associated with a 440 point rise in the Dow. Yesterday’s Dow close of 13,553 was 1,300 points above the level implied by the regression, based on average bank reserves in the week to last Wednesday. This suggests that the market is discounting an increase in reserves of $292 billion as a result of QE3 (i.e. 1,300 divided by 440/100).

The Fed last week committed to buying $40 billion per month of agency mortgage-backed securities until the labour market improves “substantially” while promising further action if this objective is not achieved. Assuming that purchases are fully financed by reserves creation, a $40 billion per month pace of buying would take more than seven months to achieve the $292 billion reserves boost suggested by the current level of the Dow, based on the regression.

On this simplistic analysis, therefore, investors betting on further significant Dow strength may be implicitly assuming that either the Fed will accelerate its bond-buying in late 2012 / early 2013 or continue the $40 billion per month pace beyond next spring.

Good news: the combined trade balance of Greece, Ireland, Italy, Portugal and Spain moved further into surplus in July – see first chart.

Bad news: the improvement reflected a further decline in imports, probably related to slumping domestic demand, rather than a pick-up in exports – second chart.

Still, exports have held up despite a global slowdown and domestic credit constraints, while cost competitiveness is improving, promising a future gain in market share at home and abroad.

A proprietary leading indicator of global growth derived from the OECD’s country leading indices rose in July for the first time since January, consistent with the forecast here of a revival in global industrial momentum from the autumn, allowing for an average three-month lead – see first chart.

An accompanying “leading indicator of the leading indicator”, moreover, rose for a third consecutive month, suggesting that the indicator itself will recover further in August and September – second chart. (The “double-lead” indicator is explained in a previous post.) This, in turn, implies that global firming will extend into year-end.

The basis for the forecast was a rise in global real narrow money expansion in June / July from a bottom in April / May – real money leads industrial output by six months and the leading indicator by three months, on average. The real money measure may have fallen back slightly in August, however, based on early data – third chart. So prospects for early 2013 may be clouding.

The suggested August real money slowdown reflects an upturn in inflation due to recent commodity price strength. Growth prospects for 2013 would be best served by monetary policy-makers stepping off the accelerator to cool commodity markets and contain the inflation drag on real money. Such an argument, of course, is dismissed by Dr Bernanke and his Fed acolytes, and the Bank of England’s target-missers.

A 29,000 fall in claimant-count unemployment in July and August – driven by an increase in numbers leaving the register rather than fewer joining – could be earlier-than-expected evidence of the economic pick-up forecast here to occur during the second half, based on solid real money expansion since late 2011.

The chart shows monthly GDP (derived from data on industrial, services and construction output) together with an indicator designed to estimate the GDP trend based on changes in the claimant count. The last GDP data point for June was depressed by the double bank holiday, with early July evidence suggesting a strong rebound. The indicator, meanwhile, has climbed well above its 2011 temporary peak, suggesting that GDP will reach a new recovery high before the end of 2012. This would entail sequential rises averaging at least 0.6% in the third and fourth quarters.

The Bundesbank’s net TARGET  2 claim on the Eurosystem – its enforced lending to central banks in weaker Eurozone states – rose by a further €24 billion in August to a record €751 billion. Most of the cash flowed to Spain and Italy – the TARGET 2 deficits of Banco de Espana and Banca d’Italia climbed €11 billion and €10 billion, to €434 billion and €313 billion respectively.

The further rise in TARGET 2 imbalances is disappointing, since a recent stabilisation of ECB lending to the banking system – via standard monetary policy operations or as “emergency liquidity assistance” – had suggested a slowdown in capital outflows from the periphery.

In Spain’s case, banks borrowed only €2 billion more during August but were forced to run down their holdings of cash with the central bank by €6 billion.

Italian banks appear to have fared better last month – they repaid €3 billion of borrowing while increasing their central bank cash holdings by €4 billion. Banca d’Italia, however, required extra TARGET 2 funds to offset a whopping €15 billion withdrawal from government accounts at the central bank, probably related to market financing difficulties.

The hope – not unrealistic – is that the ECB’s bond-buying plan together with an improving economic outlook based on earlier monetary policy easing will stem and eventually reverse capital flight from the periphery, allowing TARGET 2 imbalances to subside. Such a development is needed to signal that the current market rally is more than another temporary period of calm before another “crisis” event.