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Credit-Market Sentiment and the Business Cycle

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Credit-Market Sentiment and the Business Cycle

Federal Reserve Board,

5 min read
5 take-aways
Audio & text

What's inside?

If you want a crystal ball on the economy, look no further than to the clairvoyant credit market.

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Editorial Rating

7

Qualities

  • Analytical
  • Innovative
  • Visionary

Recommendation

Stock markets might be notoriously unreliable predictors of economic activity, but credit markets seem quite accurate at forecasting the future. Economists David Lopez-Salido, Jeremy C. Stein and Egon Zakrajsek analyzed decades of American market data and found that if spreads are low and junk bonds are popular today, you can expect a downturn in two years. Exactly why this occurs is open to debate, the authors admit, but it’s a tidbit of intelligence that savvy investors might want to take under advisement. One caveat: With a few exceptions, this report’s turgid prose will be tough sledding for readers who don’t possess advanced training in economics. Nonetheless, getAbstract recommends it to investors and policy makers for its insight into credit markets and the economy.

Summary

If you want to know where the economy will head in two years, take a look at credit markets. According to an analysis of America’s financial markets, loose credit today is a strong predictor of tight credit in two years’ time. From 1929 to 2013, periods of optimistic lending climates led to worsening conditions two years hence. Narrow spreads for corporate bonds and a high share of high-yield, or junk, bonds characterize “frothy” credit. Slowing economic output, weaker business investment and falling employment follow this condition. While credit market sentiment provides accurate forecasts...

About the Authors

David Lopez-Salido and Egon Zakrajsek are economists at the Federal Reserve. Jeremy C. Stein is an economics professor at Harvard University.

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