Ebook Credit Spreads and Real Activity
In this paper, I explore the transmission of credit conditions into the real economy. Indeed, disturbances in the financial sector, if allowed to develop fully, could have severe negative consequences for real activity. An implication of this link between credit markets and the economy is that credit spreads i.e., the difference between corporate and Treasury yields should forecast real activity. Establishing the presence of this link though is difficult because credit spreads in turn reflect current and lagged macroeconomic information that can potentially capture predictable components in future real activity.
I use a no arbitrage term structure model that captures the joint dynamics of GDP, inflation, Treasury yields and credit spreads to identify what drives the relationship between credit spreads and the real economy. I show that there is a component of credit spreads orthogonal to macroeconomic information that indeed forecasts future real activity, lending support to the presence of a transmission channel from borrowing conditions to the economy.
Exploring the relationship between credit spreads and future real activity can be motivated by the “financial accelerator” theory developed by Bernanke and Gertler (1989) and Bernanke, Gertler, and Gilchrist (1996, 1999). A key concept in this framework is the “external finance premium,” the difference between the cost of external funds and the opportunity cost of internal funds due to financial market frictions. A rise in this premium makes outside borrowing more costly, reduces the borrower’s spending and production, and consequently hampers aggregate activity.
The external finance premium can fluctuate for many reasons. Changes in the premium could reflect real productivity shocks, monetary policy shocks, or even problems in the financial sector affecting borrowers’ balance sheets. For forecasting future output, however, it is immaterial where a shock to the external finance premium originates. The external finance premium is not directly observable. Credit spreads are a useful proxy although they need not be driven by the exact same factors as the external finance premium itself.
I motivate my approach with a set of empirical results. Using simple OLS regressions of future GDPO growth on credit spreads, I find that credit spreads across the whole term structure and for rating categories ranging from AAA to B have predictive content above and beyond that contained in the the term structure of Treasury yields and the history of GDP growth and inflation.
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