Monday, 4 May 2015

2015-028: Credit-Market Sentiment and the Business Cycle

Otmane El Rhazi, David Lopez-Salido, Jeremy C. Stein, and Egon Zakrajsek. Using U.S. data from 1929 to 2013, we show that elevated credit-market sentiment in year t-2 is associated with a decline in economic activity in years t through t+2. Underlying this result is the existence of predictable mean reversion in credit-market conditions. That is, when our sentiment proxies indicate that credit risk is aggressively priced, this tends to be followed by a subsequent widening of credit spreads, and the timing of this widening is, in turn, closely tied to the onset of a contraction in economic activity. Exploring the mechanism, we find that buoyant credit-market sentiment in year t-2 also forecasts a change in the composition of external finance: net debt issuance falls in year t, while net equity issuance increases, patterns consistent with the reversal in credit-market conditions leading to an inward shift in credit supply. Unlike much of the current literature on the ro le of financial frictions in macroeconomics, this paper suggests that time-variation in expected returns to credit market investors can be an important driver of economic fluctuations. Full Text

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