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Are Credit Spreads Pricing Recession?
Credit spreads in Europe and the US have
widened sharply over the past several months.
The sell-off has been most pronounced in
Europe, especially in financials, where
corporate spread levels have more than
doubled since May. Many credit indices are
indicating spread levels that have historically
been seen only in recession.
In this Global Economics Weekly, we solve for
the economic growth outlook implied by the
current level of credit spreads. We conclude
that credit spreads are signalling growth that is
weaker than we have thus far seen in the data.
That said, looking forward, the range of
implied growth rates is broadly consistent with
our economic forecast over the next few
quarters, although more so in Europe than in
the US.
In our view, credit markets are probably no
better as a predictor of future economic
activity than any other market (and in many
respects may be worse). Our reading of the
historical evidence suggests that credit spreads
are more forward-looking when the economic
shock originates in the banking/financial
sector. Otherwise, spreads tend to look
backwards, widening out only when defaults
are imminent (which is often too late). This is
consistent with conventional wisdom on
behaviour of credit ratings, too.
We admit important exceptions to this view,
however. Credit spreads, especially on
financials, ought to be more sensitive to
systemic shocks than to garden variety
recession shocks; they have therefore been
closer to the epicentre of the current crisis than
competing indicators. Given the origins of the
current crisis, it merits paying close attention
to what the credit markets are trying to tell us
about the risks to growth.
Are Credit Spreads Pricing Recession?
Credit Spreads Signal More Trouble Ahead
Credit spreads in Europe and the US have widened
sharply over the past several months. The sell-off has
been most pronounced in Europe, and especially in
financials, where corporate spread levels have more than
doubled since May. The correlation between European
and US financials has been high (as usual), with the
iBoxx USD index of bank spreads widening by roughly
2.5x for senior 5-year bonds, vs. the iBoxx EUR broad
financials index which has widened by 2.4x. The sell-off
has been only somewhat less pronounced for US
nonfinancials, where BBB and HY spreads have widened
by 1.7x and 1.8x, respectively.
Many credit indices are indicating spread levels that have
historically been seen only in recession. Table 1 provides
some perspective by showing where current spreads are
trading as a ratio to peak spread levels in past recessions.
Consistent with the extraordinary levels to which the
European sovereign crisis has escalated, the iTraxx CDS
index for subordinated 5-year financials, for example, is
trading at 1.18x its levels at the peak of the 2008 crisis,
and the analogous index for senior debt is trading at
1.13x.
Of course, benchmarking to the 2008 crisis as shown in
Table 1 is setting the bar high. Compared with the 2001
and 1991 recessions, credit spreads look a lot wider. For
example, an index of USD 5-7yr financial spreads (based
on the iBoxx since 1999, and extended back to 1989
using our internal data) is still just 0.58x its peak 2008
levels, but it is at 1.41x and 1.66x its peak levels reached
in the 1990 and 2001 recession, respectively. Similarly
for Europe, the cash market is currently at just 0.65x its
2008 peak, but is at 4.49x its peak in the 2001 recession.
By these benchmarks, the warning lights on the economy
dashboard are flashing, especially in Europe.
Prompted by the above heuristics, this Global Economics
Weekly solves for the economic growth outlook implied
by the current level of credit spreads. We conclude that
credit spreads are signalling growth that is weaker than
we have thus far seen in the data. That said, looking
forward, the range of implied growth rates is broadly
consistent with our economic forecast over the next few
quarters.
Reverse Engineering Credit Spreads
Econometricians these days have access to a
sophisticated toolkit of models and computational
techniques that can be deployed to explore statistical
relationships in complex data sets. But to understand the
behaviour of credit spreads over the business cycle,
there’s no getting around the shortcomings of the data.
The modern US high yield market, for example, is no
more than 25 years old.
The missing values in Table 1 for most of the 1990 and
2001 entries convey the scope of the problem: most
macro indices of credit spreads are exceedingly short.
With a fair bit of work, we are able to extend some of
these indices back to 1989. A few more start in the late
1990s, and the CDX and iTraxx CDS indices have less
than 10 years’ worth of history. But for the most part, its
thin gruel for macroeconomists.
The sole exceptions to this are the two yield indices on
Moody’s Aaa and Baa bonds published in the Federal
Reserve Board’s H.15 release. At a monthly frequency,
these series extend all the way back to the 1920s. But
these indices have two significant shortcomings:
For one, the structure and composition of the
corporate bond market has changed significantly
over the years. The early market was dominated by
railroads, industrials, and utilities which tended to
issue bonds with significantly longer maturities than
are common today (and, to this day, it remains an
index of long-maturity bonds which aims to include
30-year maturities; bonds are dropped when their
remaining life falls below 15 years). A Baa-rated
issuer issuing 30-year bonds is generally going to be a
much different issuer (generally of much higher credit
quality) than a Baa-rated company that has trouble
issuing maturities beyond five years. Financials, for
example, tend to be under-represented at long
maturities.
A second shortcoming of the Moody’s Aaa and Baa
indices is the distinctly different investor base. The
long end of the market is segmented to a degree from
the front end and therefore has its own set of supply
and demand technicals. A rough empirical assessment
of the consequences of these differences in sectoral
composition, maturity and market technicals can be
quantified by using the iBoxx investment grade history
since 1999. Regressing monthly changes in the broad
15-yr+ index on, say, monthly changes in the 5-7yr
bucket yields a coefficient of 0.60 with an R-squared
of 74%. So there is non-trivial ‘slippage’ associated
with the use of long maturities as a proxy for the frontend
of the market. This is especially true around
recessions when the error term from this regression
tends to be larger.
That said, there is no getting around the fact that most
widely used credit indices span three recessions at most,
and usually fewer. Hence, we rely on both long and short
series for the analysis below. We use the longer time
series to establish some basic facts about business cycle
properties of credit spreads, and then use the shorter but
more granular series to extract growth views from
different parts of the credit market.
Chart 1 plots the history of Moody’s spreads back to
1953, annotated with shaded recession bars. We construct
a measure of credit spreads based on the spreads of the
Moody’s Baa index to the 20-year constant maturity yield
on Treasuries (both as reported by the Fed’s H.15
release). A few basic facts are immediately visible. First,
in each of the past 10 US recessions, Baa spreads
generally (though not always) tend to widen gradually for
several years before the recession, and tend to peak
towards the end of the recession (but again, not always).
This ‘typical’ recession pattern is especially visible
during the recessions of 1957, 1970 and 1981.
In other recessions, the pattern is much murkier. In the
2001 recession, for example, spreads began to widen over
1998 before reaching a plateau in late 1999 (Chart 1).
These levels persisted throughout the recession in 2001
and didn’t peak until 11 months after the recession had
ended. The recessions of 1973 and 2008 are different,
too, since spread levels gave almost no advance warning
before the onset of recession. Indeed, in the case of the
1973 recession, spreads didn’t begin to widen until the
economy was six months into the recession (by which
point stock prices had already fallen by more than a
third). In the case of the 2008 recession, spreads gave
more advance notice and were already materially wider
by the time the recession started, but to only a quarter of
their eventual peaks.
Table 2 provides a summary of these patterns, quantified
in terms of the lead-lag relationship between the peaks in
credit spreads and the beginnings and endings of
recessions. The first column shows that credit spreads
tend to peak, on average, around nine months into the
recession. The second column shows that the peak in
credit spreads more closely coincides with the recession
trough than with its peak. The spread peaks in 1970,
1973, 1980 and 1981 all fell within one month of the
recession trough, and the 1990 fell within 3 months. The
two most recent recessions are among the few notable
exceptions to this pattern. In 2001, spreads didn’t peak
until 11 months after the recession was over. And in
2008—a relatively long recession, it should be noted—
spreads began to rally six months before the economy
had bottomed.
Table 2 shows that on average, credit spreads tend to
peak just before the troughs of recessions. This pattern is
consistent with the view that spreads tend to widen as
data suggest activity is deteriorating, and then tighten as
“green shoots” appear (see also: “When markets turn,”
Global Economics Weekly, Jan. 14, 2009 ). We conclude
that treating credit spreads as a coincident indicator of
economic activity, as we do below, is reasonable.
For more granular analysis—e.g., looking at the signal
across regions, or across financials vs non-financials—
there is no alternative but to rely on the shorter histories.
To infer ‘spread implied’ growth rates from shorter, more
granular time series, we run simple, univariate
regressions of GDP on spreads with a lag length of zero.
We experimented with less parsimonious regressions, but
the effective size of the dataset is essentially just three
data points (that is just three recessions). To attempt more
seemed to risk over-fitting. We also experimented with
lag lengths, but here, too, we worried about over-fitting.
Given our desire to calculate ‘spread implied’ levels to
current activity rather than forecast future activity, it
seemed natural to assume a perfectly coincident
relationship between credit spreads and economic
activity—an assumption supported by the results
summarised in Table 2.
Credit-Implied Growth More in Line with Our View
On Europe than on the US
Our measure of economic activity varies by region. For
the US, we explored several alternatives for measuring
activity (e.g., employment growth, GDP growth,
industrial production, activity indices, etc.), but settled on
monthly employment growth as the best measure. For
Europe, we settled on the EuroCOIN measure of monthly
activity.
The results for the US are shown in Chart 2, 3 and 4, and
can be summarised as follows:
Nonfinancial BBB credit spreads are signalling
roughly zero employment growth (Chart 2). To be
exact, credit spreads are pricing a loss of 20,000 jobs
per month, vs. the actual growth of 103,000 jobs
reported for September. To derive this estimate from
Chart 2, start from the current data point, indicated by
the diamond, draw a vertical line down the regression
line, then read the jobs number off the left axis.
High-yield credit spreads are pricing a similarly
anaemic but slightly more bearish outlook, implying a
loss of roughly 90,000 jobs per month (Chart 3).
Financial credit spreads are pricing the most
troubling outlook. Benchmarking US job growth
against 5-year bank spreads suggests that employment
should be falling at a pace of roughly 330,000 jobs per
month. This is approximately the magnitude of the
monthly job loss associated with the worst months of
the 1990 and 2001 recessions—not just slow growth,
in other words, but a true recession scenario (Chart 4).
The results for the Euro-zone appear in Chart 5 and 6 on
the next page, and can be summarised as follows:
Nonfinancial credit spreads are signalling a mild
recession of roughly -0.20% real GDP growth (Chart
5). This is more bearish than our forecasts of 0.20%,
-0.10% and -0.10% over the next three quarters, but
not by much. To a first approximation, our forecast for
European GDP appears to fall well within a standard
deviation of the spread-implied view.
Financial credit spreads are pricing a mild recession
of -0.35% real GDP growth, which is very close to the
growth rate implied above by nonfinancial spreads
(Chart 6). This similarly is notable only because the
results for the US differed so much. This contrast
reflects the fact that nonfinancial spreads in Europe
have widened sharply and in synch with financials,
whereas in the US, nonfinancials have shown more
resistance to the events in Europe.
Do these results imply credit risk is attractively priced?
Not in our view, or at least not yet. To us, these patterns
all make sense, and they are broadly consistent with our
economic forecasts, although more so for Europe than the
US. For Europe, we currently think a recession in Europe
is more likely than not over the next two quarters, while
in the US we see ‘only’ a 40% probability of recession.
What is clear to us is that growth is going to slow
considerably in both regions with risks skewed to the
downside (especially in Europe).
That said, and in contrast to Europe, spread levels in the
US are clearly signalling weaker economic activity than
we currently see or expect. We would normally conclude
from this that corporate bonds are attractively valued—
especially for nonfinancial companies, where we have
argued that credit quality is near 25-year highs.
Moreover, we would be much more constructive on
current valuations if it weren’t for Europe (see The Credit
Line: Bearish on spreads, bullish on fundamentals,
September 16, 2011).
But bottom-up credit quality is no match for the topdown
pressure on the pricing of credit risk that we think
is likely to continue as a result of concerns over the
adequacy of the policy response to the European
sovereign crisis. Until we see more concrete evidence of
a significantly more robust policy response (bank recaps
would check one important box for us), we think credit
spreads, especially in financials, will remain high and
volatile.
Credit Spreads Are Better At Sniffing Out Systemic
Shocks
In our view, credit markets are probably no better as a
predictor of future economic activity than any other
market (and in many respects may be worse). Our
reading of the historical evidence has always been that
credit spreads are more backward-looking than forwardlooking.
Widening out only when recession and hence
higher defaults are imminent. This is consistent with
conventional wisdom on credit ratings, as well as the
early 1990s fashion for using the equity-Merton model as
a leading indicator for credit spreads (a fashion that
reflected a view—since altered by the arrival of CDS
markets—that equity prices were more informed about
company fundamentals than bond markets).
There is one important exception to this view, however:
Credit spreads, especially on financials, ought to be more
sensitive to systemic shocks than to garden variety
recession shocks. For this reason, they have been closer
to the epicentre of the current crisis than competing
indicators. When the primary risk to the macro economy
is located in the financial sector, it is important to pay
careful attention to what the credit markets are trying to
say about the severity of the risk to growth.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
Are Credit Spreads Pricing Recession?
Credit spreads in Europe and the US have
widened sharply over the past several months.
The sell-off has been most pronounced in
Europe, especially in financials, where
corporate spread levels have more than
doubled since May. Many credit indices are
indicating spread levels that have historically
been seen only in recession.
In this Global Economics Weekly, we solve for
the economic growth outlook implied by the
current level of credit spreads. We conclude
that credit spreads are signalling growth that is
weaker than we have thus far seen in the data.
That said, looking forward, the range of
implied growth rates is broadly consistent with
our economic forecast over the next few
quarters, although more so in Europe than in
the US.
In our view, credit markets are probably no
better as a predictor of future economic
activity than any other market (and in many
respects may be worse). Our reading of the
historical evidence suggests that credit spreads
are more forward-looking when the economic
shock originates in the banking/financial
sector. Otherwise, spreads tend to look
backwards, widening out only when defaults
are imminent (which is often too late). This is
consistent with conventional wisdom on
behaviour of credit ratings, too.
We admit important exceptions to this view,
however. Credit spreads, especially on
financials, ought to be more sensitive to
systemic shocks than to garden variety
recession shocks; they have therefore been
closer to the epicentre of the current crisis than
competing indicators. Given the origins of the
current crisis, it merits paying close attention
to what the credit markets are trying to tell us
about the risks to growth.
Are Credit Spreads Pricing Recession?
Credit Spreads Signal More Trouble Ahead
Credit spreads in Europe and the US have widened
sharply over the past several months. The sell-off has
been most pronounced in Europe, and especially in
financials, where corporate spread levels have more than
doubled since May. The correlation between European
and US financials has been high (as usual), with the
iBoxx USD index of bank spreads widening by roughly
2.5x for senior 5-year bonds, vs. the iBoxx EUR broad
financials index which has widened by 2.4x. The sell-off
has been only somewhat less pronounced for US
nonfinancials, where BBB and HY spreads have widened
by 1.7x and 1.8x, respectively.
Many credit indices are indicating spread levels that have
historically been seen only in recession. Table 1 provides
some perspective by showing where current spreads are
trading as a ratio to peak spread levels in past recessions.
Consistent with the extraordinary levels to which the
European sovereign crisis has escalated, the iTraxx CDS
index for subordinated 5-year financials, for example, is
trading at 1.18x its levels at the peak of the 2008 crisis,
and the analogous index for senior debt is trading at
1.13x.
Of course, benchmarking to the 2008 crisis as shown in
Table 1 is setting the bar high. Compared with the 2001
and 1991 recessions, credit spreads look a lot wider. For
example, an index of USD 5-7yr financial spreads (based
on the iBoxx since 1999, and extended back to 1989
using our internal data) is still just 0.58x its peak 2008
levels, but it is at 1.41x and 1.66x its peak levels reached
in the 1990 and 2001 recession, respectively. Similarly
for Europe, the cash market is currently at just 0.65x its
2008 peak, but is at 4.49x its peak in the 2001 recession.
By these benchmarks, the warning lights on the economy
dashboard are flashing, especially in Europe.
Prompted by the above heuristics, this Global Economics
Weekly solves for the economic growth outlook implied
by the current level of credit spreads. We conclude that
credit spreads are signalling growth that is weaker than
we have thus far seen in the data. That said, looking
forward, the range of implied growth rates is broadly
consistent with our economic forecast over the next few
quarters.
Reverse Engineering Credit Spreads
Econometricians these days have access to a
sophisticated toolkit of models and computational
techniques that can be deployed to explore statistical
relationships in complex data sets. But to understand the
behaviour of credit spreads over the business cycle,
there’s no getting around the shortcomings of the data.
The modern US high yield market, for example, is no
more than 25 years old.
The missing values in Table 1 for most of the 1990 and
2001 entries convey the scope of the problem: most
macro indices of credit spreads are exceedingly short.
With a fair bit of work, we are able to extend some of
these indices back to 1989. A few more start in the late
1990s, and the CDX and iTraxx CDS indices have less
than 10 years’ worth of history. But for the most part, its
thin gruel for macroeconomists.
The sole exceptions to this are the two yield indices on
Moody’s Aaa and Baa bonds published in the Federal
Reserve Board’s H.15 release. At a monthly frequency,
these series extend all the way back to the 1920s. But
these indices have two significant shortcomings:
For one, the structure and composition of the
corporate bond market has changed significantly
over the years. The early market was dominated by
railroads, industrials, and utilities which tended to
issue bonds with significantly longer maturities than
are common today (and, to this day, it remains an
index of long-maturity bonds which aims to include
30-year maturities; bonds are dropped when their
remaining life falls below 15 years). A Baa-rated
issuer issuing 30-year bonds is generally going to be a
much different issuer (generally of much higher credit
quality) than a Baa-rated company that has trouble
issuing maturities beyond five years. Financials, for
example, tend to be under-represented at long
maturities.
A second shortcoming of the Moody’s Aaa and Baa
indices is the distinctly different investor base. The
long end of the market is segmented to a degree from
the front end and therefore has its own set of supply
and demand technicals. A rough empirical assessment
of the consequences of these differences in sectoral
composition, maturity and market technicals can be
quantified by using the iBoxx investment grade history
since 1999. Regressing monthly changes in the broad
15-yr+ index on, say, monthly changes in the 5-7yr
bucket yields a coefficient of 0.60 with an R-squared
of 74%. So there is non-trivial ‘slippage’ associated
with the use of long maturities as a proxy for the frontend
of the market. This is especially true around
recessions when the error term from this regression
tends to be larger.
That said, there is no getting around the fact that most
widely used credit indices span three recessions at most,
and usually fewer. Hence, we rely on both long and short
series for the analysis below. We use the longer time
series to establish some basic facts about business cycle
properties of credit spreads, and then use the shorter but
more granular series to extract growth views from
different parts of the credit market.
Chart 1 plots the history of Moody’s spreads back to
1953, annotated with shaded recession bars. We construct
a measure of credit spreads based on the spreads of the
Moody’s Baa index to the 20-year constant maturity yield
on Treasuries (both as reported by the Fed’s H.15
release). A few basic facts are immediately visible. First,
in each of the past 10 US recessions, Baa spreads
generally (though not always) tend to widen gradually for
several years before the recession, and tend to peak
towards the end of the recession (but again, not always).
This ‘typical’ recession pattern is especially visible
during the recessions of 1957, 1970 and 1981.
In other recessions, the pattern is much murkier. In the
2001 recession, for example, spreads began to widen over
1998 before reaching a plateau in late 1999 (Chart 1).
These levels persisted throughout the recession in 2001
and didn’t peak until 11 months after the recession had
ended. The recessions of 1973 and 2008 are different,
too, since spread levels gave almost no advance warning
before the onset of recession. Indeed, in the case of the
1973 recession, spreads didn’t begin to widen until the
economy was six months into the recession (by which
point stock prices had already fallen by more than a
third). In the case of the 2008 recession, spreads gave
more advance notice and were already materially wider
by the time the recession started, but to only a quarter of
their eventual peaks.
Table 2 provides a summary of these patterns, quantified
in terms of the lead-lag relationship between the peaks in
credit spreads and the beginnings and endings of
recessions. The first column shows that credit spreads
tend to peak, on average, around nine months into the
recession. The second column shows that the peak in
credit spreads more closely coincides with the recession
trough than with its peak. The spread peaks in 1970,
1973, 1980 and 1981 all fell within one month of the
recession trough, and the 1990 fell within 3 months. The
two most recent recessions are among the few notable
exceptions to this pattern. In 2001, spreads didn’t peak
until 11 months after the recession was over. And in
2008—a relatively long recession, it should be noted—
spreads began to rally six months before the economy
had bottomed.
Table 2 shows that on average, credit spreads tend to
peak just before the troughs of recessions. This pattern is
consistent with the view that spreads tend to widen as
data suggest activity is deteriorating, and then tighten as
“green shoots” appear (see also: “When markets turn,”
Global Economics Weekly, Jan. 14, 2009 ). We conclude
that treating credit spreads as a coincident indicator of
economic activity, as we do below, is reasonable.
For more granular analysis—e.g., looking at the signal
across regions, or across financials vs non-financials—
there is no alternative but to rely on the shorter histories.
To infer ‘spread implied’ growth rates from shorter, more
granular time series, we run simple, univariate
regressions of GDP on spreads with a lag length of zero.
We experimented with less parsimonious regressions, but
the effective size of the dataset is essentially just three
data points (that is just three recessions). To attempt more
seemed to risk over-fitting. We also experimented with
lag lengths, but here, too, we worried about over-fitting.
Given our desire to calculate ‘spread implied’ levels to
current activity rather than forecast future activity, it
seemed natural to assume a perfectly coincident
relationship between credit spreads and economic
activity—an assumption supported by the results
summarised in Table 2.
Credit-Implied Growth More in Line with Our View
On Europe than on the US
Our measure of economic activity varies by region. For
the US, we explored several alternatives for measuring
activity (e.g., employment growth, GDP growth,
industrial production, activity indices, etc.), but settled on
monthly employment growth as the best measure. For
Europe, we settled on the EuroCOIN measure of monthly
activity.
The results for the US are shown in Chart 2, 3 and 4, and
can be summarised as follows:
Nonfinancial BBB credit spreads are signalling
roughly zero employment growth (Chart 2). To be
exact, credit spreads are pricing a loss of 20,000 jobs
per month, vs. the actual growth of 103,000 jobs
reported for September. To derive this estimate from
Chart 2, start from the current data point, indicated by
the diamond, draw a vertical line down the regression
line, then read the jobs number off the left axis.
High-yield credit spreads are pricing a similarly
anaemic but slightly more bearish outlook, implying a
loss of roughly 90,000 jobs per month (Chart 3).
Financial credit spreads are pricing the most
troubling outlook. Benchmarking US job growth
against 5-year bank spreads suggests that employment
should be falling at a pace of roughly 330,000 jobs per
month. This is approximately the magnitude of the
monthly job loss associated with the worst months of
the 1990 and 2001 recessions—not just slow growth,
in other words, but a true recession scenario (Chart 4).
The results for the Euro-zone appear in Chart 5 and 6 on
the next page, and can be summarised as follows:
Nonfinancial credit spreads are signalling a mild
recession of roughly -0.20% real GDP growth (Chart
5). This is more bearish than our forecasts of 0.20%,
-0.10% and -0.10% over the next three quarters, but
not by much. To a first approximation, our forecast for
European GDP appears to fall well within a standard
deviation of the spread-implied view.
Financial credit spreads are pricing a mild recession
of -0.35% real GDP growth, which is very close to the
growth rate implied above by nonfinancial spreads
(Chart 6). This similarly is notable only because the
results for the US differed so much. This contrast
reflects the fact that nonfinancial spreads in Europe
have widened sharply and in synch with financials,
whereas in the US, nonfinancials have shown more
resistance to the events in Europe.
Do these results imply credit risk is attractively priced?
Not in our view, or at least not yet. To us, these patterns
all make sense, and they are broadly consistent with our
economic forecasts, although more so for Europe than the
US. For Europe, we currently think a recession in Europe
is more likely than not over the next two quarters, while
in the US we see ‘only’ a 40% probability of recession.
What is clear to us is that growth is going to slow
considerably in both regions with risks skewed to the
downside (especially in Europe).
That said, and in contrast to Europe, spread levels in the
US are clearly signalling weaker economic activity than
we currently see or expect. We would normally conclude
from this that corporate bonds are attractively valued—
especially for nonfinancial companies, where we have
argued that credit quality is near 25-year highs.
Moreover, we would be much more constructive on
current valuations if it weren’t for Europe (see The Credit
Line: Bearish on spreads, bullish on fundamentals,
September 16, 2011).
But bottom-up credit quality is no match for the topdown
pressure on the pricing of credit risk that we think
is likely to continue as a result of concerns over the
adequacy of the policy response to the European
sovereign crisis. Until we see more concrete evidence of
a significantly more robust policy response (bank recaps
would check one important box for us), we think credit
spreads, especially in financials, will remain high and
volatile.
Credit Spreads Are Better At Sniffing Out Systemic
Shocks
In our view, credit markets are probably no better as a
predictor of future economic activity than any other
market (and in many respects may be worse). Our
reading of the historical evidence has always been that
credit spreads are more backward-looking than forwardlooking.
Widening out only when recession and hence
higher defaults are imminent. This is consistent with
conventional wisdom on credit ratings, as well as the
early 1990s fashion for using the equity-Merton model as
a leading indicator for credit spreads (a fashion that
reflected a view—since altered by the arrival of CDS
markets—that equity prices were more informed about
company fundamentals than bond markets).
There is one important exception to this view, however:
Credit spreads, especially on financials, ought to be more
sensitive to systemic shocks than to garden variety
recession shocks. For this reason, they have been closer
to the epicentre of the current crisis than competing
indicators. When the primary risk to the macro economy
is located in the financial sector, it is important to pay
careful attention to what the credit markets are trying to
say about the severity of the risk to growth.
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