Credit Spreads As Predictors of Economic Activity

Last Friday's Wall Street Journal contained an article discussing a predictive tool with which I had been previously unacquainted. The focus of the piece was a paper studying spreads between corporate debt and Treasuries. Essentially, higher corporate debt rates, and a widening spread over Treasuries, signals bad economic times. The key portion of the Journal piece was,

"To compensate for that, economists Simon Gilchrist and Vladimir Yankov at Boston University, and Egon Zakrajsek at the Federal Reserve constructed credit spreads over the 1990-2008 period from monthly price data on the corporate debt of about 900 U.S. nonfinancial companies. They divvied up the bonds based on both expected default rates (a more timely measure of quality than ratings) and time to maturity.

In a forthcoming paper in the Journal of Monetary Economics they show that spreads on low- to medium-risk corporate bonds, particularly those with 15 or more years until maturity, predicted changes in the economy phenomenally well, forecasting the ups and downs in both hiring and production a year before they occurred. Since writing the paper, they extended their analysis back to 1973 and found bonds' predictive ability still held.

It would be better for everyone if it doesn't hold in the future. With the massive widening in corporate-bond spreads last fall, the economists' model predicts industrial production will fall another 17% by the end of the year, and the economy will lose another 7.8 million jobs on top of the 5.1 million it has shed since the recession began."

A very revealing chart that accompanied the article was missing from the WSJ online version of the piece.

Never the less, the implications are sobering. This predictive tool, validated back more than 30 years, suggests that unemployment is not even half of the level at which it may peak, as production falls further this year.

Actually, this fits what my partner and I suspect, given the once-in-a-lifetime massive private credit deleveraging which has occurred in the past two years. While almost no government official mentions that deleveraging, or, when they do, suggest that federal replacement of that credit will "fix" everything, we think that the coming economic conditions forecast by this debt spread model seems accurate.