Credit-Market Sentiment and the Business Cycle

David López-Salido, Jeremy C. Stein, Egon Zakrajšek

NBER Working Paper No. 21879
Issued in January 2016
NBER Program(s):Asset Pricing, Corporate Finance, Monetary Economics

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 and t + 1. 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 role 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.

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Document Object Identifier (DOI): 10.3386/w21879

Published: David López-Salido & Jeremy C. Stein & Egon Zakrajšek, 2017. "Credit-Market Sentiment and the Business Cycle*," The Quarterly Journal of Economics, vol 132(3), pages 1373-1426.

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