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  • 2016
  • Working Paper

Credit-Market Sentiment and the Business Cycle

By: David Lopez-Salido, Jeremy C. Stein and Egon Zakrajsek
  • Format:Print
  • | Language:English
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Abstract

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.

Keywords

Investment; Credit; Macroeconomics

Citation

Lopez-Salido, David, Jeremy C. Stein, and Egon Zakrajsek. "Credit-Market Sentiment and the Business Cycle." NBER Working Paper Series, No. 21879, January 2016.
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More from the Authors
  • The Fed, the Bond Market, and Gradualism in Monetary Policy By: Jeremy C. Stein and Adi Sunderam
  • Banks as Patient Fixed-Income Investors By: Samuel G. Hanson, Andrei Shleifer, Jeremy C. Stein and Robert W. Vishny
  • A Comparative-Advantage Approach to Government Debt Maturity By: Robin Greenwood, Samuel G. Hanson and Jeremy C. Stein
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