Credit-Market Sentiment and the Business Cycle

by David Lopez-Salido, Jeremy C. Stein, and Egon Zakrajsek

Executive Summary — Using United States data from 1929 to 2013, Jeremy C. Stein and colleagues emphasize the role of credit-market sentiment as an important driver of the business cycle.

Author 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.

Paper Information

  • Full Working Paper Text
  • Working Paper Publication Date: January 2016
  • HBS Working Paper Number: NBER Working Paper Series, No. 21879
  • Faculty Unit(s): Finance