A Macro Framework of the Credit Cycle
There are typical macro dynamics across the three stages of the credit cycle. We identify key economic variables that we believe are best suited to proxy these relationships. These dynamics are summarized in the chart below.
The credit cycle originates from monetary policy. When the economy is coming out of a recession, accommodative monetary conditions incentivize bank lending and credit creation. As a proxy of monetary policy stance, the slope of the yield curve provides direct information on current financing conditions and profit margins available to banks, with a steeper (flatter) term structure indicative of easier (tighter) policy. As a result, the yield curve is one of the most reliable leading indicators of the credit and business cycle, with long lead times due to the lagged effects of monetary policy on the economy. At the beginning of the cycle, credit creation leads to a compression in credit spreads and improving economic activity.1
As the economy enters an expansionary phase, corporate borrowing continues to grow, financing investments and employment growth. Over time, this gradual process of debt accumulation leads to rising levels of leverage in the system, while monetary policy begins to tighten in response to stronger labor markets and rising inflationary pressures. This gradual and steady tightening process feeds into the real economy over the course of several years until a flatter yield curve no longer encourages bank lending. As the credit impulse decelerates, economic growth slows.2 At this point, higher leverage ratios expose the vulnerabilities of the corporate sector to economic shocks, raising questions about debt sustainability and viability of investment projects. A combination of restrictive monetary conditions, slowing economic prospects and higher leverage leads banks to tighten lending standards, causing credit spreads to widen. Rising funding costs and the inability to roll over debt further exacerbate stress in the corporate sector, leading to higher default rates. The ensuing recession leads to deleveraging, a new cycle of monetary easing, and the beginning of a new credit cycle.
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1See for example Estrella and Mishkin (1996) and Estrella and Trubin (2006). Moreover, Rudebusch and Williams (2009) document the enduring feature of this phenomenon over time, and provide evidence that simple yield curve-based forecasts of recessions outperform subjective forecasts from the Survey of Professional Forecasters.
2The credit impulse refers to the change in credit growth, and it is found to be highly correlated with GDP growth (see Biggs et al (2009)).