Developing a Leading Indicator of the Credit Cycle
We investigate the usefulness of our macro framework from an investment standpoint, testing its ability to predict turning points in the credit cycle. Our objective is to determine, on a quarterly basis, which stage of the cycle we are in, and to predict the occurrence of the next regime. We take the perspective of an investor with a long-term investment horizon and a bias to be long credit over government bonds, therefore earning the credit risk premium over time. In other words, we are not concerned about short-term fluctuations in credit spreads. Instead, we are interested in avoiding “the end of the credit cycle” (i.e., the third stage), a regime in which credit markets are likely to experience large and persistent drawdowns, underperforming government bonds.
Using our proprietary model, we develop a probability-based leading indicator of the credit cycle. This indicator, illustrated in the chart below, can be interpreted as the probability that credit markets will experience significant spread widening in the near future, associated to deteriorating macro fundamentals.
Overall, the model performed well in anticipating the major credit events experienced since 1989, namely the two credit crises of 1998-2001 and 2007-2008, with the indicator rising sharply a few quarters ahead of the actual widening in spreads. Similarly, our probability measure dropped rapidly towards the end of such episodes, signaling the increased likelihood of a recovery in credit markets. The model missed the spread widening that occurred between the second half of 2011 and the first half of 2012, when our probability estimate rose to only 20%. We do not find this surprising, since market turbulence over that period was caused by the European sovereign debt crisis, and not by U.S. macro credit fundamentals. Therefore, an interpretation of our signal at the time would have likely suggested a buying opportunity. Similarly, the indicator did not anticipate the credit turbulence that began in the second half of 2014, which was initially caused by stress in the high yield energy sector and later affected overall credit markets. However, the probability quickly rose to “warning” levels, settling between 30%-60% in the following four quarters, validating the price action in credit spreads, which experienced additional underperformance throughout 2015, particularly in high yield.
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